Question: My company purchased key man insurance on one of our executives several years ago. He recently left the business and we are stuck with the insurance. The premiums are expensive, so we don’t want to keep paying them, but we also don’t want to lose all the money we put into this coverage. Suggestions?
Answer: Companies often are urged to buy so-called key man (or key employee) insurance to protect them from losses if an employee who is invaluable to their business dies. Think about a founder who is strongly identified with the company’s success or a top salesperson who brings in the lion’s share of annual revenue: If that person were to suddenly expire, it’s likely the business would lose considerable income in the short term. The insurance is intended to compensate for that loss and help the business rebuild.
The problem is that often these key people leave the company or move to different positions where they are no longer so crucial. Then, as in your situation, the business is stuck paying expensive premiums on the policies. The alternative–dropping coverage–can be costly as well because so much has already been invested, especially if the policy has been held for many years.
Andrea Trudeau, executive vice president and founding principal of ABD Insurance and Financial Services in San Jose, says key employee policies were designed for an era when top executives typically stayed with one company for their entire careers. Often, the insurance policy built up cash value and, combined with a deferred compensation plan, provided a strong incentive for the employee not to leave and start his or her own business or go to work for a competitor.
Because fewer people spend their entire careers at one company these days, such policies are not as popular as they once were, she says. Since cash-value policies are costly, they are typically purchased by family business owners who want to make sure that retiring relatives get a “golden handshake” in the form of a hefty insurance policy and a payout of deferred compensation.
Recent changes in tax law as it pertains to these policies have also made them less desirable, Trudeau says. “Insuring a product innovator or someone who holds intellectual-property rights can be financially strapping,” particularly for a small company, she says. Licensing agreements are now negotiated with individuals who hold patents on technology or other products. “Venture-backed companies don’t want to pay insurance premiums. They want to put their money into [research and development].”
For companies that must insure an employee, she recommends low-cost term insurance that does not build up cash value and is held for as short a period of time as possible. Look for policies that can be transferred from one person to another, so that if one employee leaves, you can put her replacement on the policy.
For clients in your situation, Trudeau says she often recommends that they simply surrender policies that are no longer applicable and take a loss on the premiums they have paid already. The problem with that strategy is that some policies have surrender charges that force the policyholder to keep up with premiums for a set term or else pay a fee. If your key person policy has a surrender fee, look into transferring ownership of the policy to the insured person and let him or her decide what to do with it. “You don’t want to throw good money after bad and keep paying,” she says.
Rather than lose the money you have put into the policy, another option you might explore is something called a life settlement. Basically, this involves selling the policy to a third-party business for some fraction of its value. That business holds the policy, continues making premium payments on it, and collects the benefit once the insured person dies.
The older and sicker the insured person, the more money you are likely to get for the policy on the life settlement market, says William Scott Page, president and chief executive of the Lifeline Program, based in Atlanta. A typical purchaser on the life settlement market would pay your company between 10 percent and 60 percent of the death benefit, Page says. Obviously, the person you’ve insured must approve such a transaction.
Life settlements are a relatively new innovation and not well-known. Legislation that governs this practice varies by state, so check with your state and see what options are available to you if you’d like to pursue it. More information is available from the Life Insurance Settlement Association.