Risk management for businesses or families involves two main concepts: risk retention and risk transfer. Today, we will discuss these two key risk issues for businesses. The success of every closely held business is generally based on the leadership at the top. So what if something tragic happens to the leader or key persons of your business such as an unexpected death or disability? Many businesses may choose to ignore these issues and merely “retain” the risk. Others may choose to “transfer” the risk generally by the purchase of insurance on the key persons. Business succession planning and funding buy-sell agreements through insurance and key person coverage are just a few methods used to “transfer” the risk. These types of policies are different than traditional life insurance policies because business insurance can either be owned by the business or the owners of the company.
Each owner must determine how they want ownership to transfer in the event another owner becomes ill to the point of disability, passes away or merely retires. The loss of a key employee may jeopardize the viability of a business resulting in the loss of customers and revenue. Creating and implementing a plan is the best method to ensure a smooth transition of ownership transfers due to a tragic or unexpected event.
FUNDING OF BUY-SELL AGREEMENTS
A formal succession plan often involves a written buy-sell agreement and funding that option either by using cash reserves, future earnings from the business or more commonly with life insurance. If life insurance is not utilized, a simple method is merely an installment payment to the heirs from the business or the successor. A common method used is insuring the life of an owner whereby the company is the owner and beneficiary of the policy, pays the annual premiums and receives the death benefit. The life insurance proceeds are then used in whole or in part to fund the buy sell agreement and pay the heirs for the decedent’s interest in the business.
Another life insurance method is through a “cross-purchase” agreement whereby each owner insures the life of the other business owner. Upon the death of the insured, the surviving business owner receives the death benefit proceeds to be used to fund the buyout of the deceased owner. Generally speaking, insurance premiums are non-deductible and the death benefit proceeds are non-taxable.
KEY PERSON COVERAGE
Key person coverage is simply life insurance the business owns on key employees. In small businesses, key persons are typically owners and key employees who are critical to the ongoing success of the business. Again, the company is the owner and beneficiary of the policy and pays the premiums. However, the company retains the death benefit proceeds to be used as it sees fit. The key employee does not have any rights to the policy, but must allow the business to purchase life insurance on their person. The death benefit is often used to assist the business in training a new staff member to cover the key person’s responsibilities, pay off debts or close the business.
DISABILITY BUY-OUT COVERAGE
This type of coverage is insurance that’s is generally used for a permanent long term disability of an owner whereby the company pays the premiums and receives the monthly benefits to fund a buy-out agreement between the company and disabled owner. The premiums may or may not be deductible.
OTHER TYPES OF COVERAGE
Risk management for businesses also includes general and product liability, property and casualty, and health insurance for employees. These insurance coverages are an integral part of the safety net necessary for all successful businesses wishing to “transfer” risk.
For some owners of closely held businesses, risk management can be very simple. While in others, a written agreement may be necessary to properly assist in the exchange of ownership due to the death or disability of an owner or key employee. The planning aspect should be coordinated with a group of professional advisors including the company’s CPA, attorney and insurance consultant.
Next time: Financial Planning Basics- Part V. Estate Planning and Life Insurance: