Key-Person Policies Help Cover Brass

When fashion designer Gianni Versace was gunned down in Miami in 1997, Lloyds of London paid The House of Versace $21 million because there was a key-person policy on the founder of the $1 billion company.

Key-person insurance — known for decades as the less politically correct “key-man insurance” — has been around since the Great Depression, with moguls like J.C. Penney buying the policies during their company’s growth stages. (In Penney’s case, he was required by his bank to do so.)

Key-person insurance indemnifies a business against the death or disablement of one of its key employees. Basically, it’s insurance that’s paid to the business if someone can’t work and the business might lose money as a result. Key-person policies are usually in addition to life insurance policies that pay an executive’s family if that person dies.

But many companies that need such polices never even think about them.

“The key person has always been one of the most neglected for small businesses and middle-sized businesses,” said Bob Hall, 75, of Fayetteville, an insurance broker who has written hundreds of key-person policies since 1952.

“I think they just don’t really think about it,” Hall said.

“But the most valuable asset is the human element. All of those buildings, equipment and cars don’t make much profit by themselves.”

Fennel and Koenig

Joe Fennel, a well-known Fayetteville restaurateur, has taken out key-person insurance on himself and his business partner, Christine Sanderson, for their new venture, Bordino’s Dining LLC.

Fennel didn’t have key-person insurance on himself while he was growing Jose’s Mexican Restaurant during the 1980s and 1990s to eventually be the city’s top-grossing locally owned restaurant. But now he thinks it’s appropriate for the new business entity.

“Key-person insurance fit our situation perfectly,” Fennel said. “The way we have our new company set up, that’s the piece of the puzzle that worked for us … A lot of people don’t believe in key-man insurance because it’s just another way they’ve got to spend money. I know people who have a lot of money, and they’re the ones who have the least amount of insurance. But they have other ways of handling the situation.”

Fennel and Sand-erson plan to move Bordino’s Italian restaurant from a leased 2,800-SF space at 324 W. Dickson St. to a new 13,000-SF, two-story, $1.5 million building two doors to the east. Fennel and two other partners own the new building. They plan to open Bordino’s in the new location by June 15.

Fennel wouldn’t say how much key-person insurance he has on himself or Sanderson, who is also the executive chef at Bordino’s.

“It’s enough to take care of problems if they arise,” he said.

Upchurch Electrical Supply Inc. of Fayetteville has taken out a key-person policy on Jeff Koenig, the private company’s president and CEO. If something happens to Koenig, the policy would provide money for the other two partners — David McConnell and Ron White — so they can manage the company’s debt.

“That’s the main purpose of it, to provide cushion in the event the key person expires,” Koenig said.

He also wouldn’t give specifics about the policy or the amount of insurance.

“It’s enough to make the debt manageable,” Koenig said.

Although key-person insurance is important for small to mid-sized companies, Chet Caldwell, a Fayetteville insurance broker who has been writing policies for American National Insurance Co. since 1974, said large corporations probably have some form of key-person policies on the top executives.

Whether it’s called key-person, business continuation or executive insurance, it’s the same type of coverage.

“They go all the way up — anything from the corporate area to small mom-and-pop businesses,” Caldwell said.

“You can pretty well be assured that every major company, in one sense or another, will have it,” Caldwell said. “They’ll have contingency plans that accomplish the same objective. It could be an executive policy. It could be tied to some form of specific benefits for an executive …

“Key-person insurance is a life insurance policy, but it’s designed to be used to offset the economic loss of the talent, knowledge and experience of an individual whose loss would have a significant economic impact on the entity … It allows [the surviving company executives] to remain in their own economic world if they’re suddenly uprooted. That could be the same if it’s Wal-Mart or the local dry cleaners.”

How it Works

Hall, who taught at the University of Arkansas from 1970 to 1995, was head of the finance and insurance segment in what is now the Walton College of Business. Through Hall & Hall Inc., he writes policies through several life insurance companies, including Penn Mutual, Transamerica, Jackson National and John Hancock. Hall’s daughter Robin and son Ted also work for the company.

If a $500,000 key-person policy is purchased for a 41-year-old executive, for example, the premiums would be less than $1,000 a year for 20 years, Hall explained.

But the rate goes up with the age and health of the executive. If the insured person is 51, the premium would be closer to $1,500 per year until retirement age, Hall said.

A key-person disability policy for a 41-year-old executive would cost about $4,000 to $5,000 per year. If the insured person becomes disabled, that policy would pay about $15,000 per month for two years, for a total payout of $360,000.

As a general rule of thumb, Caldwell said age can be used to calculate premiums. For a 41-year-old, the maximum annual premium would be 4.1 percent of the amount of key-person life and disability insurance. In the case of a $100,000 policy, that would be $4,100. But that formula doesn’t take the insured person’s health into consideration.

Another aspect of key-person insurance is that it often includes a clause to reward the insured employee for staying with the company. It’s incentive to keep them from jumping ship, Hall said.

“He could quit,” Hall said, “so when you’re doing the key-person insurance, you give something to him to make sure he stays there.”

Hall noted that the insurance payments aren’t tax deductible, but the payoff isn’t taxable either.

Hall said companies like Wal-Mart Stores Inc. of Bentonville and Tyson Foods Inc. of Springdale may have had key-person polices years ago when they were smaller. But now, they’re so large, replacements for key executives are usually in place, so the companies may not carry key-person policies on the top brass.

“They’re like football teams,” Hall said. “They would have a second and third string.”

Hall said key-person policies aren’t just for the CEO. Often, other executives in small and medium-sized companies have abilities that make them difficult to replace. That would make them prime candidates for key-person policies.

Besides the cost to replace the key person, which could take months, there’s also the expense of training the replacement, Hall said.

Dun & Bradstreet Survey

Dun & Bradstreet did a survey of 17,000 business failures in the 1990s. The study concluded that more than 95 percent of the failures were due to management weaknesses, “such as incompetence, unbalanced or no managerial experience, or neglect.”

The study said the death of a key employee or a business owner could cause the following problems:

•tA weakening of the company’s credit rating.

•tThe financial cost (in time and dollars) to find, hire, and train a replacement.

•tThe distraction of other employees, resulting in deadlines not met, deteriorating morale, or a higher level of personality conflicts.

•tA need for cash to fulfill promises made to the deceased employee’s spouse or family, such as salary continuation or deferred compensation.

•tThe inability to seize a business opportunity, because cash reserves are being used to recruit and train the new employee.

•tA loss of confidence among both suppliers and customers.

•tDisagreement between heirs and surviving business owners or key employees.

•tLack of cash to buy the interest of the deceased owner, requiring a sale of the business to an unknown “outside third party.”

•tSurviving owners may be forced to work with someone who is either not competent, or not motivated enough to make the business thrive.

•tThe business may have to be sold to pay estate taxes.