A Guest Expert Article written by:

Ryan Poage, CFP® | Ryan Poage & Co.

Key-Person Insurance Considerations for Private Equity Groups

February 2014       Print

With private equity firms increasingly focusing on due diligence, operational improvements, sponsor-level infrastructure, and securing attractive financing terms, the level of sophistication among firms has never been greater. However, firms may tend to overlook the potential disruption and financial consequences that could result from the death or disability of key managers at both the portfolio company and sponsor levels.

Firms sometimes disregard buying key-person insurance since it usually isn’t required to close an acquisition. Failing to have insurance coverage on a recently deceased manager is also not likely to invite the problems that a lack of insurance coverage would create after incidents such as a fire or workers’ compensation claim. Nevertheless, the disruption is real, and insurance payouts can help mitigate the impact.

When securing key-person coverage, it is important to cover the risks of both death and disability. Life insurance to cover mortality is thought of most often in regard to this coverage, but the risk of a manager becoming disabled in the intermediate future is even greater.1 Fortunately, disability insurance can be structured to pay out not only for monthly payments to help offset extra expenses and/or loss of revenue, but also for lump sum payments to buy a manager’s ownership stake.

While procuring permanent life insurance is common for many companies, the typical time horizon for private equity funds allows for the cost advantage of obtaining shorter length term coverage. Additionally, instead of just focusing on a simple product such as 10-year level term life, a fund could obtain annually renewable term life policies. This results in increased premiums in later years (when the firm will likely have already exited the company), but keeps the premiums lower during the critical initial years after the acquisition.

When deciding which insurance companies to use, premium cost is not the only factor to consider. It is also important to compare health underwriting requirements. Underwriting becomes more in-depth with age, which results in differences in the required level of medical analysis and tests among carriers. One way to help avoid having an applicant receive a non-standard rating that will permanently raise premiums is to submit an application to a carrier with less stringent testing (e.g., no resting EKG requirement), even if premiums are somewhat higher. Any down-rating is reported to a third-party service used by all carriers and will remain on the applicant’s records, so it is best to avoid getting that rating in the first place.

After securing company-owned life and disability insurance, it is important to make sure that the premium payments are not expensed. Doing so would make the benefit payments taxable. Also, if a departing manager is allowed to receive ownership of his policy, he should consider transferring the policy into a trust when retitling it. If it is owned in his name, the proceeds become part of his estate upon death, which could result in additional estate taxes. Placing the policy in an appropriately structured trust can resolve this issue.

Overall, while handling the details of obtaining key-person coverage is never as much fun as closing an acquisition, the risk management benefits could make life easier and allow for a better exit.

[1] Source: Social Security Administration

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