Risk Management: Identifying and Insuring Key Employees Ft. Mark Gage

Speaker A: Foreign. This is Pat Ennis at Venice Legacy Partners. Welcome to the Exit Readiness podcast. I'm here with co host Walter Dial. 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 recognize 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 regard to their business in just one or two key people. Um, 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, to your customer? Relationships, operational continuity, future growth plans? Uh, for many businesses, the loss of a key employee would create significant disruption. 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 ensuring 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 the loss, and utilize insurance and how to use 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, he's a strategic partner. He's worked in the insurance industry for over 30 years, and so he's skilled in succession and estate planning, life, uh, insurance contract analysis, impaired risk underwriting. He's a certified 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.

Speaker B: Glad to be with you.

Speaker C: Hey, Mark, great to see you again. I'm going to start us off, um, just kind of trying to get a, uh, definition of key employee. You know, when I think back to my days at, uh, GRF running our tax department, you know, if you asked me who my key employee was, I would have, I would automatically go on to the woman who was kind of the behind the scenes glue that held everything together. She made sure, you know, everything got processed efficiently, the due dates were monitored, all that kind of stuff that I hated to do. Um, and our work styles meshed really well. So in My mind, she was my key employee. But I think if you looked at an org chart, I mean, you know, she didn't have a college degree. Uh, on paper it looked like her skills could be easily replaced. So from a risk management perspective, how do you view a key employee?

Speaker B: Well, I think there's 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, you know, continuing, if something should happen to them? That's, you know, a little bit maybe Gray, uh, as you pointed out, you know, I think for a lot of businesses, we focus on individuals who are top revenue drivers. So maybe the salesperson that's there, or it may be somebody who's not in sales but is an account manager who has the relationships in their pocket with various critical accounts that if those relationships left because that individual had an untimely passing, would, uh, put the business at risk. Um, in a lot of businesses, it's somebody who has. And m. You kind of alluded to this with the person that you described there, Walter, with tremendous knowledge that if they were gone instantly and they're the source of all the knowledge, all the contracts, all the passwords, all the everything, how would the business survive that type of loss? Um, for people that are in, you know, specialized businesses, whether it be manufacturing or, um, you know, medical, so many different fields, there are people that have really grown to be specialists within their fields that are very, very difficult to replace. Sometimes might take two people because of their skill sets that they've got. Um, so that's. That's critical. And then in businesses, you've got leaders that drive the whole thing. They make it all happen. They pull people together collectively, uh, to make, you know, some synergy that translates into successful business. And without their leadership, you've got a whole bunch of individuals that are all skilled in their cells of business and operations, but may not, uh, be driving the businesses successfully. And so that. That leadership role. And in all three of these, I think sometimes we look at key person coverage and we look at employees. 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 in that if an unload goes down, um, that sometimes takes a couple of people to fill those shoes. And as Pat pointed out, what a nightmare. If you're looking at a business that you're looking to sell in the next five years, if you've lost an owner or a critically key person, uh, the value of that business At a point where it should be reaching its peak could plummet, um, putting everybody at risk for 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, uh, the most important and identifying key persons.

Speaker A: 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?

Speaker B: Uh, I just think most business owners are running their business and they're going full tilt and they don't worry about risks and exposures unless it's something that they're required to have. And uh, it's not like they are underestimating the value of their people that are doing certain jobs for them. They're just often too busy. And, um, if somebody goes on an extended vacation for a month, um, I think they'd have a glaring awareness of everything that that individual has done. Most people are gone for a week and we can kind of survive. They'll be back and we kick this task down the road until they return from their vacation. Um, certainly I've experienced it with women that go in on, ah, maternity leave where they're gone for a number of weeks and they didn't realize how many critical things they were responsible for in that business. And hopefully it helps them think through the structure of their business to have some redundancies that are there. Um, but, um, can be a reliable winner for business owners.

Speaker C: So is the idea behind the insurance that, like, from a quantification standpoint, are you 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? Or how do you, how do you look at that piece of it? As far as the amount of insurance?

Speaker B: I think each individual is different and uh, I don't think you can do a blanket approach to it. Typically, key person coverage is a derivative of the income that the individual is making. So the insurance industry typically will insure up to 10 times their income, and that's typically a cap unless there's some extenuating circumstances that are there. Um, 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 occur. A portion of that will be dealing with hiring a couple of employees, maybe with a signing bonus to get them to leave quickly and, you know, to come in to save the day. Um, so it's a combination.

Speaker A: Yeah. And so what else in regard to what an owner could expect or plan for in a real life situation when, when a, uh, let's say it is a key employee, they've been around for 15 years and let's, let's say they are top salesperson and not only are they great in generating new business, but they're also great in retaining customers and clients. They're just really good at that. And so they're absolutely, um, contributing to the top line and even the bottom line. But other than replacing the revenue piece, what are some of the other. Let's talk about some of the other cost. If that, if that person was suddenly to pass away because we've, we've had situations like this, um, and no longer be available, what other expenses could, should, should the owner consider ahead of time that they're going to potentially face in a situation like that?

Speaker B: Well, I think it comes back to revenue. You know, what is the financial impact upon that? Uh, what is the knowledge impact upon the overall business that um, would be lost? What are the relationships that are there with various accounts that may be at risk? Uh, maybe it's somebody who has dealt with all the banking and has a banking relationship and the bank is given, you know, a generous line of credit for expansion and that person's gone. Now the bank is uneasy with it. So maybe the bank, uh, calls the note and uh, certainly the keepers in coverage would facilitate with 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. Um, so lots of different components that um, can address it, but predominantly, uh, looking at revenue, uh, that might be lost, looking at knowledge that might be lost, looking at leadership skills that, uh, would be no longer present when thinking

Speaker A: about this kind of coverage. Mark, should an owner, or could an owner also think of having a retention component to it? Um, in other words, structuring the contract of, if it's a life insurance contract, for example, in a way to where it could not only benefit or pay a benefit to the company, but also maybe to the employee's family.

Speaker B: So I found a lot of businesses where 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 to have you insure a policy on my life? What's in it for me. And a common approach will be 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. So the individual employee owns that second policy. They name their own beneficiary and the employer's only responsibility is to pay the premium. And um, then you've attacked, uh, both sides simplistically. 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 that individual didn't have before. Those personal policies could be structured either with permanent insurance that accrues some cash inside of them. Um, they could be structured as just a term insurance policy that just provides peer protection for the family. But I find for non owners, uh, that's the easier approach to that situation, is to offer something up for them personally as well as for the benefit of the business. Yeah.

Speaker A: And so why two policies rather than just one and splitting the beneficiaries?

Speaker B: Everything's driven by ownership. And so when you set the ownership up with a business, um, you know, the beneficiary could be changed tomorrow. You know, the employee really doesn't have any true protection in place. Um, they don't, you know, just a lot better control situation by having two separate contracts. I've had certainly plenty of businesses that will, you know, have one policy that's owned by the business and they'll, you know, say that they're going to split it. But if the business receives the cash, the individual family now is going to be taxed on that. So you know, from a tax perspective, uh, we always forget Uncle Sam is our silent partner that's in the room. We want to make sure that we acknowledge that. And, and so if the policy is set up with two separate contracts, then the family is receiving a tax free death benefit versus a death benefit that they've got to pay taxes, um, on.

Speaker C: Hey Mark, let me ask you a question. Just if you've seen this and Pat, you could probably comment too. But if you got a situation where you have you feel the need for keyman 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, uh, 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?

Speaker B: Well, well, I Think, Yes. And other steps can be done in two ways. Other steps can be monetary arrangements 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 monies that are there. If they leave me tomorrow, then they don't get any of that.

Speaker C: So.

Speaker B: So kind of a golden handcuff type of approach. And that's very popular, um, because we all are fighting to keep our best people working with us. As nice as we may be. Uh, there's somebody else out there. If there's a significant amount of money that they're walking away from and they think twice about it, they also think twice about looking to leave. Um, and then the other side is do what you suggested too. And that even if I've got significant life insurance that comes in for the benefit of the corporation, um, if I've got so many responsibilities that are only in the mind of one individual, uh, 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.

Speaker A: Yeah. So. And I would just add to that. Yep. 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, management, succession. Um, exercise. And we're looking to identify those areas of risk where there's concentration in one or two or three key people. And then do they have a successor to that key person in place being trained up to. To replace them or, you know, be available if all of a sudden that key person isn't available anymore? Mark, how do you. This is often a question. How do I decide whether or not, ah, um, to choose, uh, permanent or term insurance for this need key person coverage?

Speaker B: Well, a lot of times it depends upon the cash flow within the business as to what they can afford to do. Um, sometimes if you're trying to create a golden handcuff situation for the employee, um, you're not going to do that as well. With a term insurance policy that has no equity and buildup for the employee, uh, you'll earn some goodwill and that there's some death benefit that would be there. Um, but, you know, if there's a cash bucket, that's the benefit for the employee. If there's a death benefit only, that's the 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 individual employee has a family to worry about. So you've got to look at that, too. You've got a spouse with three kids, then the death benefit is significant and they might want to have 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 with their family members, they don't have a domestic partner in sharing their house or anything else, um, 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.

Speaker C: Hey, Mark, have you seen situations? I mean, I could imagine getting an insurance policy is somewhat intrusive. So, I mean, I could see a situation where you have an employee who, you know, maybe their health isn't that great, but they've kept that a secret. Um, 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?

Speaker B: I haven't had, uh, a lot of kickback from employees. They understand typically that they're instrumental to the business. Um, you know, kind of makes them feel special and that they're being cited as a critical operation, you know, part of the operation that's there. Um, I think, you know, I had a call earlier today with several business owners, and they started talking about how much does it cost and how, uh, how would this 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. And 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. And it may not be because of their health. It may be because of their finances. It might be because of whatever. But, yeah, you've got to honor the HIPAA rules and keep financial information and, uh, medical information very, very confident.

Speaker A: Yeah.

Speaker C: And this isn't like group term life where you, you get it without going through all the steps. Steps, right.

Speaker B: Yes. It's underwritten. So you've got medical, uh, questions and potentially insurance exams and other issues that come up.

Speaker A: Yeah. So the, um, employees. What is the, what's the when it comes to key person insurance planning, is there a gap that's just often or some aspect of it that's often overlooked and neglected?

Speaker B: Well, I think a lot of times people jump right to life insurance and if they don't address the disability side, then they're missing half the point. And disability frankly is eight times more likely to happen during the working years than death. But yet nine out of ten situations where we're dealing with key person, we're only dealing with life insurance. So I've always found that interesting. I've always talked about it sometimes because the disability coverage can be expensive. That is something that will halt the brakes with some folks. But if they understood the math on the likelihood of it actually happening versus a death occurring, they pay more attention to it.

Speaker C: So you can have disability insurance that pays an employer?

Speaker B: Yes.

Speaker C: Okay. How do you realize that?

Speaker A: Mhm. Yeah. And it's more strictly underwritten, correct, Mark?

Speaker B: Yeah, it is. Uh, you're looking at um, morbidity versus mortality. So there are a lot of issues that could preclude somebody from not being able to work but still, you know, function in other ways. You know, there's a stroke, they can't communicate like they used to, they can't work at the pace that they used to. Lots of things that can happen in a disabling event that puts them out of the game.

Speaker A: Yeah. So let's say there's an owner listening currently and they've got X number of dollars that they can contribute put toward this area of risk management. And they do indeed have one or more key employees. Would you tell them, would you encourage them to look at disability coverage for that key employee before life insurance then if they've got limited funds to manage

Speaker B: this risk, I think you got to look at each individual employee and what their roles are and what they're doing and look at the budget that you've got for that, uh, given business to discern which employees are most impactful and then come to a conclusion of what you can address disability. Some occupations I can't insure. If it's blue collar in nature and they're out uh, doing manual labor, we're not buying key person disability coverage. If I've got doctors, other professionals, yes, I can. So when we're advising businesses, sometimes it's the nature of the employees job duties that tells us that what we can do and what we can't do.

Speaker A: Okay. And so in the last few minutes, uh, how often do you should an owner revisit what they have in place and then, and how often. But then how do they do it? Is there like a 1, 2, 3 steps that they should be thinking about in regard to revisiting reviewing their risk management program for key people?

Speaker B: Well, I think as the employee force changes that warrants a review. So if you've got, in the last five years, you know, 25% of your workforce has changed, then you know, you ought to do an assessment as to what types of exposures are there for my business. If one of these people goes down, if it's somebody who just joined me three months ago, unless they've got incredible skill sets and that's the only reason I brought them in then, or incredible relationships that they're bringing with them. Um, they're typically not a, ah, candidate for key person coverage. It's somebody who's usually been there for a period of time that um, is who we're focusing in on.

Speaker A: Okay, good.

Speaker C: When the employee leaves, is the policy automatically terminated or is it just you stop paying premiums?

Speaker B: The employer owns the policy. Employer can continue the contract.

Speaker C: So they could continue. So they could have life insurance on former employees?

Speaker B: Yes. Insurable interest is only at inception.

Speaker C: Wow, that's interesting.

Speaker B: And if it's not, if it's a non owner, they need to have a 101J form signed and in file that indicates that that employee has authorized the life insurance on their life or the death benefit could come in and be taxed at 20% federal rate. So you had a million dollar life insurance policy. It would really be bad to have to give away a couple hundred thousand dollars to Uncle Sam purely because I didn't get a form signed.

Speaker C: That's interesting.

Speaker A: And there's a, there's an annual form that needs to be filed with the IRS that there's ownership of key person insurance. Because if you don't do that, it could impact the death benefits, tax favorability. Do you guys know which, what that form is? Oh, it's the 101J form.

Speaker B: Yeah. And it's just an assumption of the insurance policy. It doesn't have to be remitted to IRS every year. I don't believe. Um, it's just you do it when you take the policy out.

Speaker C: Mhm.

Speaker A: Okay. All right. Anything else that you would share with listeners today about this very important topic Mark. That we haven't covered?

Speaker B: Yeah, I would just say, you know, focus on identifying the key people, understand them, slow down just a hair with what you're doing, um, and understand what's, I mean most of us, our businesses are made from the people that we bring in that work around us in the relationships. And there's a value of that. So if we can just slow it down a hair and make sure that we're dealing with protection, um, especially if we're anywhere as close to wanting to exit from the business at some point in time, that would be a huge disruption in those goals, uh, to have that type of a, ah, situation happen, um, and not have protection that mitigates against it.

Speaker A: Yeah, good point. All right, very good. And if listeners, is there anything you want to promote today? And if listeners want to contact you, how can they do that?

Speaker B: Well, they could certainly reach out to either one of you to get m me, or they could reach out to me at Mark Gage, spelled G a g e simplicitygroup.com and my phone number is 410-552-9300.

Speaker A: Fantastic. And listeners, if you want help, need help maximizing the value of your business or planning for that, uh, eventual and inevitable exit, Walter and I can, would be happy to help you. You can reach us at Exit Ready. Emailxitready. Com. And if you're building your exit plan yourself, take a look at exit readiness diy@exitreadyness.com. um, we've built a platform providing our proven framework with tools, assessments, practical guidance, and when you need additional expertise, credentialed exit planning professionals, certified professionals are available. You can reach out to us to help you navigate those issues that matter most. And 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 Exit Readiness Podcast, this is Pat Ennis and Walter Dial signing off.