Managing Organization Risks of Death

and Disability

Life and health insurance find applications in

the business world in three areas.
• As a part of the organization’s own risk
management program, by providing
protection against loss of key employees.
• Protecting business owners against the
financial loss that might arise from the
death or disability of other owners.
• As a part of an employee benefit program.

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 Types of Life Insurance Contracts

Based on their distinguishing characteristics,

one can identify six broad types of life
insurance contracts
Term life insurance
Whole life insurance
Endowment insurance
Universal life insurance
Adjustable life insurance
Variable life insurance

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 Types of Life Insurance Contracts

Ignoring the subtle differences among some of

these types of policies for the moment, we can
divide life insurance products into two classes:
• Term insurance, which provide pure life
insurance protection.
• Cash value life insurance, which combines
life insurance protection with a savings or
investment element.

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 Types of Life Insurance

Term Insurance Cash Value Insurance

Pure Protection Insurance and Savings
Term Insurance Whole Life Insurance
Endowment Insurance
Universal Life Insurance
Adjustable Life Insurance
Variable Life Insurance

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 Rationale for Different Forms

1. Simplest form of life insurance is yearly

renewable term.
• Provides coverage for one year only.
• Permits insured to renew for successive
years at higher premium.
• Increasing mortality produces increasing
rates as the insured grows older.

29-5
 Rationale for Different Forms

2. Premium eventually becomes unaffordable

for person who wants to continue coverage:
age 21 $1.07
age 30 1.35
age 40 2.42
age 50 4.96
age 60 9.47
age 70 22.11
age 80 65.99
age 90 190.75

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 Rationale for Different Forms

3. Insurers developed the principle of the

level premium as a practical method of
providing lifetime insurance.

4. The insured overpays the premium during

the early years of the contract, which
offsets an underpayment in later years.

5. The basic contract that provides coverage

for the lifetime of the insured is called
whole life insurance.

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Term Versus Whole Life Premiums

$1000

Increasing term
premium

Level
premium
29-8
 Policy Reserve

• The level premium plan introduces the

features of the redundant premium during the
early years of the contract and the creation of
the reserve fund.
• The insured has a contractual right to receive
a part of this reserve in the event the policy
is terminated, under a policy provision
designated the nonforfeiture value.

29-9
 Reserve on Cash Value Life Insurance

• In the figure, it appears that the reserve

should increase for a time and then diminish.
• It also appears that the redundant premiums
in the early years will not be sufficient to
equal the inadequacy in the later years.
• In the case of a single individual, this would
be true, but many insureds are involved, and
the law of averages permits a continuously
increasing reserve for each policy in force.

29-10
 Reserve on Cash Value Life Insurance

• Some insureds will die during the early years

of the contracts, and the excess premiums
that they have paid are forfeited to the group.
• The excess premiums forfeited by those who
die, together with the excess premiums paid
by the survivors not only offset the later
deficiency but, with the aid of compound
interest, will also continue to build the
reserves on the survivors’ policies until they
equal the face of the contract at age 100.

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 Increase in Reserve on Whole Life Policy

$1000

Decreasing Amount
of Protection

Increasing Saving
Element

Insured’s Age 100

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 Reserve on Cash Value Life Insurance

• The policy reserve is not solely the property

of the insured. It is the insured’s only if and
when the policy is surrendered.
• As long as the contract is in full force, the
reserve belongs to the insurance company
and must be used to help pay the death claim
if the insured should die.
• If this occurs, the contract no longer exists,
and the insurance company is relieved of all
obligations on the policy.

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 Tax Treatment of Life Insurance

Life insurance policies are granted favorable

tax treatment in two ways:
1. Amounts payable to beneficiary at the
death of the insured are not generally
included in taxable income.
2. Income earned on the cash surrender
value is not taxed until the policy is
terminated and the gain is received.
3. Further, the cost of life insurance is
deductible as part of the basis in
computing taxable gain.
29-14
 Tax Treatment of Life Insurance

Favorable tax treatment is allowed only for

contracts that meet the Internal Revenue Code
definition of Life Insurance.

1. Internal Revenue Code establishes two

tests to determine if a contract is “life
insurance.”

2. If the contract fails to meet one of the two

tests, earnings on the cash surrender value
are currently taxable to the insured.

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 Other Life Insurance Products

Universal Life Insurance

Adjustable Life Insurance

Variable Life Insurance

29-16
 Key Person Life Insurance

1. An employee who makes a significant

contribution to success of the organization
is a “key person” or “key employee.”

2. Death (or disability) of a key person can be

a source of loss to the organization.

3. Key person life insurance is designed to

compensate for such loss.

4. Greatest difficulty in insuring key persons

is determining the amount for which they
should be insured.
29-17
 Key Person Life Insurance

• Proceeds from the key person life insurance

can be used to replace the lost revenue that
results from the loss of the person’s
services.
• Alternately, the insurance proceeds can be
used to fund a search for someone to replace
the key person or the cost of training
someone to serve as a replacement for the
individual whose services were lost.

29-18
 Measuring Value of a Key Person

• Determining the value of a key employee is

often the most difficult phase in deal with the
key person exposure.
• The valuation may be based on the estimated
loss of income that will result from loss of
the key person, based on estimates of the
decline in sales or other loss.
• Alternatively, it may be based on an estimate
of the additional expense that will be
required to obtain a replacement of
comparable value.
29-19
Insurance for the Key Employee Exposure

Type of Insurance for the Key Person Exposure

• Permanent life insurance can serve a dual

role of protecting the corporation against
loss of the key person, while accumulating
funds that will be paid to the employee at
retirement.
• Since the value of a key person decreases as
he or she approaches retirement (as the
number of years the business can expect to
have his or her services decreases),
decreasing term life insurance might be the
most appropriate choice. 29-20
 Tax Treatment of Key Person Insurance

• When a corporation purchases life insurance

on a key employee, the premium paid is not
deductible as a business expense.
• This is in contrast with the deductibility of
premiums paid to insure other assets.
• Offsetting the nondeductibility of the
premium, the death benefits received by the
corporation are not taxable to the
corporation.

29-21
 Key Person Disability Insurance

• When a key person exposure exists, the

organization needs protection against loss of
his or her services from any cause, not just
death.

• For the disability exposure, the corporation

purchases a disability income policy that
pays benefits to the corporation if the key
person should become disabled.

29-22
Personal Replacement Expense Disability
Coverage

• A few insurers write a personal replacement

expense coverage that reimburses the
employer for specific costs incurred in
securing a replacement for a key employee.
• Coverage may be written for a lump sum,
usually up to a maximum of $50,000, to cover
all expenses actually incurred by the firm in
securing a replacement, such as:
salary of the replacement for a time
moving expenses for the new employee
cost of searching for the replacement
29-23
 Nonqualified Deferred Compensation
Plans

• Besides its use to protect the firm against

death of an employee, life insurance is
sometimes used as part of a nonqualified
deferred compensation plan for executives.
• A nonqualified deferred compensation plan
is an executive compensation plan that is
designed to encourage the executive to
remain with the organization.
• This arrangement is aptly described as
"golden handcuffs."

29-24
 Nonqualified Deferred Compensation

• Technically, any arrangement under which a

portion of an individual's current earnings is
made payable at some time in the future is a
"deferred compensation plan."
• Such plans fall into two broad categories:
qualified plans, and
non-qualified plans.

29-25
 Qualified Deferred Compensation Plans

• Qualified plans include pension and profit

sharing plans that meet the requirements of
the Internal Revenue Code, thereby qualifying
for favorable tax treatment.

• The favorable tax treatment consists of a

deferral of taxation until the benefits are
actually received by the employees, but a
current deduction to the employer for
contributions made to fund the benefits.

29-26
 Nonqualified Deferred Compensation

• Qualified deferred compensation plans must

be nondiscriminatory.
• Nonqualified deferred compensation plans
are plans designed for a select group of
persons and are therefore, by definition,
discriminatory.
• Although nonqualified plans do not qualify
for the same tax treatment as qualified plans,
they may still have tax advantages.

29-27
 Internal Revenue Code Definition

The Internal Revenue Code provides that

....an "unfunded plan established for a
select group of management or highly-paid
employees" is exempt from the non-
discrimination, vesting, and funding
requirements of ERISA.
There are two requirements in the definition;
The plan must be unfunded.
The plan must be for a select group.

29-28
 “Unfunded” Requirement

• The term "unfunded" does not mean that the

employer cannot accumulate funds to meet
the obligations under the agreement.
• It means that such funds, if they are
accumulated, must remain the unassigned
property of the employer, and that the
employee has no vested interest in those
funds, other than as a general creditor of the
corporation.

29-29
 “Select Group” Requirement

• Inclusion of low-paid employees makes such

a plan subject to Title I of ERISA, which
requires that a plan be funded and that the
employees receive a vested right to the
benefits of the plan under one of the
statutory vesting schedules.

• Thus, not only may a nonqualified deferred

compensation plan discriminate, it must
discriminate.

29-30
 Tax Treatment of Nonqualified Deferred
Compensation Plans

• Under Revenue Ruling 60-31, a participant in

an unfunded, non-qualified plan will not be
currently taxed on the compensation
deferred under such a plan as long as the
employer's obligation is merely a contractual
obligation and is not represented by any
evidence of indebtedness or other security.
• The essential requirement in obtaining
deferral of taxes on the deferred
compensation is to avoid "constructive
receipt" of the benefits to the employee.

29-31
 Avoiding Constructive Receipt

• Under the doctrine of constructive receipt,

income is taxable when it is credited to an
employee without substantial restrictions or
limitations on the power to withdraw.

• Where there are limits or conditions attached

to the right to withdraw or receive the
compensation, there is no constructive
receipt until the conditions are met.

29-32
 Funding

• Historically, non-qualified deferred

compensation plans for employees of
closely-held corporations have been funded
largely with cash value life insurance.

• The tax-deferred accumulation of life

insurance cash values offsets the taxability
of investment earnings on nonqualified
deferred compensation plans.

29-33
 The Split Dollar Plan

• Split-dollar insurance is an arrangement

whereby an employer and an employee share
the premium cost of life insurance on the life
of the employee.
• The employer contributes that portion of
each annual premium equal to the increase in
the cash value that will result from such
premium payment.
• The employee pays the balance of the
premium.

29-34
 Split Dollar Plan Policy Arrangements

• The employer, as owner of the policy, is

responsible for paying the full premium to
the life insurance company.

• The employer is also the beneficiary of the

policy to the extent of an amount equal to the
cash value as of the date to which premiums
have been paid at the time of the employee's
death less any indebtedness.

29-35
 Advantages to Employees

• The employee is provided the opportunity to

obtain additional life insurance with a
minimum outlay of his or her own funds.
• Split-dollar insurance has the additional
advantage of being permanent insurance--not
term insurance--and can be continued
beyond retirement age.
• Split-dollar insurance provides an incentive
and an inducement for the employee to
remain with the firm.

29-36
 The Business Continuation Exposure

• The death or disability of the owner of a

business, the member of a partnership, or a
stockholder of a close corporation may
create serious problems for that business.

• If the business is a sole proprietorship, it

may be necessary to liquidate and sell the
specific assets, rather than the going
business. Any value based on goodwill or
earnings may be wiped out.

29-37
 The Business Continuation Exposure

• In the case of a partnership, the executor of

the estate of the disabled partner may find it
necessary to sell the interest in the business
at the best offer that can be obtained from
the other partners.
• In the case of the corporation, the
corporation will continue, but the heirs of a
disabled or deceased stockholder may not
want to continue their ownership, or the
other stockholders may not wish to share the
ownership with the heirs.

29-38
Key Person Versus Continuation Exposure

• The business continuation exposure is

distinguishable from the key person
exposures.
• The loss of a key person is a risk
management problem for the organization.
• The business continuation exposure is a
problem for the owner and his or her
dependents.
• An owner may or may not be a key employee.

29-39
 Buy-Sell Agreements

• The solution to the business continuation

problem is to make arrangements for the sale
of the individual's interest prior to the death
or disability through a buy and sell
agreement.

• Under the terms of a buy-sell agreement each

owner agrees that his share of the business
is to be sold to the remaining owners in the
event of death or permanent disability, and
each owner agrees to buy the share of the
deceased or disabled owner.
29-40
 Basic Approaches

In general, there are two basic approaches.

• The owners of the partnership or corporation
may enter into an agreement under which the
estate of a survivor is obligated to sell the
deceased's interest, and the surviving
owners are obligated to purchase that
interest.
• The partnership or corporation may agree to
purchase the interest of the deceased owner,
thereby proportionately increasing the
interest of the remaining owners.
29-41
 Choice of Entity or Cross Purchase Plan

• The choice of an entity or cross purchase

plan (or their corporate equivalents) will
generally be determined by the tax treatment
of each approach and the tax situations of
the participants.
• Under a cross purchase arrangement, the
surviving owners get a stepped-up basis for
the ownership interest purchased from a
deceased owner’s estate.

29-42
 Disadvantage of Cross Purchase Plan

• The principal disadvantage of a cross

purchase plan or stockholders buy-sell
agreement arises when there is a vast
difference in the ages of the owners and their
respective ownership interests, and
insurance is to be used as a funding vehicle.

• Younger owners with small interests may be

unable (or unwilling) to pay the premiums
required to fund the purchase of older
owner’s larger interests.

29-43
 Financing the Purchase

• Merely providing for the mandatory purchase

and sale of the business interest is not a
complete solution.

• Consideration must also be given to the

financing of the transaction.

• The purchaser may pay for the business out

of savings, borrowings, earnings of the
business after transfer, or out of life
insurance proceeds.

29-44
 Life Insurance

• When the prospective seller is insurable, a

business life insurance policy is an attractive
approach to obtaining the funds needed to
effect the transfer.
• Generally, premiums on business life
insurance are not deductible for federal
income tax purposes. On the other hand, the
proceeds of the policy paid at the death of
the insured are not generally taxable as
income to the recipient.

29-45
Buy-Sell Agreements and The Estate Tax

• One of the major benefits of a buy-sell

agreement is that the IRS will normally
recognize the value established in the
agreement as determinative in setting the
value of the business interest of a decedent
for estate tax purposes.

• In the absence of a buy-and-sell agreement,

the IRS may place a value on the business
interest that will result in a greater tax burden
on the survivors.

29-46
 Disability of an Owner

• While many business owners have taken

steps to address the problems associated
with the death of an owner, provisions for
disability are less common.

• In the absence of disability income insurance

which provides income to the disabled
owner, it is likely that both the disabled
person and the other owners will suffer.

29-47
 Two Problems in an Owner’s Disability

A proper view of the disability exposure facing

business owners recognizes that there are two
separate problems when an owner is disabled.
• First, there is the problem of a continuing
income to the disabled owner.
• The solution is the same as the disability
problem facing every individual: disability
income insurance provided by the
employer or purchased individually.

29-48
 Two Problems in an Owner’s Disability

• The second problem is the transfer of the disabled

owner's interest in the business to the nondisabled
owners.

• The solution to this problem is essentially the

same as the solution to the problem associated
with the death of an owner: a buy-sell agreement
designed to become effective at the disability of
the owner.

29-49
 Disability Overhead Insurance

• Some self-employed persons carry disability

"overhead" insurance, designed to pay
business expenses, such as rent and clerical
costs, while the individual is disabled.
• Disability overhead insurance is needed by
individuals whose services represent the
principal source of income to the business,
and whose disability would halt that income.

29-50