How to Choose Life Insurance

They sell insurance to protect your building or inventory in case of a fire. They sell insurance to protect your business in case someone gets hurt on your premises or using one of your products. But what can protect a small business, its partners, their families, employees, and customers in the event that the owner -- or even a key employee -- suddenly dies?

For that, they sell a special kind of life insurance for businesses.

Life insurance policies aren't only for personal use to protect and provide for your family in the event of your death. Small- and mid-sized businesses are increasingly taking out life insurance policies on owners, partners, important employees -- known in the insurance industry as "key people" -- to protect the business. Life insurance policies can help insulate small businesses from a variety of risks associated with losing someone instrumental to the business. "Depending on the type of insurance you purchase, the ownership structure, and beneficiary of the insurance, life insurance can provide financial protection, risk management, and asset protection," says Josh Patrick, founding principal in Stage 2 Planning Partners, a South Burlington, Vermont-based financial-planning firm that helps businesses.

Life insurance today can be used by businesses not only to keep the lights on in the business in the event of the death of an owner or partner. It can be used to buy out a partner's share of the business from the deceased's family members. It can also help a business buy time if a key employee dies or decides to leave and you have to find someone to replace him or her. Conversely, some policies can be used to help attract talent in your field. Used correctly, certain life insurance policies can even help you compensate valuable staff by providing funds you can access to help finance their retirement.

The following pages will cover how to figure out if life insurance can help protect your business or your family, what type of life insurance to buy, and whether to purchase the insurance yourself or with the help of a professional.

How to Choose Life Insurance: How Life Insurance Can Protect Your Business

It never fails that when there is a death in a business there is an interruption in that business.

Depending upon whether the person who passes away is an owner, partner, the best salesperson, chief product inventor, or other key staff member, there may be questions about whether the business will be able to survive. At the least, the business will need time to replace the deceased. But there may be more complicated issues that jeopardize the business's immediate survival, such as the ability to pay off business loans that were personally backed, the question of whether the business has funds to buy out a partner's widow or heirs, or whether sales orders can be fulfilled on time.

"The goal should be if in the event of the death of a major shareholder or other key person that the business can be able to continue with minimal financial interruption," says Matt Tassey, past chairman of the Life and Health Insurance Foundation for Education (LIFE), a nonprofit that helps people make smart insurance decisions, and a veteran in the insurance industry, specializing in disability and life insurance and small business insurance planning.

Executives of small- or mid-sized businesses should consider life insurance policies to protect themselves and the business from financial interruptions in the event that a key person dies. "You can't do anything about the human interruptions," Tassey says. "But you can make sure the doors stay open, the light bill gets paid, and the mortgage gets paid."

The first question you need to answer is whether your business needs life insurance. "Insurance is to insure a risk that you can't afford, so if in your business one of your key people were to die, what would it cost you to replace that person? If you were to die, what is the chance for your business surviving? And what kind of impact would that have on your family?" Patrick says. "If it's more risk than you can afford, then protect yourself and your business with insurance."

Before you can answer questions about who to buy life insurance policies for in your business -- and how much those policies should be worth -- you need to have a good understanding of your business purpose in buying the life insurance.

Decide the Purpose of the Life Insurance
There are a variety of reasons that businesses purchase life insurance these days. Once you understand what you want the insurance to do, you can decide what type of insurance to buy, who to insure, who should own the insurance, and how the insurance premiums should be paid.

Common uses and ownership of insurance are as follows:

• Death benefits to help fund business continuation. This is that "key person" insurance coverage and you can get one policy for each person you choose to cover. Patrick says to look at what the cost is to replace those key persons and take out enough insurance to cover those costs. In this case, the policy should be owned by the business.

• Proceeds used to purchase business shares. This is also called "buy/sell insurance" and, in this case, the pay out from the policy is used to buy shares of the business from widows, surviving family members, or heirs of an owner, partner, or shareholder, Patrick says. Separate from the policy, the business should have a well-crafted shareholder agreement that spells out what is supposed to happen in the event of the death of an owner/partner/shareholder. The insurance can provide the funds to make good on that agreement by allowing the death benefit to be used to buy out the deceased's share of the business. In this case, the owner should be the business or business partners.

• Benefits provide living income for surviving family members. This is also known as "family risk insurance" and it's a personal policy that replaces the cash flow of the business in the event of death. "If the owner is dead, there is a good chance the business won't survive," Patrick says. If you're an employee, this type of policy can help provide for your family in the event of your death. In this case, the owner should be a trust outside of the business or a spouse or surviving family member.

• Supplemental retirement savings. This type of insurance would provide cash value of the policy to help fund retirement or a buy-out of the insured, in the event that they live long enough. These policies are typically not used to cover the owner of a company but for other key people and it can sometimes be used to attract executives or key staff. In this case, the owner would be a trust outside the business.

• Estate tax funding. This is also known as "wealth transfer insurance" and it's a privately-owned policy set up to protect heirs in the event a business owner dies and the surviving family members must pay estate taxes if the business has been successful and is worth a lot of money, Patrick says. In this case, the owner would be a life insurance trust.

Dig Deeper: How to Create an Estate Plan

How to Choose Life Insurance: Understand the Types of Insurance Available

Understanding how you intend to use the life insurance policy or policies will help you decide which type of insurance to choose. Life insurance is broken into two broad categories: term insurance and permanent insurance. But there are also several sub categories.

Term Insurance
Term insurance is typically purchased for a particular time frame -- 5, 10, 15, 20 or 30 years -- and pays a benefit only if you die in the insured term, Patrick says. "If you don't die during the insured term, there is no return on the policy," he adds.

Permanent Insurance
Permanent insurance is designed to be used in both life and death, Patrick points out. "Permanent insurance has two components: death benefits and cash value," he says. "A death benefit is the money that is paid when you die -- for survivors' living expenses, funds to keep the business going, or providing liquidity to pay estate taxes that may be due. Cash value is the amount of money the policy is worth during your lifetime if you decide to either end the policy or borrow money from the policy." That cash value can provide supplemental savings for activities such as purchasing a house or retirement income.