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Key-Executive’s Coverage – Need, Scope and Plan Mechanics

Extract: “Challenges of life insurance marketing – business applications” by Rizwan Ahmed Farid, 2010

The Need for Key Executive Coverage

The primary function of life insurance is to indemnify or offset the economic loss that comes with death or disability of an individual. Businessmen are usually aware of this function, in particular of how life insurance indemnifies a family for the loss of a breadwinner.  The Key Executive Coverage story is a similar protection story. In this instance, however, it is the business that stands to be indemnified against loss.

Businessmen also accept without question the wisdom of insuring material assets against loss. They insure their material assets against perils of the sea, fires, riots, thefts, burglary, accidents, piracy, terrorism, or third party liabilities, etc. However in view of the following, protection against loss of human life, i.e. life insurance on the key persons may be a far more vital need:

 

  1. A fire loss may never occur but death is inevitable.
  2. The odds of loss of pecuniary human life value are considerably greater than that of loss from fire. It has been estimated that chances of death of key persons is fourteen times greater at age 45 than chances of a building being destroyed by a fire. This increases to 17 times at age 50 and 23 times at age 55.[1]
  3. A great majority of insured property and goods are never damaged by fire, accident, or marine hazards, whereas one out of three persons die while gainfully employed with consequent loss to their business organization.
  4. Average of fire losses probably does not exceed 10% of the property value insured as against the 100% loss that is suffered on the death of key personnel.
  5. There are greater odds that a young executive will die before age 65 than a senior executive who is close to retirement. Also, the chance of at least one death before age 65 increases sharply when there are more than one key executive on board. The following table illustrates these odds:

 

Odds of death before Age 65[2]

Expressed as Number of Chances out of 1000

One Key-person

Two Key-persons

Three Key-persons

Age

Chances

Age

Chances

Age

Chances

30

190

30-30

344

30-30-30

469

35

185

35-35

336

35-35-35

459

40

179

40-40

325

40-40-40

446

45

169

45-45

309

45-45-45

425

50

152

50-50

282

50-50-50

391

55

124

55-55

233

55-55-55

329

30-35

340

30-35-40

458

35-40

331

35-40-45

444

45-50

295

40-45-50

421

50-55

258

45-50-55

383

 

The loss of a key executive through death is likely to have a more severe adverse impact for the business than if a business property were destroyed by fire. The latter may be rebuilt and the new property may possibly even be an improvement over the older one; more efficient and sounder, representing the latest in design, technology and engineering developments. But can we say that the same is true for a new manager hired to replace a deceased key-executive? – Only if, and probably not until, the replacement becomes familiar with the duties and problems of the job and acts profitably.

Success in business is rarely accidental. It is achieved through planned and deliberate action by men & women, who have the drive to develop high quality products, aggressively seek out customers, and in general attempt to make life tough for competitors. Buildings, machines, materials and money do not make a business unless turned into merchandise by people of executive and technical abilities. Remove the key personnel and the business will most definitely suffer.

Who are the Key Executives?

Key persons are found in all types of organizations, new and old, large and small, incorporated or not, capital intensive or service oriented. However, the need for Key-Executive Coverage is not the same for all businesses.  The adverse impact on the business for the loss of a key person will be minimal when the business:

  1. Has a sufficient liquid fund to cope with emergencies
  2. Can borrow money on its own name without a personal guarantee of any of its owners
  3. Spreads its management responsibilities among a number of individuals, and
  4. Has a well organized staff and management training program

The need for key person coverage is great when:

  1. Liquid surplus to meet emergencies is virtually nonexistent
  2. Business loans cannot be negotiated without the personal guarantee of one or more of its owners
  3. Management of the firm rests in the hands of a chosen few who are dominating factors from the standpoint of either ownership or management or both
  4. A few individual are doing the work of many, and
  5. There is no well thought out job role and management training program to groom and develop back-up management support

The key persons in any business are those persons whose loss by reason of death or disability would cause the business a serious financial loss. They are also those employees who are important enough to the business to merit a continuation of their salaries during the period of disability to an amount beyond the usual sick leave arrangements established as the personnel policy of the company.

Key Executives fall into many classes. Top executives, sole proprietors, partners and directors of private or public companies are obvious examples. Less obvious but often equally important are departmental heads, the company secretary or accountant, planning, design and erection engineers, research workers, supply, production, sales and customer services managers, a personal assistant or secretary. In fact any individual who will be costly to replace because:

 

  1. Finding and attracting replacement personnel costs money
  2. Training new personnel will take time and money
  3. Efficiency in the department that lost a key person will sag sharply while a replacement is being trained
  4. Inexperience and mistakes of the replacement until he attains the skill and expertise of the deceased will also cost money

Active business owners are a company’s most valuable human capital. It is usually the combined talents and efforts of these persons that make the business a success. If one of these business owners were to die, the smooth working of the team would be disrupted. The death of a business owner or co-owner can have various other side effects on the business such as:

 

  1. Withdrawal or restriction of financial assistance from banks and other creditors who may be concerned about the company’s future
  2. Slowing down of the business due to customers’ concern about the future of its services and products
  3. Loss of customers who utilize the company’s services or products because of their relationship with the deceased
  4. Loss of other key executives to competitors because of fears for the company’s future progress and prosperity
  5. Dissolution of the business or partner-ship in the absence of a buy-sell agreement

It is easy to see that a business could suffer serious financial blows, including dissolution unless provisions are made to offset such monetary losses including the possibility of liquidation that may result from the death of key person.

The U.S. Court of Appeals in a case involving key executive stated[3]

“What corporate purpose could be considered more essential than Key-man insurance? The business that insures its buildings and machinery and automobiles from every possible hazard can hardly be expected to exercise less care in protecting itself against the loss of two of its most vital assets managerial skill and experience.”

Monitory Valuation of Key Persons

Determining the insurable value of a key person is rarely subject to any precise formula. In actual practice, the value is established in an arbitrary fashion, essentially by guesswork. However, the values arrived at can be an “educated guess” if careful consideration is given to several factors:

 

  1. What would it cost to replace the key executive with another person of equivalent talent and experience?
  2. What portion of the company’s profit is traceable to the man in question?
  3. How much investment would be lost if the key person passes away today?
  4. How much loss is the company willing to insure?

As to a specific method for assessing the economic worth of a key person, a number of alternatives are available.

One relatively simple method for the valuation of the pecuniary value of a breadwinner to his or her family works out as follows:

  1. Estimate the person’s average annual earnings over his or her working life
  2. Estimate the income tax and cost of maintaining him/her-self
  3. Determine the person’s life expectancy or the number of years to retirement, whichever is earlier
  4. Select a reasonable rate of interest at which future earnings may be discounted
  5. Calculate net earning cash flows for each future point in time by deducting the results from step 2 with those obtained in Step 1
  6. Determine the present value of these results over the period determined in Step 3 by discounting for survival and the rate of interest selected in 4
  7. The result is the value of human life

In a firm or a private company an objective approach can also be used to arrive at a meaningful figure. Assume that a business has three key persons whose contributions are approximately equivalent. Assume further that it would take 4 years for a replacement to acquire the key person’s managerial expertise. Finally assume that 15% is a reasonable rate of the return on the owners’ equity which is Rupees five million. The monitory value of the key executives can be worked out as follows:

 

Annual net earnings (four years’ average)

Rs.5,100,000

Less: Estimated replacement salaries for key executives’ routine duties

Rs.3,600,000

Less: Earnings on net worth of Rs.5,000,000/- at 15%

Rs.750,000

Annual earnings attributable to managerial expertise (3 persons)

Rs.750,000

Portion attributable to each key executive (1/3)

Rs.250,000

Value of each key employee (replacement needs four years                              to acquire managerial expertise)         

Rs.1,000,000

 

To indemnify itself for the expected monitory loss in the event of death or disability of any of these key person’s services the business would need to purchase three policies, for an amount of Rs. 1,000,000 each, on the lives of each of its key executives.

Mechanics of the Plan

Key Executive Insurance is life insurance on the lives of key persons in a business for an amount sufficient to offset the estimated loss that may occur in the event of death of those persons.

The Employer is the applicant for and owner of the insurance policy. They pay the premium and are the beneficiaries to the policy money. For example, we have Mr. Muhammad Amin, Factory Manager, the person who is most actively engaged in making the business profitable and whose technical ability and character has enabled the organization to obtain an A-1 credit rating. He is insured by the Employer for Rs.5,000,000. Upon his death the insurer will pay this amount to the Employer who will then use it to undertake steps to reduce the negative impact of the Mr. Amin’s death for the business.

The above example is a simple solution to a serious problem but one that could be vital for the success and continuity of a business. To recap, the most effective way to offset the loss of a key person is cash compensation to the employer and Key Executive Insurance does just that. Proceeds from Key Executive Insurance make it possible for the business to:

  1. Protect the surviving owners and executives from losing control of the business to outsiders
  2. Absorb the financial shock of sudden death of the key person so that the business may continue and avoid the possibility of financial chaos and forced sale
  3. Cover losses during the readjustment period during which time the replacement is being groomed and the firm is stabilizing
  4. Attract quality personnel, comparable to the deceased employee, to join the business
  5. Retain good credit standing of the company
  6. Retire loans, mortgages bonds, and stock, etc
  7. Continue with the current dividend schedule despite sustaining temporary operating losses
  8. Carry out plans for expansion and development
  9. Provide a pension or financial assistance to the deceased’s widow or children
  10. Provide deferred compensation or pension for the disabled key executive

In addition, the Key Executive Insurance plan serves usefully in ways other than indemnifying the business in the event of the key person’s death. The growing cash values of insurance builds an ideal reserve, every rupee of which strengthens the financial position of the business. Further, life insurance reserves are not subject to the same demand on the part of the minority shareholders for payment as dividends as are the reserves that are written as cash in the books of account/financial reports.

Insurable Interest

Various business relationships justify the taking of insurance policies by one person on the life of another. An employer may insure the life of an employee, the employee the life of the employer, a partner the life of a co-partner, a partnership the life of each partner, a company the life of key persons, a creditor the life of the debtor, etc.

Cost

The premium varies depending upon age, health and occupation of the key person as well as the type of desired cover (death, disability, retirement benefits, etc).

Tax Treatment

Generally Key Executive Insurance premiums are not deductible as a business expense where the business is directly or indirectly a beneficiary of the plan. The primary reason for non-deductibility is that the premiums are treated as capital investment rather than business expense. Likewise the proceeds received through the death of the Key Executive Insurance should not attract Income Tax.

However, if the business organization is able to establish that the premium paid for the key person insurance is an expenditure laid out wholly and exclusively for the business needs, the Income Tax Officer may approve the premium as expense under Section 20 of the Income Tax Ordinance 2001 {23 (xviii) of the repealed Income Tax Ordinance 1979} The eligibility however, depends on the facts of each case.



[1] “Business Insurance”, May, 1982, Research & Review Services of America, Unit 14, p.1.

[2] LIC Mortality Table 94-96 Assured Lives (Ultimate)

[3] Diamond Life Bulletins Agent Service Reports from, Unanimous Decisions, U.S. Court of Appeals, 3rd Circuit, 189F, 2nd, 230 (1951).

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