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 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 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.
Permanent insurance has several sub categories:
• Whole Life Insurance. This contract pays a dividend from the issuing company and cash values grow as dividends are declared by the issuing company, Patrick says. Dividends come from profits of the company as well as investment returns on invested premium dollars the company earns.
• Un iversal Life Insurance. This contract allows flexible premium payments and has a term insurance component as well as a cash account component, Patrick says. The term insurance costs are deducted monthly to provide the life insurance and the excess cash in the policy is credited with interest from the insurance company. The excess cash typically earns an interest rate that is very close to what can be earned in a bond account.
• Variable Universal Life. This contract is the same as universal life with the exception that there are several sub accounts the owner of the insurance policy can choose, Patrick says. Typically the sub accounts will have stock as well as bond accounts within the policy. The owner of the policy will choose the asset allocation and take the risks of whether the market increases or decreases the cash in the policy. This policy is typically used for those who are looking for supplemental retirement income.
In deciding what type of life insurance to purchase, cost may be a factor. "Term insurance is what most businesses do when they are starting up because it is inexpensive and often everyone is watching every penny," Tassey says. "But as a company grows and becomes more successful, they may want to consider permanent insurance, which accumulates money over time." That money can be used to help the company go through a bad stretch, or if access to bank credit gets tight, because depending on the policy they may be able to take a loan or a withdrawal, Tassey says. A company-owned permanent policy is a corporate asset that can be used to subsidize a retirement payout or even the purchase of company assets.
Tassey tells the story of a 79-year-old company president who had a $2 million life insurance policy designed to take care of his family when he passed away. "But he lived," Tassey says. "It ultimately helped the company buy him out."
Dig Deeper: Inventing a New Kind of Life Insurance
How to Choose Life Insurance: How to Buy Life Insurance
Now that you have achieved clarity of your goals in purchasing life insurance and the different types available, it is time to start shopping. Insurance is a complicated product that provides a variety of uses for owners and beneficiaries and so the first step in purchasing life insurance is deciding whether you will purchase the insurance yourself or use the advice and help of a life insurance professional. If you decide to purchase the insurance yourself, you can do so through a variety of Internet providers. Patrick advises that if you buy your own policy, you should also consult with either your attorney or accountant regarding the ownership structures and what type of insurance to purchase.
There are reasons to go through an insurance professional. They can help you determine the best type of insurance for your business, who should own the policies, how much insurance to purchase, and how to structure the policy so that you achieve your objective. "I suggest that you use an insurance professional when purchasing life insurance," Patrick says. "The product is complicated and those who don't work with life insurance on a regular basis will often make mistakes that a seasoned and honest insurance professional won't." In addition, professionals can often alert you to clauses that might be helpful -- such as a rider on a permanent key person insurance policy that allows for the transfer of that policy to a new hire if the key employee leaves, Tassey says.
Dig Deeper: How to Buy the Right Business Insurance
How to Choose a Life Insurance Professional
If you decide to use a life insurance professional, choosing the correct one is the most important step in helping you achieve your life insurance goals. Patrick suggests that you should consider a life insurance agent with the following criteria:
• Extensive experience in the life insurance business (at least five years)
• A positive reputation in the community
• A designation such that shows competence with life insurance such as CLU (Charted Life Insurance Underwriter), ChFC (Chartered Financial Consultant), or CFP® (Certified Financial Planner)
• Extensive experience working with private business owners in solving risk management, asset protection, and wealth transfer engagements
• An ability to understand your goals and provide solutions that don't always include life insurance (for example, using a "529 college plan" to finance a college education instead of using a cash value life insurance product)
Who Should Be Insured -- And for How Much?
One of the first questions you will want to determine is who should be insured. You can insure one person or dozens and there are sometimes group policies offered that will pay out when the first of, say, three owners passes away. Executives of each business must decide on their own who to cover based on individual circumstances, but often the list of "key persons" considered includes owners, partners, major shareholders, executives, and certain employees.
"If you sit down with business owners or decision makers and ask them who would have had to die last night to have an impact on your business, they know the driver," Tassey says. "You might have two or three in a company or dozens."
The next question is how much insurance you need. "If you are purchasing insurance for business continuation, you want enough death benefit to insure the company continues to operate," Patrick says. "If you are purchasing insurance for family protection, you want enough insurance to provide cash for your family." Determining the amount and type of insurance is often a primary activity of a life insurance professional, your accountant, or your attorney.
Dig Deeper: Smart Questions for Your Insurance Agent
How to Choose Life Insurance: Additional Resources
Financial Planning Association
The trade association that represents financial planners
Life and Health Insurance Foundation for Education
Includes a small business planning section
National Association of Insurance Commissioners
This is the association for state insurance commissioners. There is a link on the front page to bring you to your own individual state for more information.
National Association of Insurance and Financial Advisors
The largest of the trade associations that represent life insurance agents