Most people can appreciate why an individual should purchase life insurance, to help provide important financial protection for loved ones. What many people don't realize is that life insurance also can play an important role in a business, particularly with regard to key employees.
Key employees are the foundation of a good business. They are owners, sales directors, corporate officers and others who are sources of leadership and profitability in a business, and who would be extremely difficult to replace, should they die unexpectedly.
Not only can insurance protection for a key employee help avert a potentially devastating blow to a business, many banks and venture firms insist on key employee insurance protection to help offset a loan. The following information can help you weigh the merits of purchasing insurance for the key employees in your company.
Cost-effective funding
The main purpose of insuring a key employee is to help the business get through potentially difficult times, should that individual die unexpectedly. Depending on who the key employee is, the business may need funds to hire and train replacements; replace an employee's contribution to profits; and maintain the confidence of clients and creditors.
While cash or loans can be used to help fund a plan to protect key employees, using life insurance to do so is a cost-effective alternative. Using cash can take essential money out of the day-to-day running of the business, and there is a danger that having accumulated cash savings at the business' disposal may prove too tempting when other expenses and needs arise.
Loans come with their own disadvantages, not the least of which is that the business will have to repay the loan, plus interest. And the company's credit may be adversely affected due to greater debt.
On the other hand, funding with life insurance is easy to administer, funds are available even if death occurs tomorrow, and although the premiums are not deductible, insurance proceeds at death are usually received income-tax free to the business.
When funding a key employee plan with life insurance, the business applies for a life insurance policy on the life of a key employee, naming itself as beneficiary of the policy. At the key employee's death, the employer receives the death benefit, usually income tax-free.
Access to credit
Many bankers would agree that life insurance is an important player in the credit game. Any time a lender is dealing with a business that has a key employee whose loss would disrupt the business, the lender will look to life insurance as a means of secondary collateral. This is especially true in situations involving a sole proprietorship or other closely held businesses.
In some cases, banks and venture capital companies make key person life insurance, with benefits assigned to the bank, part of the approval process. Lenders and venture capitalists may also look at the overall presence of life insurance as a sign of character and willingness to meet responsibilities.
In short, key person life insurance can help a business access credit in the following ways:
It can make a lender more willing to grant credit on a loan. With key person life insurance, the bank's risk may be reduced.
Because key person life insurance can be used as a form of collateral, it can open access to higher amounts of credit.
In some instances, it can result in a more competitive loan rate, boosting the borrower into the preferred customer ranking.
Types of insurance
If you are a business owner, chief financial officer or chief executive officer and you recognize the importance of insuring your human assets, your next question would be which type of insurance would be best for your circumstances. There are several options:
Term insurance: This type of insurance provides coverage for a specific period of time, usually 1, 5, 10 or 20 years. It is often used where protection needs are short-term or limited, or where a situation calls for a higher dollar amount of coverage. Term is often more appropriate when premium dollars are scarce, since it provides coverage for a lower immediate premium dollar than permanent insurance.
One major drawback to term insurance is that it is a pure cost product that does not provide cash value accumulation. Furthermore, if coverage is needed for more than a short period of time, the premium cost will increase over time. That means key person insurance funded by term insurance may eventually become cost prohibitive as the insured gets older.
Lastly, if your key employee does experience health problems and becomes uninsurable, you may not be able to buy coverage when you apply for it if your insurer requires an additional physical to renew your term coverage at the end of the term, or if you need additional underwriting to increase your company's coverage limits.
Permanent insurance: Many business owners and key executives prefer using permanent life insurance to fund key employee insurance, especially if they routinely depend on credit. Some of the major advantages of permanent life insurance are its permanence (provided premiums are paid), level premiums and availability of cash value.
Cash value life insurance removes the potential problem of insurability as an employee gets older, since once you purchase a policy, it is yours until you die. Premiums are usually locked in when you purchase a policy, so you don't have to worry about increasing premiums; the premium you pay at age 30 is the same one you pay at age 60.
Furthermore, cash value can be borrowed from the policy at a highly competitive rate and without publicity. Loans accrue interest and reduce the policy's death benefit, however.
Preserving your business
As a business owner, you recognize the importance of insuring your building, inventory and equipment. These assets are vital to the success of your company. It is equally important to consider insuring the person or people who are vital to the success of your business.
Lon G. Wilson is president of The Wilson Agency LLC in Anchorage. He can be reached at 907-277-1616.
