Key Person Insurance

Succession Planning: Key person insurance is important element

When a company’s survival relies heavily on one individual or group, it’s wise to prepare for a day when those “key people” might be taken from the picture by death or disability. To prepare for such unexpected circumstances, many executives include key person insurance as an important element of their company’s succession planning. These policies can provide much-needed cash to compensate for the loss of an owner, key salesperson, someone with specific technical or creative knowledge, or anyone who drives profits to the bottom line.

Key person insurance is not an insurance product, but a specific reason for buying life insurance, says Bob Guina, regional insurance consultant in Comerica Bank’s Insurance Group.

“It’s a life insurance policy, no more, no less. But instead of buying it for your family, it’s purchased and owned by a company and the company is the beneficiary,” he adds. A key person insurance policy can be purchased from an insurance company or an independent agent.

Expenses resulting from the loss of a vital employee can be covered with key person insurance. If a business must urgently replace a top-performing salesperson to prevent a key customer from being wooed away by the competition, the policy pays for costs related to the replacement, i.e., a headhunter’s commission or signing bonus. If the client walks, the insurance can provide cash flow to help recover the loss until a new client is found.

“Sometimes a lending institution will require a company to insure its key people to cover the loan, especially as they get older,” Guina says. “If you have a 70-plus-year-old business owner who’s still active and involved in the business and he wants to borrow several million dollars, the bank wants to feel confident that it’s going to get paid back.”

Eliminating debt is one of the most important and practical benefits of key person insurance.

“If you erase the debt, it makes it easier for the business to maintain profitability and survive,” Guina says. On the other hand, if the surviving spouse of a sole owner chooses to sell the business, a company with little or no debt could fetch a higher price.

Key person insurance does not cover all financial losses stemming from the exit of an essential employee – but only the fixed amount specified in the policy. Guina recommends that companies consider debt, a multiple of the individual’s salary (commonly three times the amount), and the anticipated costs of replacement when estimating how much coverage is needed.

Most life insurance products can be applied to key person insurance, including term life, universal life, and whole life policies. Term life policies are typically less expensive and provide coverage for periods as short as one year and up to 30 years. Universal life combines relatively low cost with flexible premiums and insured amounts that can adapt to changing business conditions. Whole life insurance is in effect for the life of the insured and charges higher premiums earlier on. Whole life products have cash values from which a company can borrow or use as collateral for a loan. Company executives should consult with a qualified insurance agent to determine the best policies for their particular situation.

Guina says CFO’s should consider the impact of key person insurance when formulating their company’s tax strategy.

“If structured properly, it should be a tax-free benefit to the company,” he says. “The value of a life insurance policy is often included in one’s estate for purposes of calculating federal estate tax, but the coverage can be structured to avoid that tax as well.” A joint estate can have a value of $10.5 million ($5.25 million each for husband and wife) before it’s subject to federal estate tax, “but it’s really easy to be a middle market business and go over that number,” Guina says.

“Having key person insurance can make the difference between a business thriving or just surviving,” he adds. “When trouble strikes, cash is king. As a business owner, if you lose one of your key people it creates a financial crunch on the business. Having cash on hand in the form of a life insurance death or disability benefit really solves a lot of problems.”

To learn more about key person insurance, contact Bob Guina at 313-584-4482 or rguina@comerica.com.

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