Private Equity firms understand risk. Managing risk on all levels is a critical component to driving and protecting shareholder value. In today’s economy, human intellectual capital reigns supreme. Knowledge, relationships and creativity have replaced or enhanced property, plant and equipment in determining shareholder value. Intellectually rich companies tend to be highly dependent on the human capital of one or two key leaders that drive shareholder value. Virtually all corporations respond to the risk by securing Key Person Life Insurance. The greater risk is the exposure to a disabling injury or illness that prevents these leaders from executing their plan and completing their vision.

Statistically, the risk of disability during the working years is significantly higher than the risk of death. A 45-year-old executive is 3 ½ times more likely to suffer a disability lasting greater than 90 days than to die before age 65. In either event, the corporation faces significant loss. Why is it that less than 35% of all companies that secure key person life coverage, fail to purchase the corresponding key person disability coverage? In today’s competitive business environment, protecting the value of a star executive is more critical than ever. Using markets once reserved for elite athletes and entertainers, carriers such as Lloyd’s of London and other domestic niche market players have developed key person disability products designed to protect a company’s most critical assets. These specialty carriers have the ability to deliver disability benefits exceeding $100,000 per month and lump sum benefits to $50,000,000, allowing companies to insure those whose vision, knowledge and experience are critical to a business’s continued success.

Recent Case Studies:

• A Private Equity firm recently purchased a highly successful service company. The transaction was split in two parts. Part A. was a cash payment upon close of the investment paying nearly $10,000,000 to each partner, Part B. was a cash payment made to each shareholder over time based on certain performance targets. The acquisition agreement called for $10,000,000 of key person insurance on each owner. The intent of this provision was to secure Key Person Life Insurance, however, when the Private Equity firm understood the risk of disability was the greater exposure to the corporation, disability contracts of equal value we purchased to protect the firm.
• In order to expand a start up company, an entrepreneur of an international cosmetics company required additional capital. Three private equity investors were hesitant to release funds, as the success of the enterprise rested exclusively on the CEO’s extensive network of industry contacts. The investors required $3,000,000 of Key Person life and disability insurance, as a safeguard against the loss of their key executive. Since there was strong financial justification for the $3,000,000 limit, the underwriting process with respect to the Life exposure was straightforward, and the client had hundreds of Life companies and products to choose from. Utilizing a custom designed Key Person Disability Policy, a contract paying the corporation $50,000 per month for up to 12 months in the event the CEO became totally disabled was placed. If the executive were deemed permanently disabled after that period of time, the company would receive an additional $2,400,000 in one lump sum. Despite the fact that the start-up company had few tangible assets, underwriters were able to fund a trust with disability insurance, for the purpose of redeeming the investors’ shares in the event of the loss of the key executive. With this protection in place, the investors released the funds.
• A hedge fund recently launched a fund that required institutional investors to commit their capital to a 5-year "lock up" period. The fund received over $1.0 Billion in capital, which generated in excess of $10,000,000 in annual management fees. The investors could only liquidate their position under specific circumstances, which included the death or disability of the Fund Manager. The Hedge Fund quickly realized they had a significant exposure tied directly to their star Fund Manager. Specialty underwriters worked with the broker and Fund Executives to design a reducing key person disability contract which would pay the fund $50,000,000 at inception, reducing by $10,000,000 per year over a five year period. Coverage paid a lump sum benefit in the event the executive became totally disabled for the elimination period, and was unable to perform his contractual duties to the fund, thus causing the liquidation by investors and loss of fees to the fund. The client paid a significant premium for such a customized definition, however, when the exposures are very large and specific, the policyholder and the carrier left the table satisfied.
• A well-established specialty retailer sought a $2,000,000 loan from a private lender. Since the CEO was the namesake and key manager, the lender required adequate life and disability insurance protection be put in place to cover the loan. The loan was to be repaid in 60 equal installments of $33,333 (plus interest). Since cash reserves were low, the elimination period was established at 60 days, and the benefit structured was $33,333 per month for 60 months, reducing by one month with each policy month. Placing coverage in this manner enabled the CEO to keep his existing personal disability coverage, which he was going to assign prior to applying for this coverage.

The actual transaction is straightforward. Often the client has established the "need" for this type of coverage, the next steps are educating them on the risk of disability versus the risk of death. The key to this market is knowing it exists, and developing a relationship with an underwriter that can assist you with a complicated placement. The statistics bear out the need for the coverage, and justification for the cost.

Key person disability coverage is more expensive than key person life insurance, however, the risk is greater, and the premiums tend to be in direct proportion to the added risk exposure. While some of the above examples are illustrated on a grand scale, countless early and mid-stage companies in particular are reliant on key leaders for investment success. If these companies recognize their dependency on these individuals by securing key person life coverage, you can bet the same exposure is facing them in the event these individuals suffer a disability.

Edward A. Tafaro
Managing Director - BISYS Special Markets
October 19, 2004