If one of your borrowers suddenly lost a key person, how would it affect their productivity, profits and ability to service debt? For many small businesses, the death or long-term disability of an owner or key employee spells disaster. Some businesses eventually recover after finding and training a replacement, but others are so reliant on key people that they’re forced to close shop.
When the unexpected occurs, businesses and lenders can offset their losses with key person life and disability insurance proceeds. Many loan covenants require family businesses and startups to purchase key person insurance, but you may want to require it of other companies as well. Even though most key persons are owners, other employees — such as CFOs, production managers or IT specialists — may warrant coverage.
The mechanics
Typically, borrowers pay non–tax deductible key person insurance premiums. But payouts to beneficiaries — which may include the company or the financial institution, but rarely the key person or that individual’s estate — are made tax-free.
The key person must be notified that the company is taking out a policy and be able to prove insurability. Before issuing a key person life policy, most insurers also require companies to implement a formal succession plan, which minimizes their reliance on key people and maps out a contingency plan.
The price tag
Monthly insurance premiums are a function of the key person’s age, health and medical history, as well as the type of insurance product. Term coverage, which typically expires in 10 to 20 years, generally is less expensive than permanent insurance.
When a company has more than one key individual, a “first-to-die” policy can save money. After one key person dies, the “first-to-die” policy expires. Most insurers will permit the company to purchase a new policy on the surviving key people without proving insurability again.
Adequate coverage
The amount of desired coverage also affects the cost of key person insurance. Financial professionals can help borrowers estimate coverage needs. Factors to consider include the value of the business, the individual’s contribution to the bottom line and replacement compensation.
In addition to covering outstanding debt principal, insurance proceeds may need to cover short-term operating cash flow deficits, replacement costs, liquidation costs, and/or shareholder buyouts in accordance with the company’s buy-sell agreement, if applicable.