Protecting Your Human Capital: Is ‘Key Person’ Insurance Right for Your Small Business?By Susan Caminiti.
When Micron Technology CEO Steve Appleton, 51, died in a plane crash on Feb. 3, the company not only lost its long-time leader, it experienced a stock price drop amid concerns about who would take the helm at the memory chip maker.
The company’s board of directors swiftly announced that COO D. Mark Durcan would replace Appleton. But what if—as is so often the case with small businesses—there isn’t another qualified person waiting in the wings should tragedy strike at the top?
If that’s the case, so-called key person insurance can help soften the blow. This type of policy protects a company in case of an untimely death of a critical manager or employee; in the case of a small business, that usually means the owner or founder and a few top people. The company is the beneficiary of the policy and pays the premiums, so should this key person die, the business gets the insurance proceeds.
“The purpose of key person insurance is to help the company survive the blow of losing the individual who makes the business work,” says Loretta L. Worters, vice president of the Insurance Information Institute based in New York City. “The company can use the proceeds for expenses until it can find a replacement person, or if necessary, buy out the heirs of the deceased. It gives a company breathing room to make the next step when they’ve lost this key person.”
PQ_KeyMan.jpgAccording to Worters, a small business needs key person coverage when:
The business is a professional services firm and key employees can’t be replaced right away. For example, a law firm or medical office cannot replace an experienced attorney or doctor with a recent graduate.
The business cannot continue in the event of a loss of a particular person. Worters cites producer and director Tyler Perry of Tyler Perry Productions. “Without him,” she says, “there is no business.”
Business continuity is a concern. If there are partners in a company and one dies, the deceased’s shares will likely go to his or her heirs. Do they know the business? Are they interested in being involved in running the company? If not, the proceeds from key person insurance can be used to buy out their stake in the company.
Future financing is possible. Venture capitalists, banks, and other lenders often require key person insurance for start-up companies. In the event of a death, the insurance proceeds can be arranged to go directly to the venture capitalists to protect their investment.
The business owners are between the ages of 30 and 55. It’s human nature for young people to ignore their mortality and this lack of planning can hurt a company in the case of a tragedy, Worters says. Further, she adds, “Entrepreneurs are, by nature, risk-takers.” For instance, Appleton of Micron, was piloting a small experimental plane when he crashed and died—and had been in previous plane crashes as well. (The company’s financial filings with the SEC make no mention of key person insurance for Appleton.)
Despite all these reasons, less than one quarter of small business owners surveyed by the National Association of Insurance Commissioners have key person policies in place. Yet 71 percent say that they are “very dependent” on one or two key people for their company’s success. This disconnect stems from a belief that the insurance is prohibitively expensive or difficult to obtain. Not so, says Robert Garner, executive vice president of wealth management at CBIZ Insurance Services in Baltimore. “Most insurance companies will cover one to two times a person’s annual compensation,” he says.
The majority of key person policies are basic, inexpensive term coverage that spans the numbers of years until the person reaches retirement age—65 in most companies. The actual cost, says Garner, depends on the health, age, lifestyle (does the person like to fly small, experimental planes or bungee jump, for instance) and medical history of the person being insured. Permanent insurance—or a policy that accumulates a cash value—is more expensive to obtain, but allows a company to borrow from it with tax-free loans.
Carl Belt Jr., president of The Belt Group Inc., a construction company based in Cumberland, Maryland, has key person insurance policies for 10 employees and shareholders. The first policy was taken out on his father, who started the company in 1962. “By the time my Dad died in the 1970s, I was running the company and the proceeds from the insurance helped me buy out his stake in the business,” Belt recalls. “Basically, I was paying my mother for his share. It would have been difficult for me to do that without the insurance.”
Over the years, Belt’s business has expanded to about 250 employees and now includes roofing and paving businesses. He’s also taken on several shareholders. With nearly $60 million a year in revenues, he says key person insurance for his CFO, head estimator, and the heads of his roofing and paving businesses, seemed like a good idea. “If anything happened to these people it would affect the business, no doubt,” he says.
Belt says in the event of a death, proceeds from the policies would be used to buy out the ownership stake of his shareholders, and then finance the search for a replacement. Since he elected to buy policies that accumulate a cash value that he can tap into if needed, he views the insurance as a sort of “forced savings account.” Still he says, “You never want to think about anything bad happening to these people you depend on, but you have to be ready just in case.”