Companies around the world insure their assets with business insurance. This is designed to protect from financial losses arising from property and equipment damage or destruction, such as in the case of certain natural disasters. Protecting key employees, however, is a commonly-overlooked area for many firms. Most people know that successful businesses are made up of more than just buildings and equipment, and the employees are a major contributor to the success or failure of a given business operation. In fact, it can be argued that employees are among a company’s most valuable assets.
To fill the gap, protecting both the company’s physical assets and its most valuable employees, key employee indemnification insurance policies are a great solution. In this two-part article series, we will investigate what may happen to a company if critical personnel should die, and the solution for protecting against financial losses associated with that death.
When Key Employees are Lost
Businesses are comprised of far more than physical assets like buildings, equipment, product inventory, and vehicles. Employees form the core of any business operation. As some of the most valuable assets a company can have, certain employees with extensive experience or unique talents tend to stand out. These are called “key employees”, and such employees can account for much of the success a business enjoys. Key employees include managers, department leaders, and directors, but are not limited to these categories. Such employees may be:
What happens when key employees were to die unexpectedly? First, profits may suffer. Businesses may also have to face significant expenses in recruiting and training suitable replacements for the lost employee(s). There both tangible and intangible losses a company may experience, including:
When a valued employee central to the operation is lost, it is clear that companies may face significant hurdles, both financially as well as in relationships with other employees or business partners. It is also clear that a logical move would be for a company to protect itself against these losses. How can companies protect themselves and their financial interests?
Key Employee Indemnification Insurance
A potential solution for protecting against the tangible financial losses of an unexpected death of critical employees is that of life insurance, specifically key employee indemnification insurance. In simple terms, this is an insurance policy purchased by a business to compensate that business for financial losses that would arise from the death or long-term disability of important company employees. This type of insurance is sometimes referred to as key man or key person insurance.
A key employee indemnification policy is typically a life insurance policy purchased on any employee who is considered a critical part of the business operation. Proceeds from such a policy can be used for a number of purposes, including:
There are many advantages in having these policies on critical employees. When a key employee dies unexpectedly or becomes permanently disabled and can no longer fulfill his or her duties, insurance proceeds work to maintain business continuity and to offset any potential financial hurdles the company may experience.
We’ve learned what key employee indemnification insurance is and how it can protect a company from financial loss when a critical employee dies or becomes permanently disabled. We’ve also talked about how the proceeds may be used for a wide range of purposes. In our next article in this two-part series, we will go over the components of key employee indemnification policies and how they work, including tax implications. Finally, we will provide a summary of the benefits these financial protection solutions provide to companies that rely on their most valued employees.
In our first article about business expense protection, we discussed the odds of a business owner becoming disabled at some point in his or her career. We also talked about typical business overhead expenses and the potential funding sources that can be used to pay for these expenses while the owner is disabled. We also covered three scenarios that impact the future of a given business. Finally, we introduced the concept of business overhead expense protection as the sole means of providing reliable funding for the business as the owner recovers from a disability.
Business Overhead Expense Protection Explained
Business owners may opt to purchase a business overhead expense protection policy. This is a type of insurance product available from many business-oriented insurers. This method of protection is the only reliable source of funds to pay for overhead expenses, especially as compared to the alternatives of draining business and personal savings accounts, conducting a forced liquidation of the business, or taking out a loan.
There are significant advantages associated with this type of business insurance. After purchasing such a policy, the business owner can pay overhead expenses during the recovery period from a short-term disability. This can ensure that when recovery is complete, the business will still be a going concern and can resume its operation when the owner returns.
In addition to providing a reliable means of paying for overhead expenses when the owner becomes disabled, this insurance protection can also accomplish:
In simple terms, business overhead expense protection insurance is a relatively affordable and efficient means of providing funds needed to keep the company running, covering expenses like rent, salaries, utility costs, and mortgages, only to name a few of the many overhead expenses a typical business faces.
How Does a Business Overhead Expense Protection Policy Work?
To understand a business overhead expense policy, it is useful to know its makeup and how it is configured. The owner of the business is insured by the policy, which is in turn owned by the owner or the business. For sole proprietorships, the owner is the policy owner as well. In businesses that are arranged as corporations or partnerships, the business itself is listed as the policy owner. Premiums paid to the policy are paid by the policy owner (individual or business). If the business owner becomes disabled as defined in the specific language of the insurance policy, the benefits are paid directly to the policy owner (the beneficiary of the policy).
If the owner becomes disabled, benefits covering all taxable business overhead expenses are paid to the policy owner. In general, these insurance policies provide coverage for up to two years of disability, which typically gives the business owner sufficient time to recover and to return to operation. If the disability is longer than the term in the policy, this two-year coverage window is usually sufficient for the owner to arrange an orderly and equitable business liquidation or sale. So, in other words, such a policy covers overhead expenses and buys the time needed to recover without rushing into a situation that may impact the future of the business operation.
As discussed earlier, any overhead expense benefits paid from the policy are reportable as income and are subject to taxation. However, business expenses actually paid by the benefits are eligible for tax deductions. Typically, there will be no additional income tax payable, eliminating the tax burden on the disabled business owner. The only potential tax implication is if benefits paid by the policy exceed overhead expenses. The overage may need to have tax paid on it as income.
Finally, premiums paid by the policy owner are fully tax deductible. This tax advantage is regardless of the type of business entity, including sole proprietorships, partnerships, LLCs, or corporations.
Final Words on Business Overhead Expense Protection
After evaluating the potential for a business to be impacted by the owner’s short-term or long-term disability, it is clear that there are few easy answers. Business owners face significant odds in becoming disabled for 90 days or longer at some point before they reach the age of 65. Faced with a disability, the business owner and his or her family must scramble to make several very tough decisions; should they sell the business? Liquidate its assets? Try to maintain the business until the owner can return? It can be a difficult and confusing situation for even the savviest business professional.
Business overhead expense protection stands as the logical and economical solution to these difficult situations. As a form of business insurance policy, overhead expense protection insurance allows the business to continue, paying overhead expenses as it goes along and allowing the business owner to recover without the financial worries associated with the company’s operation. Business insurance agencies can help company owners find the right policy to meet their specific needs, regardless of business type.
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The decision to liquidate a family-owned business is not one to be taken lightly. The death of a business owner, or a situation where the owner becomes disabled and is no longer able to manage business operations, can cause family members to feel pressure to divest themselves of business assets. This can have long-ranging negative effects.
In the first part of our series on business liquidation insurance, we discussed two potential scenarios, that of a forced liquidation or of a planned business liquidation. We also talked about some of the difficult decisions surviving family members must make regarding the future of the business or its sale. In this part, we will introduce the concept of business liquidation insurance, particularly the role of life insurance in buying time to dispose of the business assets in an advantageous manner.
Considerations on Business Liquidation Insurance
There are many types of insurance, including policies that protect business assets as well as life insurance policies designed to provide income after death or disability of the policy owner. For the purposes of this discussion, life insurance is the focus for business liquidation purposes.
As mentioned in our previous installment, a planned (or unplanned) business liquidation requires that the owner’s executor and/or family members need time to address the sale of the business, helping it to command a sale price that is fair and adequate. Rushing into a quick sale of a business after the owner dies or becomes disabled, or being forced into such a situation due to the lack of funds after the owner dies, can result in significant loss of value. Life insurance may be the solution that buys time.
In the Event of a Business Owner Death
When the liquidation of a business and its assets become the sole course of action when a business owner dies, life insurance can provide the financial liquidity needed to plan the sale of the business. Without adequate funds, the family of the deceased or his or her executor may be forced into a sale, creating a potential financial disaster for surviving family members. Life insurance can be put to use in several ways during a planned business liquidation:
In simple terms, only life insurance policies can protect a family’s financial future in the case of a business liquidation. The guaranteed funds from such a policy can stave off a forced liquidation, allowing family members or executors the time needed to make smart and advantageous decisions on the sale. Of course, the guarantee is dependent on the claims-paying ability of the policyholder and the insurer itself.
Insurance in the Event of Business Owner Disability
The disability of a business owner can take many forms. An owner may become disabled for a short period of time or may face a long-term or even permanent disability. It goes without saying that any disability severely impacts the owner’s ability to conduct business, and in many cases may result in the need to liquefy the business and its assets.
When a disability occurs, a business owner and his or her family will want time to make tough decisions about the future of business operations. As in the case of an owner death, life insurance buys critical time for the planned liquidation to occur.
For a short-term disability, it can be useful to consider the following scenario: imagine the owner wishes to keep the company operating while he or she recuperates and to avoid a forced business liquidation. As might be expected, business expenses continue to accrue, and the need for an income is paramount. Two special types of insurance policy may be valuable in providing continuity of business interests. In the first, business overhead expense insurance can be used to reimburse costs incurred by the business owner during a short-term disability. Disability income insurance is similar in that these policies are designed to provide income, especially lost income due to the disability.
Longer-term disability considerations are also similar. Loss of income can mean a forced business liquidation, and funds are needed to put an advantageous liquidation plan into place. In the case when a business owner is sick for an extended period of time and unable to work, disability income insurance serves as an income replacement. This helps provide the time needed to make decisions about the future of the business, such as who it will be sold to, its fair sale value, and when the sale may take place.
An Action Checklist for Business Liquidation Insurance
Now that we’ve learned the value of life insurance in buying the time needed to liquefy a business, an action plan can be useful. In the following checklist, there are three components: implementing a life insurance plan, implementing a disability insurance plan, and conducting an annual review of policy coverage.
Implementing a Life Insurance Plan:
Implementing a Disability Insurance Plan:
Smart business owners know that circumstances change. Because of these changes, it is critical to review insurance coverage, policy premiums, and specific terms on an annual basis. The guidance of a qualified insurance agent can be greatly beneficial during this review, helping business owners make the financial decisions needed to ensure a smooth business liquidation if the situation arises.
There are many factors that influence the success or failure of a business. The costs of doing business, including manufacturing, distribution, and marketing of products or services are some of these financial factors. Overhead costs, such as rents, employee salaries, and utilities can also eat into the profitability of a given company.
If the company’s owner and/or key employees should die unexpectedly or become disabled and cannot work, overhead costs continue to pile up. Business operating expenses may be protected using a specialized form of insurance that helps to cover overhead costs in cases of disability or loss of the owner. These policies provide money when it is needed, and premiums are generally considered tax-deductible business expenses. Business overhead expense insurance policies protect a company from forced liquidation, helping to preserve the hard work and market share the company has developed over its time in operation. In this guide, we will introduce business overhead protection plans and discuss options available to business owners.
Before delving into business overhead protection plans, it is useful to take a look at statistics associated with disability. The odds of a business owner becoming disabled for 90 days or longer before reaching the age of 65 is surprisingly high. If there is more than one owner, the odds increase dramatically. For example, a single business owner aged 30 has a 54% chance of becoming disabled for 90 days or longer. A business with 5 owners, all around the age of 30, shows a 98% chance of one of the owners becoming disabled.
The odds drop with age, but the numbers are still significant. Building on the example above, a single owner aged 55 has a 25% chance of a 90-day or longer disability. With 5 owners the same age, there is a 76% chance one of those owners will become disabled.
The length of disability is high as well. For disabilities lasting longer than 90 days, the average duration of the disability is approximately 2.2 years for a business owner aged 30. For a 55-year-old owner, the average duration of disability is right at 2.5 years. These numbers have serious implications for business operations.
How Will Business Overhead Expenses Be Paid?
In the case of a long-term disability or the death of one or more primary business owners, many companies struggle to pay for the day-to-day expenses associated with keeping the business running. Day-to-day expenses, or business overhead, consists of costs like:
These costs continue to stack up, even if the owner were to become disabled and cannot work. Of course, these expenses must continue to be paid, regardless of the circumstances. The business and its leaders have important decisions to make regarding the future of the business and its continued operation, especially when it comes to a long-term disability.
Alternatives in Cases of Owner Disability
When a business owner becomes disabled for a length of time, three potential scenarios as to the future of the business arise. Each scenario has its own advantages and disadvantages. The first is to sell the business, which can serve as a relatively viable alternative only if the current owner wishes to sell and can identify an interested party with the funds needed to complete the sale on favorable terms.
A business may liquidate – and, in fact, financial analysts refer to this scenario as a forced liquidation. The business may be disposed of rather quickly in this scenario, but the terms may not be favorable. The business may sell for a fraction of its true value, especially when contrasted to the value of the business if it was still operating with an eye to the future. Owners and family members may also rush into agreements before carefully evaluating the business operation and its intrinsic value.
Finally, remaining owners and family members may wish to maintain the business. This has advantages when the owner’s disability is considered to be a short-term situation; he or she can return when recovery is complete. Without a viable source of income, however, operating expenses pile up and the remaining alternative may end in a company sale or forced liquidation.
Funding Sources for Overhead Costs
Business expenses continue to accrue, even if a business owner is disabled. There are several potential sources of income to cover these expenses. As with the scenarios discussed above, there are strengths and weaknesses to each of these income sources – and most stand out as insufficiently reliable to ensure business continuity. Funding sources include:
Business and Personal Savings – smart business owners know that they need to create a savings plan to hedge against future circumstances. However, saving revenues can be a lengthy process. If a business owner were to set aside 10% of revenues each year, it may take 10 years or more to save one year’s worth of business revenue. Owners facing a long-term disability may consider dipping into personal savings to cover overhead costs, but this can create further financial instability and hamper the ability to pay for personally-related expenses.
Loans – a loan is an option, but finding a lender willing to fund a loan while the owner is disabled is difficult, at best.
Asset Liquidation – a business may opt to sell a portion of its assets, including equipment, inventory, properties, and vehicles. Again, this option is considered a forced or emergency liquidation. Selling assets can interfere with the continued operation, and it also lowers the value of the overall business.
Personal Disability Income – like personal savings, a business owner may attempt to cover operating expenses with this income source. However, the owner and his or her family’s expenses will still need to be covered, and using disability income for business means that it may create significant financial hurdles for the family.
There is only one reliable source of funds to pay for business overhead expenses. Referred to as business overhead expense protection, this funding source has many advantages over the alternatives. In our next article, we will go over the highlights of this source, helping business owners to make smart decisions about the future of their operations.