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Education, analysis, and advice for uncertain times

 

INSURANCE
 
BUSINESS LIFE INSURANCE

 

There are basically two categories of business life insurance.

The first type, known as :"key man" insurance, looks at the adverse impact death or disablement can cause a firm and the kind of cash infusion from a life insurance policy that would help to sustain the business as a going concern until it can make up for its loss in leadership, contacts, and expertise.

The second type of business life insurance, which typically overlaps the first one, and is often the most important of the two, looks at the adverse impact of death on the ownership structure the firm and how messy estate settlement issues can destroy the business as a going concern. This category is often known as "buy-sell" agreement insurance.

WHO NEEDS BUSINESS LIFE INSURANCE?

If you are involved in a business that is medium to large in size, and has liquid, publicly traded stock, there is a good chance your firm can survive without business life insurance. (Ironically, these types of businesses tend to have more life insurance than small businesses, because they can better afford to carry it as an executive perk. It is the old story, often those who need insurance the most can least afford it).

On the other hand, if you are involved in a sole proprietorship, any kind of partnership, or any kind of closely held (private) corporation, where the transfer in ownership is generally illiquid, you may have no idea what kind of horrible mess and tragic loss in business value may lie ahead if you do not get some kind of business life insurance.

Typically anyone who is important enough to be considered a "key man" also has a significant ownership in the firm. The best possible time to value his or her (I will stick with "his" to keep it simple) contribution to the firm, and to fully value his ownership stake, is while he is still alive and contibuting towards the firm's success.

The absolute worst time to scrounge up resources equivalent to his contribution, or to figure out what others will pay to buy out his stake, is after he is dead. From a negotiation viewpoint, once a key man dies, his estate is usually over a barrel, and the amount anyone will pay for his stake drops precipitously. In many cases, without a buy-sell agreement in place a head of time for a majority shareholder, the personal representative of the deceased is forced to liquidate the business at fire sale prices to settle the estate. This can not only cannabalize or waste a major portion of the value of the business as a going concern, but also severely damage the income-earning ability of many employees who must now go elsewhere for a job.

 

A CLOSER LOOK AT KEY MAN INSURANCE:

The beneficiary of key man insurance is the business entity itself, which upon death or disablement of the insured receives a healthy boost to its working capital. The business itself pays the premiums on the key man insurance policy. The premiums are not tax deductable, however the proceeds are tax free.

Many banks require key man insurance on a business loan, since the loss of a key person can affect a company’s credit rating and its ultimate ability to repay, particularly if the individual made personal bank guarantees. The bank may require at least enough insurance to pay off the loan. In other instances, estimating the life insurance requirement may be based on such factors as the additional working capital required to locate, hire, and train a replacement or adopt a different business strategy. It may also factor in a loss in revenues netted against such recurring expenses as taxes, rent, advertising, and telecommunications bills.

A CLOSER LOOK AT BUY-SELL BUSINESS INSURANCE:

Buy-sell insurance has some interesting and unique properties. In many ways it reminds me of health insurance. In the case of the latter, once you get a bad disease and now know that you absolutely should have got the insurance in the first place, it is too late. No insurance company in its right mind will give you a policy. Obviously there is no longer any risk to insure against. The only kinds of entities that deal with 100% probability of misfortune are charities, government welfare programs, friends and family, and the like.

While a stakeholder in a business is alive, he and other stakeholders have a mutual interest in valuing each other's shares fully. Put differently, if I devalue my partner's shares, I in effect devalue my own share in case I die first. So everyone is motivated to be a gentleman and be magnanamus and value each other's shares fully just in case they happen to die first.

That is the time to get everything in writing, and set in place with insurance contracts.

Once a partner dies, everything tends to flip-flop among among surviving partners or shareholders. Now, like vultures, they have a strong interest to try to pick up the deceased's stake as cheaply as possible. The inheritor of the deceased's stake may be a distraught widow with screaming kids who is in a very poor position to negotiate. It might also be handled by a personal representative of the deceased's estate who is required by the laws of certain states to liquidate in the absence of a will or insurance contract, regardless of underlying business conditions.

The buy-sell contract fixes a contractual value in which the insurance policy will buy out an ownership stake upon death. This value can be periodically adjusted by people who control a business, such as once a year, or upon ownership changes, or in view of economic changes in America (such as the onset of hyperinflation).

There are many considerations involved in deciding the appropriate level of buy-sell insurance:
...a) Type of business. Is this a sole proprietorship, partnership, limited partnership, closely held corporation, or corporation with publicly traded stock? The more illiquid the ownership position, the greater the need for insurance.
...b) Degree of ownership. Majority or minority interests? Whoever survives as business owners, they have a strong interest in knocking down their costs in acquiring the stake of the deceased in the business.
...c) Succession. Does the estate of the deceased want to get cashed out, or transfer shares to an heir? Typically heirs lack the ability, experience, or inclination to successfully step in and run a business.
...d) The firm's existing resources. What resources could a firm borrow against or liquidate to pay off the deceased's stake? Most businesses have problems surviving amidst America's current economic woes, much less accumulating cash reserves to effect a buy-out upon an untimely death.
...e) Estate planning of the deceased. Without a will or insurance contract, the personal representative is required by the laws of certain states to liquidate the ownership share, regardless of the underlying condition of the business.



 



 

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Flag carried by the 3rd Maryland Regiment at the Battle of Cowpens, S. Carolina, 1781

© William Fox. Sometimes William Fox offers viewpoints that are not necessarily his own to provide additional perspectives.