Life insurance content: “What are the reasons businesses purchase life insurance?”

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There are many planning issues that businesses must consider:  general management issues about defining target markets, staffing, and supplier contracts are vital to business success.  Other planning matters include which corporate form to choose, how to capitalize the business (i.e. debt vs equity), as well as operating agreement details.  Finally, there are issues that are unique to family-owned businesses or firms contemplating mergers and acquisitions, divestitures, or outright sales.  There are roles for life insurance to address certain business issues, and I spent some time reviewing the 2009 Chartered Life Underwriter (CLU) text from The American College:  Planning for Business Owners and Professionals.

Three primary areas where life insurance matters to the planning of a business venture include business succession, business continuation, and employee recruitment/retention.

Business succession

As stated in the above referenced CLU text, “[t]he death of a shareholder of a closely held corporation does not terminate the legal structure of the business.  However, the actual business operations of the corporation may be dramatically affected.”  As a consequence of this, business ventures should include buy-sell agreements which address scenarios where ownership interests are potentially transferred, and rules around how those transfers may (or may not) occur.

It is vital to deliberately consider the implications of specific buy-sell language, including details including, but not limited to, valuation, timing, financing, and operation.  Among the numerous important decisions is whether to enter into a redemption agreement or a cross-purchase agreement.  These decisions inform the need for, amount, and type of life insurance.

Advice should be solicited from legal and tax counsel on implications (e.g. ownership structure of applicable policies and implications to estate tax calculations, as well as step-up in basis.)

Business continuation

Much like there are strategies to value the financial impact of the loss of a breadwinner in a family context, there are strategies to value the financial impact of the loss of a key employee in an organization due to premature death.  The unexpected loss of a top sales professional may lead to lost client relationships and revenue;  The unexpected loss of a CFO with unique skills and experiences may require an extensive global search and incremental consulting fees;  The unexpected loss of a leader may result in staff defections, leading to increased operating expense and decreased margins and profit.  Valuing the risk of these unexpected losses may lead to decisions by businesses to purchase life insurance

Employee recruitment/retention

Compensation of key employees is a matter of great importance to most businesses.  As stated in the above mentioned CLU text, “[w]hile the main focus of this textbook is on maximizing the benefits of business operations to their owners, the compensation scheme for the business’ nonowner-employees should not be overlooked...  The success of the closely held business often hinges on the continued services of [key] employees…  Quite often a key employee accepts employment or leaves a firm based on the fringe benefits that are provided in addition to the cash compensation.”

In addition to salary, short-term and long-term incentives, executives often evaluate the benefits offered:  health, prescription, dental, vision, life and disability benefits are often considered alongside retirement plans and other perqs.  There are important rules in offering these types of benefits, which are governed by the federal tax code, as well as federal and state law.  “The federal tax and labor statutes contain numerous complex nondiscrimination rules that provide that most employee benefit plans must be nondiscriminatory in eligibility for participation and/or benefit levels.”

Conclusion

The financial protection created for a business through the purchase of life insurance is important.  Based upon a review of the risks and priorities of an organization, it is possible, if not likely, that life insurance purchases may be suitable to address one (or more) of the issues articulated above.