Insurance on the life of a "Key Person" is a critical (often times required) element in a merger or an acquisition transaction. Many times, the ongoing viability of the business enterprise rests entirely in the hands of the senior executives. These executives may exclusively manage key relationships or may possess unique knowledge of a particular process or technology. The loss of one of these "Key People" could cripple the business. This exposure is magnified during times of business transition or high growth.
Life insurance is designed to provide money to help overcome financial obstacles. Life insurance is a versatile financial tool that pays cash to a beneficiary after the insured’s death or that pays cash to a policy owner while the insured is alive. One of life insurance’s biggest advantages is its flexibility. Policies can provide benefits for a limited number of years or for the lifetime of the insured. Premium amounts can be large or small. Benefits can be received during life or paid to beneficiaries after death. When properly handled, policy distributions can be income tax-free.
The three most common uses of life insurance by a business are:
- Key Person Coverage - Life insurance is frequently used to reimburse the business for the revenue, profits and relationships that can be lost with a key employee’s death. Life insurance can also provide funds to pay for locating, hiring and training a qualified replacement.
- Business Succession - If there is a business succession plan in place, it needs to be backed-up by money so a deceased owner’s interest can be purchased. Life insurance is an efficient way to secure the dollars needed to keep the promises in the agreement.
- Key Executive Selective Benefits - Companies today are challenged with keeping key executives with their business and giving them incentives to do their best. There are many, unique, non-qualified solutions that can recognize a key executive’s hard work and make it satisfying to continue. Life insurance policies are regularly considered as a vehicle to fund these types of benefits.
The life insurance acquisition process, especially for higher limits of coverage ($5,000,000 and higher) is more time consuming than most purchasers expect. The typical acquisition process takes 75 to 90 days; this can be a challenge in a situation where M & A deals call for life insurance coverage at the time of a transaction’s funding. The underwriting process focuses on two main areas; medical underwriting and financial underwriting.
- Medical underwriting - Routinely, the proposed insured for a life insurance policy is required to complete:
- Blood & Urine test
- Brief medical exam - blood pressure, etc.
- Telephone “health interview”
- EKG (usually at $2,000,000 or higher)
- Treadmill “Stress Test” (usually at $5,000,000 or higher)
Additionally, the individual proposed for the insurance will be asked to provide names and addresses of treating physicians so that historical medical records can be obtained for review. There is a tremendous range of medical underwriting outcomes. Generally speaking, a “Preferred” outcome is the most favorable (lowest rates) with higher priced classifications assigned to individuals with health concerns and / or complications.
- Financial underwriting - Financial documentation is requested for all life insurance applications. For coverage in amounts less than $1,000,000, the information is simply provided via answers on the application. For amounts in excess of $1,000,000, financial documentation requirements increase.
Like many financial institutions, insurance companies have ratios that they work within when determining eligibility for coverage. Since one of the primary purposes of “Key Man” insurance is the replacement of a key executive, the total compensation package of the executive is a factor that is considered. While not “etched in stone,” insurance companies are most comfortable when coverage amounts are within “10 times” the total compensation package of the insured executive. For amounts in excess of this guideline, greater financial documentation and additional justification will be requested.
The life insurance acquisition process, especially for higher limits of coverage ($5,000,000 and higher) is more time consuming than most purchasers expect. The typical acquisition process takes 75 to 90 days; this can be a challenge in a situation where M & A deals call for life insurance coverage at the time of a transaction’s funding. The underwriting process focuses on two main areas; medical underwriting and financial underwriting.
Key Person life insurance policies must be established with an owner and a beneficiary that has an “insurable interest” in the insured. Simply defined, there must be a demonstrable reason why coverage is needed. If an “economic exposure” cannot be justified, the acquisition of insurance could be very difficult. As stated above, financial documentation will generally be requested to further substantiate the “amount” of the insurable interest.
If a company involved in a merger or an acquisition “inherits” a Key Person policy on an executive, there are a number of options that exist for the coverage:
- Policies can be maintained if the executive is still “Key” to the organization. However, since most Key Person insurance is funded with term life insurance, the competitiveness of a policy should always be reviewed.
- If an executive is no longer “Key” to an organization, a policy can be surrendered / cancelled. If term life insurance, a surrender should trigger a refund of any unused premium from the current policy year. If cash value insurance, a policy surrender should generate a return of the policy cash value (net of any surrender charges) to the policy owner (generally the company).
- As opposed to surrendering a policy, it can be transferred to the Key Executive for personal planning. Few issues exist if the policy is a term insurance policy. If the policy is a cash value policy, there will be tax ramifications in the transfer of the cash value to the Executive.
- # An additional option exists in a situation where an insured executive has experienced a significant, negative change of health. If this fact-pattern exists, it is possible that a policy can be “purchased” via a lifetime settlement. A large, secondary market has developed for the acquisition of a life insurance policy (for cash) where the insured has a limited life expectancy.
There are numerous, competitive life insurance companies. The ultimate selection of a life insurance company is made with consideration given to the type of policy desired, premium rates, company financial ratings, the health of the insured, reinsurance markets (with very large policies) and other factors. A true insurance broker skilled in working on large insurance transactions should manage this process on behalf of the client acquiring the coverage.
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Case Study #1 |
Privately held company with 300+ restaurants; receiving major expansion financing. $25,000,000 of corporate-owned term life insurance was secured on the life of the CEO at the request of the investor group. |
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Case Study #2 |
The company acquiring its competitor chose to protect its investment by insuring the Chief Technology Officer (CTO) of the acquired company. A $10,000,000 life insurance policy on the life of the CTO was purchased because it was determined that the Key individual possessed a unique skill and knowledge of the particular technology that the acquiring company was seeking. |
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Case Study #3 |
The CEO of the acquired company is insured for $5,000,000 to protect the interests of the investment firm. It was determined that the CEO controlled and maintained key business relationships that would be compromised if the CEO passed away during the first few years after the business acquisition.
A company going through a merger or acquisition transaction is especially vulnerable to the loss of a key executive. While life insurance cannot “replace” a deceased executive, the money provided by a life insurance contract can be the difference between the continuance and the demise of the company. |
