Among the many lessons learned from the pandemic, one that cannot be overlooked is the importance of planning for the unexpected. Doing so can be essential to staying in business.
However, we are often too consumed by day-to-day business operations and put off planning for these unlikely but highly impactful events. And while a global pandemic is hopefully a once-in-a-century problem, one thing that is more likely to occur is the sudden and unexpected loss of a key person. Preparing in advance for the death, serious illness, or unexpected termination of the senior members of your organization is critical to maintaining a functioning business.
Planning for the sudden departure of a key person is a subset of a business continuity plan. Unlike disaster recovery plans, which are reactive in nature and assume that a business has ceased operating, continuity plans attempt to be proactive and ensure that critical operations continue.
In addition to the sudden loss of a key person, continuity plans include strategies for dealing with natural and environmental disasters, sabotage and cyber attacks, and power and service disruptions.
Business Impact Analysis
The most important element of a continuity plan is to conduct a thorough business impact analysis. The keys to survival lie in determining the following:
- Critical services, products, and people
- How long a service, product, or person will be unavailable
- Potential revenue losses.
- If there will be expenses outside the normal operating budget.
- If there will be intangible losses such as damage to reputation.
- Appropriate types and amounts of insurance coverage
As part of the impact analysis, consideration must be given to the effect on the business if a key person:
- Becomes disabled
- Becomes incapacitated
- Suddenly retires
- Has their employment terminated
- Is required to resign due to bankruptcy or ethics violations
Should any of the above occur, it is important that a communication plan is in place to ensure a clear process for informing management, employees, stakeholders, and customers.
Once news breaks of the loss of a key person, the first thing on everyone's mind is, “how does this affect me?” While the purpose of the plan is to provide reassurance to staff and customers, there are some important agreements that should be prepared in advance.
- List of all key advisors and their contact information
- Banking Agreements
- This is especially important for small businesses where there may be only one signatory to the bank account or one guarantor for loans and lines of credit. Ensure there is at least one other signatory for all accounts used in daily operations. Should the firm rely on credit, additional guarantors or security should be arranged in advance in order to avoid having a loan called when the company is already suffering financially.
- Employment Agreements for Key People
- Upon hearing of the loss of a senior executive, employees may ask themselves if the business is at risk. One way to help retain important staff is with a “stay clause.” When added to an employment agreement, such a clause offers employees who remain with the company for a minimum of two years and hit specified targets a substantial bonus – often as much as two years salary.
- Salary Continuation Plan for Key People
- This point protects the income of the key person. It’s crucial that businesses set a policy regarding the length of time a disabled key person can expect their salary to continue. Generally, the risk of salary continuance is transferred to an insurance company through a group plan that offers long term disability insurance. However, group disability plans are designed for the average worker and frequently contain limits which leave senior people woefully underinsured. It is important for an organization to determine if the benefits offered are sufficient for high income earners and determine if alternative arrangements need to be made. Failing to do so can leave a key person struggling financially and delay recovery, causing reputational and possibly additional financial damages.
Key Person Insurance provides funding to the business to offset lost revenue and cover increased expenses. If a key person is also a shareholder—generally defined as anyone holding 10% or more of the voting commons—then additional coverage is likely required to purchase the shares in the event of death or incapacity.
Given its finite nature, most organizations only consider this insurance in the event of a death. However, a disability or critical illness is far more likely, which is why businesses must determine if there would be revenue losses or increased expenses should key people be unable to work at their usual pace or not at all.
Finally, structuring policy ownership, beneficiary designations, and the premium payor requires careful consideration as there can be negative tax implications if done incorrectly. Engage an advisor with experience in business insurance to ensure policies are held in the correct hierarchy.
Determining the Need
In order to quantify the amount of insurance needed, the following factors should be considered:
- Loss of revenue to the firm in the first 12 months.
- Depending upon industry could be 18 or 24 months
- Increased expenses.
- If the key person is also a shareholder, they may be taking a below market income
- May need to hire more than one person to cover all their duties
- Search costs
- Amount of debt which may need to be repaid earlier than expected.
As it's impossible to determine precisely what these numbers would be, reasonable estimates are appropriate.
Types of Insurance Coverage
While determining the amount of insurance that may be required, it is also important to consider the types of coverage under consideration.
- Life Insurance
- Since death is finite, this is the easiest one to contemplate and quantify. Consider the length of time the coverage will be needed. Ideally, premiums on the coverage will be level until the expected retirement date of the key person. If the retirement date is unknown, it is best to purchase permanent coverage to avoid sharp price increases when the key person is in their fifties, sixties, and seventies.
- Disability Insurance
- Primarily needed for the disabled key person not the company
- Some specialty carriers offer coverage to the company to cover losses during the first 12 months of a disability
- Buy – Sell coverage may make sense in some share purchase scenarios but costs versus benefits needs to be examined
- Critical Illness Insurance
- While disabilities—most often due to mental health or musculoskeletal conditions —are the likely reasons a key person would be sidelined, a critical illness can make it virtually impossible for a person to continue contributing to the organization. When serious illnesses strike, this type of insurance provides a lump sum payment to the businesses to offset lost revenue and increased expenses.
Business Continuation planning is a process and not an event. The plan should be revisited on an annual basis, and the insurance needs to be reassessed approximately every three years or during periods of rapid change. If you are unsure where to start, reach out. We can help implement or review your continuation plan and key person coverage.