Managing Key Person Risk

Insurance supports business continuity after an untimely death

Business owners often put risk management measures in place to protect their companies from almost every hazard except the one that could prove to be the most devastating—their own premature death or that of other key players within their organization.

For some, purchasing key person life insurance is the most efficient way to cover that exposure. Key person coverage can be achieved by a business owning an individual policy or an institutionally priced corporate-owned life insurance (COLI) product, a kind of key person insurance category that covers multiple individuals.

Common uses of key person life insurance

Key person coverage is commonly used to:

  • Provide liquidity to give the company time to get through possible financial operating challenges associated with the loss of a key player, such as the primary revenue generator or top product development talent
  • Enable the company to buy out the ownership interest of the deceased key person as provided for in a prior agreement
  • Retire debt guaranteed by the deceased business owner

Key person coverage can help meet additional needs; a long-term disability or long-term care rider would provide assets when a key player is incapacitated and dies or when the key person is recovering from an illness or temporary disability.

As more insurance carriers compete to sell key person products, look for more flexible and creative policy features.

Tax implications

When the company is also the beneficiary of a key person life insurance policy, the insurance premium payments are not tax deductible. Assuming the employee provides consent after receiving notice of the policy, the government doesn't tax the death benefit itself, if the company collects one.

Guaranteed issue?

As with other forms of group coverage, depending upon the number of lives to be covered, insurers might sell key person coverage on a guaranteed issue basis, meaning no one is denied coverage due to medical risk considerations.

Ten to 15 lives is a common minimum threshold for this purpose. However, whether guaranteed issue policies are more competitively priced than underwritten policies will depend upon the risk profiles of the individuals whose lives are to be insured.

Even with guaranteed issue policies, the prospective insureds will need to answer a few simple questions, such as whether they have missed more than several days of work over the past year due to a serious illness.

Also, when the group is too small to be eligible for guaranteed issue coverage, some carriers offer a middle ground solution known as "simplified issue." Under that system, insurers ask more medical questions but do not require an actual medical exam.

Term or permanent?

Business owners must make a fundamental decision when purchasing key person coverage. Do you buy term or permanent coverage? You'll need to weigh many of the same pros and cons as when you're buying personal life insurance coverage. It essentially boils down to whether you're seeking a financial risk management solution exclusively or whether you also are willing to pay more for some additional financial benefits on top of the insurance protection.

At first glance, term insurance often looks attractive—since you're buying pure insurance protection, the premiums tend to be lower. For companies with a limited budget, term insurance may be a good fit, especially if the company only needs the coverage for a limited period of time.

The benefits of permanent coverage include a tax-efficient asset accumulation (cash value build-up) strategy, the ability to lock down insurance coverage perpetually once the pure insurance coverage component of the whole life coverage is fully funded and another source of credit, since you can borrow against the policy's cash value.

Permanent life policies also offer the ability to book the cash value on the corporate balance sheet. That, in turn, could enable a company to present a stronger risk profile to an outside lender, if borrowing outside the policy made more sense, or help satisfy performance bonding requirements. Also, growth in the cash value of key person policies is recorded on the company's income statement.

Finally, with variable permanent life policies (meaning they have an investment component), policy owners receive the benefit of professional asset management services.

IRS requirements

In 2006, the government addressed some abusive practices related to key person insurance arrangements by adding new requirements to the Internal Revenue Code. Today, in order for key person insurance to pass muster with the IRS, the corporate owner of the policies must: 

  • Provide written notification to the employees of the planned insurance coverage
  • Inform the covered employee the company is the beneficiary of the policy
  • Receive written consent for the coverage from the employees being insured
  • File an annual form (8925) with the IRS

However, these requirements do not apply if the insureds are company directors, owners of at least 5% of the company during the preceding year, among the five highest paid officers or among the highest paid 35% of all employees.

Another requirement, basically a given in a typical scenario, is that the company have an insurable interest in the key person whose life is insured. That means the policy owner would sustain an economic loss if the person being insured dies.

Assessing coverage needs

Pertinent questions to ask when determining the amount of key person coverage to buy include:

  • Who are the most "key" people in the company and what impact would their sudden death have on corporate operations, both in severity and duration?
  • If any of the key people are shareholders whose shares the company would need to buy upon their death, how large is that obligation likely to be?
  • Should the company continue to insure the lives of key people after they retire, for the sake of ultimately recouping the company's cumulative investment in the policy?
  • How attractive would key person coverage be as a form of compensation for key employees? (One type of policy known as a split-dollar plan enables the covered individual to pay for some of the coverage but retain some rights to direct a portion of the policy death benefit to designated beneficiaries other than the corporation.)
  • Is the cost of the coverage in line with the protection it provides?

Periodic plan review

After you implement key person life insurance coverage, it's important to review it periodically to ensure the level and kind of protection secured continues to meet your needs. Questions to ask include:

  • Have new key people joined the company—people whose deaths would bring significant financial harm to the enterprise? Have others ascended to "key person" roles?
  • Has the value of the company—and thus its stock—risen to a level such that the death benefit for covered shareholders would no longer be sufficient to enable the company to honor its stock repurchase obligations to benefit the heirs of the deceased?
  • Has the health status of any of the key persons covered changed enough to alter your original risk calculation regarding the amount of coverage to purchase?
  • Has the market for key person life insurance products changed, opening the door to less expensive coverage or insurance contracts with attractive new features?

Alternative strategies

Managing risks—whether it's the possibility of a fire, a devastating storm, a serious worksite injury, litigation or the death of a key person—is a basic component of running a successful business. Life insurance can be a flexible and tax-efficient tool to hedge against the financial risks associated with the loss of a business owner or key employee.

However, life insurance is only one way to plan for the loss of a key employee. Whether you implement a side fund for savings, use other insurance such as disability insurance or incorporate a combination of these ideas, making sure your company has the liquidity it needs to move forward is vital to the future of the company and its employees.

For additional information on using life insurance to protect your business, consult with your tax advisor as well as the insurance professionals at BB&T.

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