In Part I of our series on Life Insurance, “To Insure or Not to Insure,” we discussed the possible uses for life insurance and the most common types of policies—permanent and term.
In Part II, we review several client case studies and how life insurance is being used by owners to protect their hard-earned wealth, including their privately held businesses.
Client Case Study 1: Being Underinsured Could Mean Financial Difficulty for the Owner's Family
Paul, age 50, is the sole owner of a growing manufacturing company with 35 employees. We assisted Paul in developing a long-term Business Ownership Transition Plan that outlined his exit planning options and how much money he would need to net in order to achieve his financial goals. This helped Paul to realize that he was dramatically underinsured. His business profits had grown significantly in the last 10 years, but so had his personal lifestyle and spending. Paul realized that if he were to become disabled or pass away prematurely, his family would need a significantly larger nest egg in order to maintain their lifestyle, pay his children's tuition, and allow his wife to retire comfortably.
Paul purchased a combination of term and permanent insurance, with a disability rider, to cover both his short and long-term financial needs. Paul is also now saving more money toward his retirement, knowing that he could live well into his 80s like his parents. He knows that there is no guarantee that his business will continue to do well, and he will be able to monetize the value at some point in the future, especially if he passes away prematurely.
Client Case Study 2: How to Ensure Business Continuity
Janice, age 64, has two long-term key employees, ages 38 and 40, who want to own her $18 million business when she steps away. Janice is implementing a six-year ownership transition plan that uses a combination of bank debt and company profits to fund the buyout of her shares. Her key employees are not able to contribute a lot of personal capital, but they are effective in managing the day-to-day operations of the business, which is increasing the profits. This is enabling Janice and her retired husband to travel extensively to all of the places they have on their "bucket list" without worrying about her business.
During the implementation of her plan, Janice purchased a key-person term insurance policy for herself and permanent life policies for her key employees. If Janice passes away before she has collected all of the value for her shares, the insurance proceeds will be used to pay her husband or their heirs the balance of what is owed. If one of her key employees passes away before Janice is fully paid, those life insurance proceeds would be used to pay Janice the balance of what she is owed and provide the business with the funds necessary to hire a new executive, and cover the possible dip in sales and profits that may occur. Once Janice is fully paid, her managers will be able to use their key-person insurance policies as a source of funds (cash surrender value) in case they become disabled, and be able to fund their own buy/sell agreement.
Client Study 3: Ways to Cover Estate Taxes
Glenn is currently the CEO of a business his father and mother started almost 40 years earlier and continue to own. His two siblings also hold key executive positions. The business reached $40 million in revenue last year and the estimated value is $20 million. Mom and Dad are both in their mid-70s and have always been skeptical of financial and insurance advisors, thinking these people would try to take advantage of them. When we met, they didn't realize that if they took no action, their children would have a significant, unfunded estate tax liability that is growing larger each year.
In order to address this issue, we recommended a combination of estate planning techniques and life insurance. They decided to sell the majority of their shares to an Intentionally Defective Grantor Trust (IDGT), which will allow the business value to grow outside of their estate as well as their children's. The IDGT will also gradually eliminate their estate tax liability over the next 10 years. In addition, they purchased term life insurance in order to pay the estate taxes, both state and federal, in case they both pass away during the next decade when they would still have an estate tax liability. Despite all of the recent discussion about tax law changes, they know they can't count on the estate tax laws being favorable at the time of their death, and they know any changes are always temporary.
We should also note that there is a secondary market for the sale of life insurance policies so owners may monetize policies that are no longer needed should the business sell or key personnel leave the company. We have seen cases where owners turn in policies for cash surrender value or simply let policies lapse without a fair market appraisal, leaving significant money on the table. The general rule of thumb is that the insured must be over 65 and have at least $500K of life insurance coverage in order to qualify.
These are just a few examples of how life insurance may be used as a critical financial backstop for business owners at every stage in their lives. But the decision to purchase insurance should only be done in conjunction with your financial, estate, and ownership transition plans.
Too many times we have seen owners take no action or take shortcuts that have resulted in the purchase of inadequate products, expensive fees, and unfunded liabilities.
When it comes to life insurance, make sure that you're fully educated and understand your coverage needs. Deciding which kind of policy is best for you depends on your goals and needs, in addition to the needs of your family and business.