People are often a business’s most valuable asset. Individuals build relationships with customers and possess in-depth knowledge of the company’s technology, trade secrets and strategic plans. Chances are that some of your borrowers rely so heavily on key people — owners, salespeople or executives — that a sudden, unexpected loss of those individuals would impair the company’s credit standing or ability to service debt.
Identify these borrowers and request key person life insurance policy as a form of collateral, especially if they’re applying for additional financing. If they’ve already purchased coverage, review whether circumstances have changed, requiring policy modifications or cancellations.
Key person candidates
Not every business needs key person life insurance coverage. It’s most commonly purchased by professional services firms, small family-owned businesses and startups that depend on the day-to-day involvement of a founder or an employee with in-depth knowledge of the company’s technology. But key people also exist in the world of retail, manufacturing and construction, especially when the founder is unable or unwilling to relinquish control.
Any business without a viable succession plan could potentially be a candidate for key person life insurance policy. Ask borrowers what steps they’ve taken to prepare for another leader to take over the reins. Examples include identifying, mentoring and training the next generation of management. If current employees lack the skills and experience to take control, a borrower might need to consider finding outside replacement candidates.
Types of key person life insurance coverage
Once you’ve identified which borrowers might benefit from a key person life insurance policy, help them find the right insurance products and coverage levels. Term policies last for a specified number of years, typically five to 20. Whole (or permanent) policies — which are generally more expensive than term policies — provide coverage as long as premiums are paid and gradually build up cash surrender value. This value appears on a borrower’s balance sheet and may be drawn on, if the borrower needs working capital.
When a company has more than one key person, it may be cost-effective to consider a first-to-die policy. This type of coverage pays out death benefits when the first key person dies. Once it expires, the company can decide whether it needs additional key person policies on the lives of the remaining shareholders.
The cost of key person insurance also depends on the key person’s health, age and medical history, as well as the desired death benefit. When they’re budgeting for key person premiums, remind borrowers that payments to their insurers generally aren’t tax deductible. On the flip side, death benefits generally aren’t included in the company’s taxable income when they’re received.
In terms of coverage limits, insurers may quote a rule-of-thumb of eight to 10 times the key person’s annual salary. But every business will have different cash flow needs when a key person unexpectedly dies. A more accurate estimate comes from evaluating lost income (or value), as well as the costs of finding and training a suitable replacement. Additionally, some key person death benefits may be used to buy a deceased owner’s stock.
In general, the business pays for, owns and is the designated beneficiary of key person insurance. To attract and retain talent, however, some borrowers use key person insurance to supplement their compensation plans. In other words, the company purchases more coverage than it needs and then splits death benefits between the company and the key person’s family. If the key person retires at a predetermined age, the company may assign ownership of the policy, including any cash surrender value, to the key person as a perk.
Key person life insurance coverage that fits
The unexpected loss of a key person can impair a borrower’s credit standing and debt service — or, worse, force a sale or liquidation of the business. Key person insurance provides short-term cash flow until the business can recover.
But a policy should also evolve as business conditions change. For example, less coverage may be needed as successors are trained or key people leave the company. Or more coverage may be needed as the value of the business grows. Financial advisors can help borrowers estimate adequate coverage based on an objective assessment of projected cash flow needs and the value of the business.
Key questions about key person insurance life insurance policies
Once you’ve identified the borrowers that might benefit from key person insurance, provide this list of questions to help them get the right amount of coverage:
- How much would it cost to find, train and compensate a replacement candidate?
- How much net profit would the company temporarily lose until the key person is replaced?
- Would the loss of a key person adversely affect relationships with suppliers, customers and lenders, resulting in a temporary setback or a permanent reduction in the company’s value?
- Does the company have a buy-sell agreement and, if so, how much will the company need to purchase for the deceased owner’s interest?
- Should key person insurance be part of the individual’s compensation package, and, if so, should benefits be assignable upon retirement?
- Have conditions changed that might affect key person coverage, such as a change in the organization chart or the retirement of a key individual?
Have questions about a key person life insurance policy? Or, are you looking for more information on our commercial lender services, including SBA valuation? Contact Marvin Willis, CPA at 404-874-6244 or fill out our form for more information.