UNDERSTANDING THE NEED FOR KEY EMPLOYEE INSURANCE

Let's say your family company includes a great group of employees and business couldn't be better. You know that much of your success is due to one or two people with skills and personalities that are hard to match. Suppose they were injured and out of work for a while? Or worse, suppose they died unexpectedly? Would your company survive?

When an owner or a key employee of a closely held business dies or becomes disabled, there are five separate groups that are concerned about the immediate financial health and future of the operation:

• Employees who are anxious about the continuation of their jobs.

• Creditors who are worried about the earning power of the business and its future ability to repay any outstanding debts.

• Suppliers who fear losing a customer.

• Customers who wonder about the ability of the business to continue furnishing its products and services. Will they need to look elsewhere to satisfy their needs?

• Tax collectors may also be interested, but only to the extent that there are sufficient funds to pay various taxes, even if it means the ultimate sacrifice of the business.

One way to help soften the impact of these concerns is with key employee life and disability "buy out" insurance policies.

Typically, your business purchases a life insurance policy on a key employee, pays the premiums, and is the beneficiary in the event of the employee's death. As the owner of the policy, the business may surrender it, borrow against it, and use either the cash value or death benefits as it sees fit.

To determine how much insurance you need, it may be difficult putting a dollar value on a key employee's economic worth. Although there are no rules or formulas to follow, several possible methods to determine the insurance amount may be used. 

The appropriate level of coverage might be the cost of recruiting and training an adequate replacement. Alternatively, the insurance amount might be the key employee's annual salary times the number of years a newly hired replacement might take to reach a similar skill level. Finally, you might consider the key employee's value in terms of company profits. The level of insurance coverage might then be tied to any anticipated profit or loss.

Key Employee Disability Insurance

The death of a key employee isn't the only threat to your business. Suppose a key employee is injured, or becomes ill, and is out of work for an extended period. Disability insurance on such a key employee is another way you can protect your business against financial loss.

A critical part of key employee disability insurance policies is the definition of disability. Usually, these policies define it as the inability of an employee to perform his or her normal job duties due to injury or illness. As with life insurance, your business buys a disability insurance policy on the employee, pays the premiums, and is named the beneficiary. If the employee becomes disabled, the insurance coverage pays monthly disability benefits to your business. These benefits can equal a certain percentage of the key employee's monthly salary, up to either a maximum monthly limit or 100% of their salary. The benefits can be used to pay business operating expenses and cover the expenses of finding a temporary or permanent replacement for the key employee.

The policies typically offer elimination periods (the waiting period between the disability and when the benefits begin) ranging from 30 to 365 days. Depending on the policy, your business may receive benefits for 6 to 18 months, which would be long enough to allow the key employee to return to work or for the company to replace the person.

Planning ahead can prevent a family business from having to liquidate to raise cash and can assure families, employers, creditors, suppliers, and customers that the future of the business is not in jeopardy. By purchasing life and disability "buy out" insurance on owners and key employees, a business lets everyone know the financial condition of the operation will remain sound, no matter what happens.