Risk Management: Identifying and Insuring Key Employees to Protect Business Value
Most business owners know how important it is to attract and keep talented employees. What many don't appreciate is how much risk can be concentrated in just one or two people. If a top salesperson, lead engineer, operations manager, or other critical team member were suddenly unable to work, what would happen to your revenue, your customer relationships, your day-to-day operations, and your growth plans?
That's an ExitReadiness® issue. Losing a key person can materially reduce what a business is worth, and if it happens in the years leading up to a sale, the value can drop just when it should be peaking. Buyers look closely at how dependent a company is on a few individuals, including the owner. Identifying that risk, building redundancy, and putting the right protection in place all help preserve the value you've worked to build.
In this episode, Pat Ennis and Walter Deyhle welcome back Mark Gage, CLU, Vice President at Northeast Brokerage, who has more than 30 years in the insurance industry. Mark explains how to identify the people your business can't easily replace, how key person insurance is sized and structured, why disability coverage is often overlooked, and how to use insurance as a retention tool as well as a safety net.
Key Takeaways
Key people aren't always the obvious ones. They include top revenue drivers, account managers who hold critical relationships, people who hold the knowledge (contracts, passwords, processes), hard-to-replace specialists, and the leaders who pull it all together. Owners are key people too.
Owners underestimate the risk because they're busy. A month-long absence, like an extended leave, often reveals how much one person was quietly handling. That's a signal to build redundancy.
Coverage is usually sized as a multiple of income. Mark says carriers typically cap key person coverage at about 10 times the person's income, and many businesses choose five or six times, enough to cover lost revenue and the cost of hiring replacements.
The money covers more than revenue. It can steady a lender that's nervous about a lost banking relationship, fund recruiting and signing bonuses, and buy time while knowledge and leadership are rebuilt.
Use two policies to make it a benefit for the employee. One policy, owned by the business, protects the company. A second, owned by the employee with the employer paying the premium, protects their family. The family receives its benefit tax-free, and the employee sees what's in it for them.
Insurance can double as golden handcuffs. Permanent policies that build cash value can reward employees who stay, giving them a real reason to think twice before leaving.
Don't forget disability coverage. Mark notes that disability is far more likely than death during the working years, yet most key person plans cover only life insurance. Availability depends on the job; professional roles are usually insurable, while manual-labor roles often aren't.
Get the paperwork right. For non-owner employees, Section 101(j) of the tax code requires written notice and consent before the policy is issued, or much of the death benefit can become taxable. Businesses that own these policies also file Form 8925 with their return each year. Confirm the details with your CPA.
Insurance isn't a substitute for redundancy. Even a large death benefit won't replace knowledge that lives in one person's head. Develop successors and spread responsibilities so the business doesn't depend on any one individual.
Where to Start: Protecting Against Key Person Risk
Identify your key people. List who drives revenue, holds critical relationships or knowledge, has hard-to-replace skills, or leads the team, and include yourself.
Estimate the impact of losing each one. Consider lost revenue, at-risk accounts and lender relationships, lost knowledge, and the cost of replacing them.
Choose coverage that fits each person. Decide on life and disability coverage, term or permanent, and whether to add a separate policy for the employee's family or a retention benefit.
Build redundancy and successors. Document what key people know and train others so no single loss stops the business.
Review when your team changes. If a significant share of your workforce has turned over, reassess who your key people are and what protection you need.
About Mark Gage
Mark Gage, CLU, is Vice President at Northeast Brokerage. He has worked in the insurance industry for more than 30 years and specializes in succession planning, estate planning, life insurance contract analysis, and impaired risk underwriting. A Chartered Life Underwriter through The American College, Mark works with insurance professionals and their clients to identify appropriate life, disability, and long-term care insurance solutions, representing more than 30 insurance carriers.
Connect with Mark: LinkedIn
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Disclaimer: The information presented in this podcast is provided for educational purposes only. Neither the presenters nor ENNIS Legacy Partners are engaged to render legal, accounting, tax, or other professional services. Consult a qualified professional regarding your specific circumstances. ENNIS Legacy Partners assumes no legal liability for any loss related to information contained in this presentation.
Full Episode Transcript
This transcript was generated automatically and lightly edited for readability. It may contain minor errors.
Hey there, this is Pat Ennis of ENNIS Legacy Partners. Welcome to the ExitReadiness® PODCAST. I'm here with co-host Walter Deyhle. Our mission is to provide you, the business owner, with subject matter expertise on topics pertaining to building sellable business value and for planning your eventual exit from the business. We want to help you build a business that's transferable and then help you exit successfully on your own terms and conditions.
Most business owners that we work with very much recognize the importance of attracting and then retaining talented key employees. However, what not a few fail to appreciate is how much risk can be concentrated in their business in just one or two key people. If a top salesperson, a lead engineer, an operations manager, or some other critical, essential employee were suddenly unable to work for whatever reason, what would happen to your revenue, your customer relationships, operational continuity, and future growth plans? For many businesses, the loss of a key employee would create significant disruption, and in some cases it could materially reduce the value of the business itself.
And that's why today's conversation is so important. Our topic is risk management: identifying and insuring key employees. We'll discuss how business owners can identify the individuals whose contributions are critical to the company's success, evaluate the risk associated with their loss, and utilize insurance and other planning strategies to protect both the business and its stakeholders. And our guest is Mark Gage of Northeast Brokerage. Mark's been with us before. He's a friend and a strategic partner.
He's worked in the insurance industry for over 30 years, so he's skilled in succession and estate planning, life insurance contract analysis, and impaired risk underwriting. He's a Chartered Life Underwriter from The American College and spends his time helping insurance agents and their clients identify and implement the right life, disability, and long-term care insurance solutions, and he does this representing over 30 different insurance companies. So Mark, welcome back. Good to see you. Glad to have you back with us today.
Glad to be with you. Hey Mark, great to see you again. I'm going to start us off by trying to get a definition of key employee. When I think back to my days at GRF running our tax department, if you asked me who my key employee was, I would automatically have gone to the woman who was the behind-the-scenes glue that held everything together. She made sure everything got processed efficiently and the due dates were monitored, all that kind of stuff that I hated to do. And our work styles meshed really well. So in my mind, she was my key employee.
But if you looked at an org chart, she didn't have a college degree. On paper, it looked like her skills could be easily replaced. So, from a risk management perspective, how do you view a key employee? Well, I think there are lots of different ways to analyze it. You've certainly described somebody who's very valuable to a business, but are they integral to the business continuing if something should happen to them? That's a little bit gray, as you pointed out.
I think for a lot of businesses, we focus on individuals who are top revenue drivers. So it may be the salesperson, or it may be somebody who's not in sales but is an account manager who has the relationships with various critical accounts in their pocket, and if those relationships left because that individual had an untimely passing, it would put the business at risk. In a lot of businesses, and you alluded to this with the person you described, Walter, it's somebody with tremendous knowledge. If they were gone instantly and they're the source of all the knowledge, all the contracts, all the passwords, all of everything, how would the business survive that type of loss? For people in specialized businesses, whether it be manufacturing or medical or so many different fields, there are people who have really grown to be specialists within their fields who are very, very difficult to replace. Sometimes it might take two people because of the skill sets they've got.
So that's critical. And then in businesses you've got leaders who drive the whole thing. They make it all happen. They pull people together collectively to create synergy that translates into a successful business. And without their leadership, you've got a whole bunch of individuals who are all skilled in their cells of the business and operations, but may not be driving the business successfully. And in all three of these, I think sometimes we look at key person coverage and we look at employees, but owners are often key people as well, for the roles that they've got, and they should be viewed the same way from a protection perspective.
If an owner goes down, sometimes it takes a couple of people to fill those shoes. And as Pat pointed out, what a nightmare if you're looking to sell the business in the next five years. If you've lost an owner or a critically key person, the value of that business, at a point where it should be reaching its peak, could plummet, putting everybody at risk of not getting what they thought they were going to get out of their business someday. So those are some of the areas that I find are the most important in identifying key persons. Yeah. So, hey Mark, why or how do business owners often underestimate the financial risk that's associated with losing a key employee?
Do you have any thoughts on that? I just think most business owners are running their business, they're going full tilt, and they don't worry about risks and exposures unless it's something they're required to have. It's not that they're underestimating the value of the people doing certain jobs for them. They're just often too busy. If somebody goes on an extended vacation for a month, I think they'd have a glaring awareness of everything that individual has done. Most people are gone for a week, and we can kind of survive; they'll be back, and we kick the task down the road until they return.
Certainly I've experienced it with women who go out on maternity leave, where they're gone for a number of weeks, and the owners didn't realize how many critical things they were responsible for in the business. Hopefully it helps them think through the structure of their business, to have some redundancies there. But it can be a real eye-opener for business owners. So is the idea behind the insurance, from a quantification standpoint, that you're trying to estimate what a potential income hit could be for a period of time if you lose someone? Or are you trying to have enough insurance to fund finding a new person? How do you look at that piece of it, as far as the amount?
I think each individual is different, and I don't think you can do a blanket approach to it. Typically key person coverage is a derivative of the income the individual is making. The insurance industry typically will insure up to 10 times their income, and that's typically a cap unless there are some extenuating circumstances. A lot of businesses don't need to insure 10 times. They may insure five or six times, with the idea that a portion of that will deal with a reduction in revenue, should it occur, and a portion will deal with hiring a couple of employees, maybe with a signing bonus to get them to leave their current job quickly and come in to save the day.
So it's a combination. Yeah. And what else could an owner expect or plan for in a real-life situation with a key employee? Let's say they've been around for 15 years, and let's say they're the top salesperson, and not only are they great at generating new business, but they're also great at retaining customers and clients. So they're absolutely contributing to the top line and even the bottom line. But other than replacing the revenue piece, let's talk about some of the other costs if that person were suddenly to pass away, because we've had situations like this, and no longer be available.
What other expenses should the owner consider ahead of time that they're potentially going to face in a situation like that? Well, I think it comes back to revenue. What is the financial impact? What is the knowledge impact on the overall business that would be lost? What relationships with various accounts may be at risk? Maybe it's somebody who's dealt with all the banking and has a banking relationship, and the bank has given a generous line of credit for expansion, and that person's gone.
Now the bank is uneasy with it, so maybe the bank calls the note. Certainly the key person coverage would help by having some dollars there to put the bank at ease, and maybe they don't call the note because they know there's more cash in the business now. So there are lots of different components it can address, but predominantly it's looking at revenue that might be lost, knowledge that might be lost, and leadership skills that would no longer be present when thinking about this kind of coverage. Mark, could an owner also think of having a retention component to it? In other words, structuring the contract, if it's a life insurance contract, for example, in a way where it could not only pay a benefit to the company but also maybe to the employee's family?
I've found in a lot of businesses that it's an awkward conversation to say, "Listen, Pat, I'd like to have you insured, because you're bringing in a lot of revenue and my business would suffer if something happens to you." And you're sitting there thinking, "Well, what's in it for me? Why do I want you to have a policy on my life?" A common approach is to set up two insurance policies: one that benefits the business if something should happen, and a separate policy that is bonused for the benefit of the family. The individual employee owns that second policy. They name their own beneficiary, and the employer's only responsibility is to pay the premium.
And then you've addressed both sides simply. You've got the dollars that are there for the corporation, and you've got the dollars that are there for the benefit of the family that the individual didn't have before. Those personal policies could be structured with permanent insurance that accrues some cash inside, or as a term insurance policy that just provides pure protection for the family. But I find for non-owners, that's the easier approach to the situation: offer something for them personally as well as for the benefit of the business. Yeah. So why two policies rather than just one and splitting the beneficiaries?
Everything's driven by ownership. When you set the ownership up with the business, the beneficiary could be changed tomorrow, so the employee really doesn't have any true protection in place. It's a much better control situation to have two separate contracts. I've certainly had plenty of businesses that have one policy owned by the business, and they say they're going to split it. But if the business receives the cash, the individual's family is now going to be taxed on it.
So from a tax perspective, we always forget that Uncle Sam is our silent partner in the room. We want to make sure we acknowledge that. If the policy is set up as two separate contracts, then the family receives a tax-free death benefit versus a death benefit they've got to pay taxes on. Hey Mark, let me ask you a question, and Pat, you could probably comment too. If you've got a situation where you feel the need for a key man insurance policy on an employee, that should also tell you, I would think, that you need to be developing some plans to diversify away from this person in a sense, because he might not necessarily die. He could just leave, or he could retire.
So in my mind, if you have an employee of that stature, it should trigger something in your mind that you need to be taking other steps. Would you agree with that? Well, I think yes. And other steps can be done in two ways. Other steps can be monetary arrangements, so that if they stay, they get well rewarded. And the insurance policies can be structured that way, so that if the employee meets the employment time frame and arrangements, they're going to have additional money there. If they leave me tomorrow, they don't get any of that.
So it's kind of a golden handcuff type of approach, and that's very popular, because we're all fighting to keep our best people working with us. As nice as we may be, there's somebody else out there. If there's a significant amount of money they'd be walking away from, they think twice about it, and they think twice about looking to leave. And the other side is to do what you suggested, too. Even if I've got significant life insurance that comes in for the benefit of the corporation, if I've got so many responsibilities that are only in the mind of one individual, I'm at risk. I'm going to have problems.
Even if I've got money coming in, I'm going to have problems navigating that loss. So redundancy within any business is always a smart plan. Yeah, and I would just add to that, Walter: as you know, when we engage a new client, one of the exercises we take them through is what we call our owner centricity and management succession exercise. We're looking to identify those areas of risk where there's concentration in one, two, or three key people, and then whether they have a successor to that key person in place, being trained up to replace them or be available if all of a sudden that key person isn't available anymore. Mark, this is often a question: how do I decide whether to choose permanent or term insurance for this key person coverage need?
Well, a lot of times it depends on the cash flow within the business, as to what they can afford to do. Sometimes, if you're trying to create a golden handcuff situation for the employee, you're not going to do that as well with a term insurance policy that has no equity buildup for the employee. You'll earn some goodwill, in that there's some death benefit there. But if there's a cash bucket, that's a benefit for the employee. If there's a death benefit only, that's a benefit for their family.
Some individuals are about what's in it for me, so the one that has the cash is giving them some potential benefits, not just a beneficiary. And not every employee has a family to worry about, so you've got to look at that, too. If you've got a spouse and three kids, then the death benefit is significant, and they might want a larger death benefit policy and not worry about cash at all, for protection purposes, and have the corporation pay for it. Versus if they're single and they don't have any financial responsibilities to family members, or a domestic partner sharing their house or anything else, then it may be all about the money, and what would be in it for me if I work for you for the next 10 years. So it's an individual consideration.
Hey Mark, I could imagine getting an insurance policy is somewhat intrusive. I could see a situation where you have an employee whose health maybe isn't that great, but they've kept that a secret, or maybe they have something in their past that would disqualify them from insurance. So an employee can just say no, I'm not letting you put a policy on my life, right? Have you seen that situation, and are there implications of that? I haven't had a lot of kickback from employees. They typically understand that they're instrumental to the business. It kind of makes them feel special, that they're being cited as a critical part of the operation.
I had a call earlier today with several business owners, and they started talking about how much it costs and how it would work. And I said, I have to call each one of you individually, because it's nobody else's business, and I will never share with any of you the information that I receive from someone else. If I can't get a policy, I'll just tell you I can't get a policy. I'm not going to tell you why. It may not be because of their health; it may be because of their finances, or whatever.
But yes, you've got to honor the HIPAA rules and keep financial and medical information very, very confidential. Yeah. And this isn't like group term life, where you get it without going through all the steps, right? Yes. It's underwritten, so you've got medical questions and potentially insurance exams and other issues that come up. When it comes to key person insurance planning, is there a gap, or some aspect of it, that's often overlooked and neglected?
Well, I think a lot of times people jump right to life insurance, and if they don't address the disability side, they're missing half the point. And disability, frankly, is eight times more likely to happen during the working years than death. Yet in nine out of 10 situations where we're dealing with key person coverage, we're only dealing with life insurance. I've always found that interesting. Sometimes it's because disability coverage can be expensive, and that's something that will put the brakes on for some folks. But if they understood the math and the likelihood of it actually happening versus a death occurring, they'd pay more attention to it.
So you can have disability insurance that pays an employer? Yes. Okay. I hadn't realized that. Yeah. And it's more strictly underwritten, correct, Mark? Yeah, it is. You're looking at morbidity versus mortality.
So there are a lot of issues that could leave somebody unable to work but still functioning in other ways. Someone has a stroke. They can't communicate like they used to. They can't work at the pace they used to. Lots of things can happen in a disabling event that put them out of the game. Yeah.
So let's say there's an owner listening who has X number of dollars they can put toward this area of risk management, and they do indeed have one or more key employees. Would you encourage them to look at disability coverage for that key employee before life insurance, if they've got limited funds to manage this risk? I think you've got to look at each individual employee, what their roles are and what they're doing, and look at the budget you've got for the business to discern which employees are most impactful, and then come to a conclusion about what you can address with disability. Some occupations I can't insure. If it's blue collar in nature and they're out doing manual labor, we're not buying key person disability coverage.
If I've got doctors or other professionals, yes, I can. So when we're advising businesses, sometimes it's the nature of the employee's job duties that tells us what we can do and what we can't do. Okay. And so in the last few minutes, how often should an owner revisit what they have in place? And how do they do it? Are there one, two, three steps they should be thinking about in regard to reviewing their risk management program for key people?
Well, I think as the employee force changes, that warrants a review. If 25% of your workforce has changed in the last five years, then you ought to do an assessment of what types of exposures there are for your business if one of these people goes down. If it's somebody who just joined three months ago, unless they've got incredible skill sets and that's the only reason I brought them in, or incredible relationships they're bringing with them, they're typically not a candidate for key person coverage. It's usually somebody who's been there for a period of time that we're focusing on. Okay, good.
When the employee leaves, is the policy automatically terminated, or do you just stop paying premiums? The employer owns the policy, and the employer can continue the contract. So they could have life insurance on former employees? Yes. Insurable interest is only required at inception. Wow. That's interesting.
Yeah. And if it's a non-owner, they need to have a 101(j) form signed and on file indicating that the employee has authorized the life insurance on their life. Or the death benefit could come in and be taxed at roughly a 20% federal rate. So if you've got a million-dollar life insurance policy, it would be really bad to have to give away a couple hundred thousand to Uncle Sam purely because you didn't get a form signed. Yeah. And there's an annual form that needs to be filed with the IRS indicating that there's ownership of key person insurance, because if you don't do that, it could impact the death benefit's tax favorability.
Do you guys know what that form is? There is one. Oh, it's the 101(j) form. Yeah, and it's just at the inception of the insurance policy. It doesn't have to be remitted to the IRS every year, I don't believe. You just do it when you take the policy out. Okay. All right.
Anything else you would share with listeners today about this very important topic, Mark, that we haven't covered? Yeah, I would just say focus on identifying the key people and understanding them. Slow down just a hair with what you're doing. Most of our businesses are made up of the people we bring in to work around us, and the relationships, and there's value in that. So if we can just slow it down a hair and make sure we're dealing with protection, especially if we're anywhere close to wanting to exit the business at some point, because it would be a huge disruption to those goals to have that type of situation happen and not have protection that mitigates against it.
Yeah, good point. All right. Very good. Is there anything you want to promote today? Okay. And if listeners want to contact you, how can they do that? Well, they could certainly reach out to either one of you to get me, or they could reach out to me at mark.gage, spelled G-A-G-E, at simplicitygroup.com, and my phone number is 410-552-9300.
Fantastic. And listeners, if you want or need help maximizing the value of your business or planning for that eventual and inevitable exit, Walter and I would be happy to help you. You can reach us at email@ennislp.com. And if you're building your exit plan yourself, take a look at exitreadiness.com. We've built a platform providing our proven framework, with tools, assessments, and practical guidance, and when you need additional expertise, Certified Exit Planning Professionals are available. You can reach out to us to help you navigate the issues that matter most.
So thank you for listening today. If you've benefited from today's episode, please consider liking it and sharing it on social media. Until next time on the ExitReadiness® PODCAST, this is Pat Ennis and Walter Deyhle signing off.
