Keyman Insurance: What are downsides to employees?

Posted: Sat Nov 21, 2009 02:51 am Post Subject:

Key Person insurance (formerly "key-man" before political correctness reared it's ugly head) is specifically intended to protect the company. The life insurance and/or disability placed for key person insurance does nothing for the employee and is only intended to "indemnify" the employer for the loss of the key employee.

A key employee is generally defined as one that "contributes substantially to the profitability of the company" and as a high-revenue producing employee, the employer is obviously concerned that if you were to die, the company would be in dire straights. Their thought is to insure you and then upon your death, use the life insurance death benefit to replace the income you would have brought into the company had you remained alive and to provide the funds necessary to fund a replacement search and training environment for the person that replaces you after your death.

These are very commonly effected. I have a $5,000,000 key person policy on me right now and am flattered to have it. While it doesn't do anything for me or my family should I die, I feel "important" in a sense.

The employer is not "profiting" per se if you die, they are being "indemnified" for the loss of the key employee. The principle of indemnification is that the beneficiary be placed in the same approximate financial position he would have been in had you remained alive.

I have set up dozens and dozens of key person contracts and normally the employer does something additional to provide an extra goodie for the employee. The conversation that I had with my current employer regarding the plan on me went something like this:

Me: "So, you want to place a $5mm life insurance policy on me, with the idea being that if I die you get the $5 million, right?"

Employer: "Right on target."

Me: "And this is to replace the income I would have produced and give you extra money to find someone to replace me if I croak."

Employer: "Right on target."

Me: "My family gets nothing out of this?"

Employer: "Right on target. You have your group life insurance that will pay your family."

Me: "My group life benefit is maxed at $50,000. That ain't squat. What do I get out of this?"

Employer: "Right on target." (just kidding...)

Seriously, I would suggest that if your employer want to do this, it's perfectly normal. I would also suggest that you try and get something out of this. I would specifically request (if life insurance is your concern) that you ask your employer to get you into what's called a "Section 162 Executive Bonus Plan."

A 162 plan is a plan where your employer buys you a cash value life insurance policy. The policy is for your benefit- you own the policy and you choose the beneficiary; the employer just pays for the policy. Normally your employer will gross up your paycheck to pay for the premium on the policy, and as such, the premium he gives you will be considered income on which you'll be taxed. The employer gets a tax write-off on his business tax returns for this as he can't be the beneficiary. These are normally pretty nice arrangements that allow the employee to get a nice, fat permanent life insurance policy on his life outside of the group life plan for a much, much lesser cost compared to if he bought the policy on his own.

If you have any other concerns, please let us know!

InsTeacher 8)

Posted: Sat Nov 21, 2009 06:02 am Post Subject:

InsTeacher laid it out pretty well for you....not too much that can be added to what he said.

Posted: Sat Nov 21, 2009 08:38 pm Post Subject:

The company is doing it to for its own protection if something was to happen to you. However, I, personally would not be comfortable with the company owning the policy once I left the job. At this point, the company simply benefits by your early demise.

I would let a company take out a keyman policy on me if only it was set up in such a way that it would become mine when I left the job.

I've taken out keyman policies on employees of mine and I've kept the policies in force after they have left. Fortunately for them, I'm not going to do anything to speed up their demise.

Posted: Sun Nov 22, 2009 09:33 pm Post Subject:

So there is little or no benefit to the employee? I guess this makes sense considering they are not paying the premium.

Posted: Mon Nov 30, 2009 07:03 pm Post Subject:

Faskfakl errs when he says "I would let a company take out a keyman policy on me if only it was set up in such a way that it would become mine when I left the job."

If there is no exchange of value when ownership of the policy changes, as described, there is going to be taxable event on the payment of the death benefit proceeds to the extent they exceed the value paid for the policy (i.e., the premiums). So the only way to effect this kind of change in ownership is for the departing executive to reimburse the company for up to 100% of the total premium it paid. Anything less than 100% will create a tax liability for the beneficiary.

As recommended by a fellow "InsTeacher", the Section 162 plan (in lieu of a split-dollar plan) is probably a better solution for the individual needs of the executive, but it does not dismiss the needs of the employer to protect itself from the economic harm it would suffer at the death of the insured executive.

As for Faskfakl's other statement, "I, personally would not be comfortable with the company owning the policy once I left the job," there is no reason for any such discomfort. The owner has an insurable interest at the time the policy is purchased, and just because that ends when the employment relationship does, is no reason to force the owner to give up ownership. Same as his neighbor cannot force faskfakl to give up the home he lives in when the neighbor moves away.

It's not for faskfakl to say what the owner chooses to do with his policy (before or after he leaves the company. But he can withhold his required consent to be insured under a key-person policy, and the employer can turn around and fire him, too, without recourse.

If a person is so valuable to an employer that they need a key-person policy, that employee probably has the resources to purchase their own individual life insurance. They could probably get it at the same time as the key-person policy from the same company without separate underwriting.

Heidrek . . . there is NO benefit to the employee or their family when insured under a key-person policy. Not "little to or no" benefit. It has nothing to do with who pays the premium -- they could be paying it (dumb thing to do). It has everything to do with the ownership of the policy and who the beneficiary is. The employer is the policyowner and may name itself or any other party as the beneficiary.

Posted: Tue Dec 01, 2009 03:41 am Post Subject:

Max, there is plenty of reason for discomfort. Imagine that your boss takes out a $1,000,000 key man policy on you and you no longer work in the business.

How much money will your boss collect if you get murdered? That's a pretty big target on your ass. I would not want that on mine.

I would absolutely want to reimburse the company to make the policy mine or have some guarantee that the policy will not be in existence when I leave.

Posted: Tue Dec 01, 2009 05:33 am Post Subject:

Max, I'd be careful about this:

The employer is the policyowner and may name itself or any other party as the beneficiary.

Posted: Tue Dec 01, 2009 11:55 am Post Subject:

I'm simply not getting this idea of a change in policy ownership as a key employee leaves the organization. If a key employee leaves, it would be a loss to the organization and not the employee. Then, why would the employer let the benefits pass on to the employee!

Posted: Tue Dec 01, 2009 12:27 pm Post Subject:

If the employee has left the organization, their death, 10 years into the future, won't hurt the employer.

The reason for a change in ownership is that the employee's family may need the life insurance benefit while the employer is no longer counting on this ex-employee.

Posted: Tue Dec 01, 2009 04:58 pm Post Subject:

OK -- going to cover four posts in one more.

InsTeacher, with all due respect, and as a teaching colleague, the California Insurance Code, with which I have the most familiarity, does not require that a beneficiary ever have an insurable interest in the insured, and this is true of nearly all the states, as far as I know. And such Code sections, wherever they may still exist, can probably be easily defeated as archaic, as InsInvestigator has pointed out elsewhere. (What happens in the event of a divorce, will the Court tell the ex-wife she cannot collect on her former husband's policy because she lost insurable interest the day the divorce became final? I doubt it.)

The question, however, is not so much that of a beneficiary's insurable interest but of the use of COLI. And here, the subject is clearer, the employer has an absolute insurable interest in his employee, key person or otherwise, because he stands to be harmed financially at the sudden, unexpected loss of the employee, vertically -- by his walking out the door to another employer ("slave insurance" -- which once existed -- was outlawed many decades ago), or horizontally -- by his being laid to rest 6 feet under. So the employer purchases the policy to protect himself against the latter, since he has no control over the former. (Sorry, ladies, this is not intended to be a sexist discussion.)

The whole concept of life insurance, especially "COLI and its brethren" (let's agree to exclude STOLI as one of them), not to mention viatical or life settlements for the terminally-ill or the elderly with substantial face amounts but little cash value, would fall apart over the issue of a beneficiary's [continuing] insurable interest, so even if the employer-owner has designated its corporate retirement plan trust ("any other party") as beneficiary, when the employee leaves the business, I know of no insurance code section in any state that demands that the employer give up either its ownership of the contract or that it change the beneficiary to a party with a continuing insurable interest. The employer is fully entitled to continue paying premiums to obtain the benefit of the policy at the death of the employee, as was the original intent.

[It should be noted that California did change its Insurance Code in the aftermath of the "Wal*Mart incident" in 2001 or 2002, where it became public knowledge that Wal*Mart was obtaining COLI on some of its common employees and, obviously, retaining the death benefit at their demise -- which, of course it had the right to do, but it looked really bad as portrayed on the 6:00 news. Today, at least in California, only true key-persons can be the insureds on COLI policies. It did not change a business' ability to purchase a group life policy to benefit employees' own beneficiaries.]

I worked for one of the largest agencies in the US specializing in COLI for informal funding of non-qualified executive benefit plans, and none of the thousands of polices we administered for hundreds of corporations and other businesses ever changed ownership or beneficiary following the termination or voluntary departure of an employee, except those which were either (a) a split-dollar plan in which the executive had a prior agreement to purchase the policy upon departure, or (b) the company offered the executive the opportunity to purchase the policy, which the employee accepted. Some of these policies that the corporations retained had multimillion dollar face amounts, and they had paid (or were paying) tens or hundreds of thousands of dollars annually to keep them in force. I regularly filed death claims for them and passed on five-, six-, seven-, and at least one eight-figure death claim check.

Moving on to "asfqeer" and his discomfort over an employer's decision to murder a former employee to collect the life insurance benefit. "How much will he collect . . . ?" Absolutely nothing, other than a prison sentence . . . all states prohibit a person from obtaining the benefits of a life (or any other form of) insurance policy through a criminal act, such as murder (or arson). When a husband or wife suddenly turns up dead shortly after a life policy has been obtained, to whom do you think the police first cast their vision? So it's absurd to even speculate that a corporation or business owner is going to engage in such an unlawful act believing they will "get away with it." You also don't have any standing to force the employer to do away with its policy after you leave -- it's his property. Just like he can't force you to give up your car, house, or boat to him because the money he "gave" you as his employee was used to purchase it.

Next, to "anonymous00", I'm not sure what there is that you're not "getting". The employer could easily allow the employee to purchase the policy for the same amount of premiums that it had paid, and some do offer the option. It is the employee's choice in such a circumstance to accept or not. But as I mentioned above, if the total premium is now into the tens or hundreds of thousands of dollars, the employee is likely to take a pass, and the corporation will either keep the policy or surrender it for its remaining cash value, if less than its cost basis. Most accountants would advise against terminating a life policy if it creates an income tax liability that cannot be offset in other respects.

You also have to understand these policies are always cash value policies, not term, and that corporations frequently draw down the "basis" portion of the cash value to fund operations (and sometimes they take more, which is definitely a problem in the event they want to surrender the policy or assign ownership), while the purpose of the insurance is to backstop a deferred comp or similar benefit plan. So, in some respects, they may be impairing their own ability to cover their future liability to the plan participants, and usually without the participants' knowledge.

Thus, the company will likely need the balance of the face amount at a later date to meet its unfunded liability to other employees, and has to keep the policy in force in order to collect the death benefit. This is a specialized and highly complex area far removed from "traditional" uses of life insurance and not known to or understood by most agents. let alone the Joe and Jane Bluecollars who work hard and make America a great place.

I think what's been lost in all of this is why businesses buy key person insurance in the first place. The overwhelming majority of such policies are purchased to "informally" fund executive/employee benefit plans (discussed briefly above) for "highly compensated employees" rather than direct funding to the company if the executive dies. The latter maybe comprises 10%-15% of all key person sales (I'm speculating here), mostly in smaller businesses. The IRC currently defines highly-compensated/key employees (for purposes including executive benefit plans) as those earning at least $110,000 per year, or having at least a 10% ownership interest in a business or corporation among a few other qualifications. We're definitely not talking about Joe or Jane Bluecollar. A larger percentage (20% maybe) of key person policies are used to fund partnership or close-corporation Buy-Sell agreements rather than direct business funding. The insurance companies climb over one another in their quest for the "non-qual plan" business because it represents such a huge amount of cashflow. And they take the rest for the same reason, but you don't see them beating down any doors looking for it.

Finally, to "ajlruwerm", I think you miss the point of the potential of economic/financial harm to endure beyond the working years of an executive/key person. Whenever any employee, but especially a key person or executive, leaves the business, the company likely faces the prospect of short- or long-term financial loss. There could be loss of clients, loss of business "status" (what happens to Apple when, not if, Steve Jobs leaves again), or at the very least, the cost to recruit, interview, hire, relocate, train and allow a replacement to become comfortable in his/her new position (easily 100% or more of the employee's first-year compensation). Losses like these could, literally, harm the business for decades to come. Maybe the company is willing to wait ten or more years to recoup its "investment", or maybe it already has during the executive's working years, and if so, it might reward the executive by offering the opportunity to purchase the policy.

But you're looking at this as if the discussion is about Joe or Jane Bluecollar ("the employee's family may need the life insurance benefit"), when it's not, really. It's about Tom or Susan Whitecollar, and if they are a C-suite executive or in senior management (VP or similar status), they usually, but not always, have sufficient personal insurance and other assets to cover their family's future financial needs, and for that reason they may pass on an offer to purchase their key-person policy(ies) (for some, their decision against the offer may have more to do with estate taxes than family needs -- which is going to be a real concern after 2010).

The company cannot merely "give" the policy to the executive as a "thank you/retirement gift" due to the tax liability to either the company, the employee, or to the beneficiary at the death of the executive, or all three.

But even if "ajlrewerm" has a legitimate concern about the employee's family, let's take a look from the other side of the coin: what happens if the employee dies while working for the company? The family doesn't get the proceeds of the policy then either. So your point about the family's need escapes me in this discussion.

On the other hand, that is precisely, and always will be, the single most important reason for taking personal responsibility for one's own (family's) needs through proper insurance and other financial planning, and why we agents need to discuss life insurance with everyone, not just the wealthy who buy the occasional big ticket policies that pay huge commissions.

Whew! Did I miss anything?