Key people, key protection - 'key person' life insurance could save a business

Nation's Business, March, 1993 by John S. DeMott

Here's a type of life-insurance policy that could keep your business going.

When Walt Thompson died of a rare blood disease in 1990, the Thompson Machine company could have fallen into disarray, rudderless without its founder

Instead, the story has a happier ending. Thompson had the foresight to buy about $750,000 worth of insurance that not only provided for his widow, Agnes, but also assured the survival of Thompson Machine, an Altoona, Pa., firm that makes specialized metal parts and has sales of about $1 million a year.

This so-called "key person" insurance, which had been known as "key man" before women started moving into upper managerial ranks, allowed Thompson Machine to award stock in itself to two key people, Buck Lightner and Tim Drenning, who became 49 percent owners of the company.

The proceeds from the insurance also enabled the company to raise the two executives' salaries to a level that could persuade them not to jump to another employer.

With their talent and experience, plus the savvy of Thompson's daughter, Tracey, 21, as both office manager and secretary-treasurer, the company has begun thinking about expanding into new markets.

What key-person insurance does is "indemnify the business in the event an important person dies," says Eric Hall of Grange Insurance, in Columbus, Ohio. And it's what Tom Sullivan, senior counsel to the advanced sales force of Connecticut Mutual Life Insurance, calls "the simplest of business sales because it's so analogous to what we call income replacement for a family."

Ellen Begleiter, head of estate, business, and financial planning at The Guardian, a major insurer of small businesses, in New York City, says, "It's insurance that's necessary" for small firms. "It can mean the difference between survival and bankruptcy."

Yet for all its ability to deliver money when and where it's needed, key-person insurance is not carried by an estimated 75 percent of small businesses. One possible reason is that many business owners don't know about such coverage. Another possible reason is price. Some owners, forced by law to carry several other types of insurance, see key-person coverage as a frill.

Still another reason, says agent Allan Hancock, who had sold the insurance to Thompson Machine, is that businesses resist buying key-person insurance for the same reason that many people-- business owners or not--neglect to buy life insurance: It means coming to grips with one's mortality, "and people don't like to do that."

Key-person insurance actually is more of a way of selling insurance than a distinct type of insurance. No such policy has "key person" stamped on its cover. Instead, forms of ordinary whole and term life are mixed to produce a package that's sold by direct writers and independent agents to businesses and business executives as key-person insurance.

Says Steve Shaw, this year's president of the National Association of Life Underwriters: "Some people get all caught up in labeling. In reality, all you're doing is buying money for future delivery,"

In its simplest form, key-person coverage pays cash to the company, which is usually the policy beneficiary, when a key person dies or becomes disabled. The person covered could be the founder, as in the case of Walt Thompson, or it could be anyone critical to the business--a patent-generating engineer, a partner who brings business to a law firm, a movie star, even an administrative assistant who happens to know everything about how an office works.

Insurance agent Hancock, for example, carries a $20,000 policy on Jill Hannah, his personal assistant of 17 years. "She knows my clients," he says. "She can deal with 90 percent of the things that happen here."

Key-person insurance can be structured in numerous ways, sometimes under the term of "business continuation planning," to fund deferred-compensation arrangements or buyout arrangements between partners, for example. Bayshore Metals of San Francisco, with annual sales of about $2 million, has two $500,000 policies on its partners, Ron Marchand and Chuck Warner, for that purpose, although Marchand is in the process of buying out Warner.

Another purpose is to pay off company debt. This is one of the least complex forms of key-person insurance--a policy much like mortgage insurance-that pays a loan from an important creditor if the boss dies. Lenders like to see such protection in place because it's good collateral and, says Shaw, "it shows good planning."

Face values of key-person insurance can begin at $50,000 and go as high as $15 million--or even higher Reebok International, for example, paid a $513,601 premium in 1991 on a $50 million life insurance policy for Paul Fireman, chairman and CEO, and his wife, Phyllis.

Premiums, like those for any insurance, can vary considerably. One form of a $1 million key-person policy for a 44-year-old executive in good health can start at $2,800 a year but rise to $16,500 annually after 20 years. Another policy starts at a stiff $16,180 and runs for 10 years, but rapidly mounting cash values effectively wipe out costs to the policyholder and net a profit of $6,407.