A business owner is faced with many risk management decisions as part of running a company. Yet few business owners realize that, for most businesses, there are two types of assets, and both should be addressed as part of a solid risk management approach.

There are physical assets, such as buildings, cars, machinery or technology. There are also human assets, and this is the part many business owners miss. Employees can be a crucial asset — particularly for a service business — and the big question is: “Have I put the right protection in place to manage the loss of one of my key people?”

Impact of a death on operations
The loss of a key employee has a number of significant impacts. By definition, a key person is someone who is critical to the success of a business. The death of a key person can seriously affect the ability of that business to operate successfully and can result in lower revenue or higher expenses.

Think about the loss of a top product designer, engineer or salesperson. What happens when employees in these roles don’t come to work? Their expertise — or relationships, in the case of the salesperson — are so specialized that generally you can’t simply move employees around to fix the problem. For a small business, losing a key person for a few days to the flu or jury duty can be challenging, but the permanent loss of a key person can be devastating.

Emotional impact of a death
The death of a key person can have a secondary impact as well: the emotional affect on the owner and other employees can hurt productivity. A small business owner spends 8+ hours each day with his key people, and if one of those people dies, the owner loses a friend or colleague as well as an integral part of his business. The net result is that everyone becomes less effective, at least temporarily.

If businesses purchase warranties on assets like a phone system or copier (the loss of which would be much easier to recover from than the loss of a key employee), then they will likely be interested in protecting an asset like a key person.

How key person insurance proceeds are used
When a key person dies, a company’s cash needs increase immediately. If the business owner has purchased a life insurance policy on that key person, the insurance proceeds can be used to fund an executive search to find a replacement if the ideal candidate isn’t available internally. The funds could also be used to hire additional staff to support the employees who temporarily take over the key person’s duties. Additional cash assets in the corporate bank account also allows the owner some emotional relief; it allows them to worry a little less about how the business might be affected financially by the loss. While a bank or investor may not want to extend credit or investment to a company who just lost a key person, having key person life insurance in place strengthens the balance sheet of the company.

How to approach the business owner
A business insurance conversation typically starts by asking a business owner or CEO whether there is an employee who is so critical to the business that his or her sudden death would impact the business financially. If the owner is slow to respond, you can ask about specific positions, such as a key engineer or salesperson. The smaller the business, the more likely that a death will have an impact. In a larger organization there are usually teams of people working in a department, and although the loss of one team member may be problematic, generally it is more of a problem in a closely held business where the key person may be a “department unto themselves.”

Once a key person has been identified, ask if the business owner would also like to discuss ways to incentivize this employee to stay with the company long-term. If the employee is so important that his or her death will impact the company, then another scenario is that the employer could lose the key person to a competitor. The financial professional can create an incentive plan to help retain key employees at the same time he or she is indemnifying the company in the event of death.

Live, die, disabled
Term or whole life insurance can be used very effectively to address these concerns. At its simplest, we use term insurance with a duration roughly equivalent to the working life of the employee. For example, a 45-year-old would be served well by a 20-year policy if 65 is the estimated retirement age. I typically write two policies, both of which are paid for by the company. One is the key person policy, which is on the life of the key person and is owned by the company and payable to the company. The key person premium is not deductible to the company.

The second policy is to provide protection for the key person’s family. It is owned by the key person, is payable to the key person’s beneficiary, but is paid for by the company. The value of the premium is “bonused” to the key person and the key person pays tax on the money as compensation. The second policy is important for two reasons: it makes the conversation about the first policy much easier and it provides a benefit to the key person that will increase his or her retention. In practice, if a key person dies and the company receives money, it would be awkward if there is nothing additional for the employee’s family, which is why I sell both policies together. Imagine a small business receiving a $250,000 key person benefit and just giving the family the employee’s last paycheck. I never want a client to be in that position.

Golden handcuffs
Alternatively, a business may prefer to use a whole life insurance policy instead of a term policy. This is particularly effective if it’s a family business where the key person may work until his or her death. Whole life can provide an additional benefit beyond the insurance protection. If the employee lives to retirement, the cash build-up in the life insurance policy can be used to supplement the employee’s retirement needs, or the policy can be transferred to the employee for his or her estate needs.

Brad Elman, CLU is a Financial Representative of Northwestern Mutual. He is a 19 year MDRT Member with 9 Court of the Table Qualifications. Brad’s practice focuses on helping closely held businesses with their employee benefits and business continuation strategies. Brad’s office is in Los Altos, CA and he can be reached at brad.elman@nmfn.com or 650-209-5743.

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