Life insurance is not just for people. Many companies benefit from buying life insurance for key employees as part of their business continuation and succession planning. Seven out of 10 small businesses surveyed by the National Association of Insurance Commissioners said they were very dependent on one or two people for their success (source). However, only two out of 10 had key person life insurance in place.
The emotional toll on family and family and the damage to the company’s morale are the most painful effects of an employee’s death. However, it also can be financially devastating. Including life insurance in your risk management planning is especially crucial for small and closely-held businesses.
To illustrate, imagine what would happen to a small biotech startup that is close to developing a new product if its top scientist — the only employee with a full understanding of the technology — were to die or be permanently disabled in an accident.
Creditors would probably get nervous about the company’s outstanding business loans, which could reduce the company’s ability to refinance or access more credit. The startup would need to invest considerable resources in hiring a new world-class researcher, and delays in the development of the product could wreck their cash flow. If the key employee is also a shareholder in the company, it may also result in large cash expenditures to buy out family members who inherit an interest in the business.
Even large corporations are vulnerable to losing key employees. Think of the impact the death of Paul Allen or Bill Gates would have had to Microsoft in the early days, or what would happen to the stock price of Berkshire Hathaway if they lost Warren Buffet.
The good news is there are life and disability insurance options available to help small businesses plan for such tragedies. Let’s briefly look at five popular insurance solutions that small businesses can consider.
- Key Employee Life Insurance.
- Key Employee Disability Insurance.
- Supplemental Disability Insurance.
- Disability Business Reducing Term Insurance.
- Business Overhead Expense Insurance.
Here is a summary of how each solution works and what are the benefits to the company.
Key Employee Life Insurance
Key employee life insurance provides businesses with cash when a key employee dies. The company is the owner and beneficiary of the life insurance policy and pays the premiums after-tax dollars. If permanent life insurance is used, the policy cash values are accessible to the company through withdrawals and loans and can show up as a cash reserve the business’ balance sheet. If there are several key employees in your business, you can sometimes save money by buying a first-to-die life insurance policy. This type of policy covers the first of the group of employees that dies. Once that happens, another employee becomes eligible for coverage. This option provides coverage to several employees, but the premiums reflect that only one person at a time is receiving the coverage.
Key Employee Disability Insurance
This option is similar to the key employee life insurance solution but covers for disability instead. If a key employer is disabled for longer than the preselected waiting period (e.g., 90 days), the company receives monthly payments to mitigate the loss of the employee. Some businesses offer their employees disability protection as a benefit, and the funds from this policy can be used to fund these contractual obligations. The payments are also made by the company with after-tax dollars, but the benefits are tax-free.
Business Overhead Expense Insurance
Business overhead expense insurance is an option that allows businesses to own the policy and pay for it with tax-deductible dollars. The policy will pay for practically any business expenses for the preselected period (typically up to three years). The money received from this policy is taxable. However, the overhead expenses that are paid with this money are still tax-deductible. This solution is typically only used by smaller businesses. It can be a particularly good option for sole proprietors who have to continue paying overhead expenses even if they can’t work.
Supplemental Disability Insurance
Some businesses offer supplemental disability insurance as a benefit to employees. The premiums are tax-deductible, and the employees own the policies. This solution ensures the key employee and her family are taken care of without requiring the business to make hard decisions, such as whether or not an employee is disabled or how much to pay for rehab expenses.
Disability Business Reducing Term Insurance
Another option for businesses who want to purchase coverage for disability of a key employee is disability business reducing term insurance. The policy works in a similar way to standard supplemental disability insurance but is used to repay the principal and interest on a business loan. The company uses after-tax premium payments, but the benefits are tax-free.
What is next?
If you are the owner of a small business that depends on one or two key people, consider whether a life or disability life insurance policy is a good option. Most small businesses rely on key employees and could benefit from some time type of key employee life or disability insurance.
Ask yourself how much it would cost to replace your key employees. What revenue would you lose? Would you lose hard-to-quantify benefits, such as valuable relationships in the industry or the community?
Business owners often like to say that people are the most important asset of their company. If that is the case in your business, it might make sense to insure your key workers.