The role of life insurance as a financial protection policy for families is well understood. Life insurance as a risk management tool designed to protect the value of the business, however, might not be as well known.
A company’s value, especially in small and mid-sized companies, can be tied to the owner or a single executive and their ability to manage the business. That makes protecting the business from their sudden demise or inability to work critical; otherwise, the company can’t continue to provide for the people who have come to rely on it.
“Small and mid-sized companies need a mechanism that helps them deal with the death or disability of shareholders and key individuals, both of which are foundational to the company’s ability to perform and maintain company value,” says Sean O’Connor, PA/WVA Middle Market Group Leader, Huntington Bank.
Smart Business spoke with O’Connor about life insurance, and how it can preserve company value in the event of the unexpected loss of a key individual.
Why is life insurance important for companies?
Business owners and key executives are a wealth of information in their organizations. But the size of their organization typically limits the size and depth of the management team, meaning there are fewer people with whom skills and organizational knowledge can be shared. That compartmentalization creates risk in a company. Life insurance, in this scenario, would serve as a safety net, replacing the monetary value of what that key person brings to the company while giving the company time to adjust and replace the person in the event he or she is unexpectedly lost.
Another common protective application of life insurance is in situations involving multiple shareholders. In the event that one shareholder dies, life insurance becomes a funding mechanism for the remaining ownership to purchase the deceased partner’s shares. Without this protection, the existing shareholders or the company may be forced to buy the shares with their own cash, depleting valuable liquidity unnecessarily.
Life insurance is also useful for risk mitigation. In some instances, a bank may require a company to have an insurance policy in place to cover the value of a loan to ensure it gets repaid if a critical member of the business passes away. That requirement is more common in early stage companies that don’t otherwise have the collateral to cover a loan.
In what ways can a corporate life insurance policy benefit larger companies?
The application of life insurance in a larger company is really more about the creation of an alternate funding mechanism. Businesses are looking for tools to attract, retain and reward key executives. One method is to set up nonqualified deferred compensation plans that trade enhanced retirement benefits for an executive’s commitment to the organization for a set number of years. A life insurance policy can be a method of funding that long-term obligation. This approach is appealing because it’s balance-sheet neutral and also offers a tax benefit.
Corporate-owned life insurance can be bought for a set number of people with no medical underwriting. Corporations also like that it doesn’t have any surrender charges.
What is important for companies to consider as they design people-centered risk management strategies?
Companies should work to identify and understand their most significant risks. It’s important that business owners take time to consider what could diminish the value of the business. To that end, it’s critical to determine who are the people driving operations and what is being done to protect the business should they become unavailable for whatever reason.
Organizations that have multiple shareholders should review the financial obligations that would arise in the event of the death of a shareholder, specifically whether any existing insurance is structured in a way that provides the remaining shareholders or the company with the cash to buy those shares.
It can be a hard discussion to have, but the company’s risk position in this regard should at least be reviewed every three to five years, or whenever there is a significant change to the business.
