Key-Person Insurance a Hard Sell

In the wake of Sarbanes-Oxley, insurers are making a case for covering CFOs with key-person policies. But who's buying it?


Andrew Morrison, CFO of American Science and Engineering Inc., passed away in August at the age of 52, a year after joining the $70 million manufacturer of X-ray detection and imaging systems. At the time of Morrison's hiring, AS&E chief executive officer Ralph Sheridan said the CFO brought "a wealth of international treasury finance experience" that was "invaluable" to AS&E in broadening the global reach of field operations. Yet, while his death left a void, AS&E had elected not to insure Morrison — or any other company officer for that matter — with key-person life insurance. "It just didn't make sense," says Paige Cochran, vice president of human resources at the Billerica, Massachusetts-based company.

AS&E is not alone in forgoing key-person life insurance, employer-paid coverage that provides a payout to the employer in the event of a key person's death. While it is routine for corporations to insure their physical assets, many do not insure their human assets, believing key-person life insurance to be pointless, if not inappropriate. They contend that prudent succession planning obviates the need for the insurance — the argument at AS&E.

Vendors of key-person life insurance policies maintain companies are wrong about this. They note the policies' wide-ranging utility, relative inexpensiveness (costs are based on standard actuarial tables), and tax-free benefits. Moreover, they point out that the insurance payout from the policy not only defrays the costs of replacing an executive, but also can finance employee-benefit obligations and absorb financial strains caused by a key executive's death, from an impaired credit rating to lost customers.

Such benefits are part of a renewed campaign by insurers to sell key-person insurance to the C-level suite. And given the new responsibilities bestowed upon them since the Sarbanes-Oxley Act was passed, some are convinced that policies for CFOs will be a major new market. "The role of the CFO has taken on an importance post-Enron and post-Sarbanes-Oxley that is greater than at any other time in history," says Patrick Smith, director of advanced marketing at Hartford-based insurer The Hartford, adding, "We believe that key-person life insurance on CFOs will be a growing phenomenon, given their expanded responsibilities."

Smith is not alone. "Key-person life insurance on a CFO makes sense today," says Robert Hartwig, chief economist at the New York-based Insurance Information Institute. "CFOs' reputations and potential freedom are at stake in the wake of Sarbanes-Oxley. Consequently, companies will seek higher-quality CFOs — individuals whose integrity is unimpeachable and whose skills are broad. These CFOs would be more costly to replace in the event something happened to them."

Still, key-person life insurance promises to be a tough sell. Many public companies are loath to buy insurance that pays a large sum of money when a C-level executive dies. And, given the strain on cash-strapped budgets from skyrocketing insurance premiums, beleaguered risk managers are not about to add another policy to the mix. "Insurance is not a good substitute for high-quality management teams," says Richard Inserra, assistant treasurer and director of risk management at Praxair Inc., a Danbury, Connecticut-based industrial gas company with $5.2 billion in 2002 revenues. "When you lose a general, the colonels take over until a new general is put in place."

Game of Life

While key-person life insurance has been around since the 1960s, it has been eclipsed in recent years by the insurance industry's push toward corporate-owned life insurance (COLI) policies. The controversial product covers more than just key executives; it's designed to cover the entire rank and file, hence its more colloquial name — janitors' insurance.

The problem with COLI policies, which were born in the 1980s as a tax-advantaged way for companies to fund rapidly rising employee health-care costs, is that actions by Congress, the Internal Revenue Service, and the courts have removed some of their gleam. In 1999, for instance, Congress phased out corporate deductions for interest on loans against COLI policies. Negative publicity about how companies were benefiting financially from employees' deaths — especially in relation to September 11 — has slowed growth in a line that traditionally accounts for up to 30 percent of the life insurance market.

With COLI policies losing their luster, insurers are returning to key-person life insurance as a risk-transfer strategy for critical human assets. The benefit of having such coverage, vendors contend, is that it helps defray the cost of recruiting and training a replacement executive. In addition, the insurance also helps fund any financial promises made to a deceased executive's spouse, such as salary continuation or deferred compensation. And on the softer side, the insurance proceeds also can counter the financial impact of distracted employees — missed deadlines, deteriorating morale, and personality conflicts, according to W. Thomas Lobaugh, a senior vice president in the Chicago office of insurance broker Willis Group Holdings.

The case for having such coverage, says Lobaugh, is often clear. "The impact of a key executive's death is many-fold," he comments. "It can cause a loss of confidence among suppliers and customers, and an inability to seize upon a business opportunity, because cash reserves are being used to train the new employee. There's also the potential of impairing a company's credit standing and its ability to secure financing."

Deciding whom to cover, however, is tricky. Traditionally, public companies that purchased the coverage did so to insure their CEOs, particularly those with long tenures and high profiles whose sudden demise would impair public confidence and cause financial repercussions. It has been rumored for years, for example, that Robert Maxwell, the late British media mogul and owner of the tabloid Daily Mirror, who either fell, jumped, or was pushed to his death from his yacht in 1991, had taken out a $100 million key-person life insurance policy just weeks before the plunge.

Unfortunately, getting companies to reveal that they even have the insurance on their CEO (or any top executive) is difficult. "You don't want some disgruntled shareholder to catch wind of the fact that the CEO's death could mean a windfall for the company," says an insurance broker, off the record. So while it is likely that such marquee CEOs as Martha Stewart are covered by key-person life insurance, the extent to which this is the case at other large companies remains speculative.

Statistics on the prevalence of such insurance at private companies are also hard to come by. But given that CEOs' close ties to customers and suppliers are often irreplaceable at such companies, the policies are said to be more popular, though equally secretive. It's the same case with partnerships, where it is common for one partner to insure the life of another partner. And experts say that the insurance is often used to cover certain other employees — a salesperson with decades of experience nurturing customer relationships or a corporate scientist whose ideas are about to be commercialized — since their loss means corporate loss.

Where statistics do exist, however, is in England, where a study last year conducted by Continental Research for U.K.-based insurer Royal & SunAlliance found that nearly half of all midsize and smaller U.K. companies purchase the insurance. Forty-four percent of 135,000 companies surveyed said they had bought key-person life insurance on one or more key executives whose loss would have a serious impact on trading and profitability. Overall, says Bill Kelly, a former J.P. Morgan managing director who headed the investment firm's risk-management department until recently, such policies make the most sense "in terms of [covering] someone in a critical revenue-generating position or for an executive with tremendous intellectual capital."

Moribund or Morbid?

No one knows how many companies buy key-person life insurance on their senior finance executives. What is clear is that there may be specific circumstances in which such a policy is vital. "If the CFO is in the middle of negotiations with another firm, in the midst of an incomplete project, or just short of reporting to regulators and Wall Street, his or her death would cause huge financial distress. Key-person life insurance would offset any losses caused by the CFO's demise through an inflow of cash," says Robert Travers, counsel in the estate- and business-planning group at Boston-based insurer John Hancock Financial Services Inc.

Willis, for example, "just bound a policy for a company that was acquiring another company," says Lobaugh, noting that "it wanted short-term key-person life insurance on the target company's CFO." He adds that the CFO was critical to the success of the postmerger company.

Going forward, vendors are sure to leverage the importance of senior finance executives in such situations, as well as in the new legal responsibilities bestowed on them by Sarbanes-Oxley. Still, a sampling of corporate risk managers indicates few accept such arguments. While Praxair's Inserra agrees that "the passing of a CFO could be a major blow," he notes that "they're not irreplaceable." Moreover, he says, there isn't a compelling financial case for such insurance — meaning its tax benefits and investment potential. "A whole-life policy pays about 4 percent," says Inserra. "You can't tell me a company can't get a higher return than that on its capital. Shareholders want 10 percent returns anyway. This is just a way to squander shareholder value."

And David Hennes, director of risk management at Minneapolis-based Toro Co., is simply not comfortable with the whole premise of the coverage. Says Hennes, who eliminated such policies for two of his last three employers on his first day on each job: "It's not appropriate for a midsize or larger company to rely on a cash windfall in the event a key executive dies. The whole principle of insurance is to absorb catastrophic loss. In 99.9 percent of companies, the loss of any one person would not be catastrophic." Toro, a maker of turf-care equipment with $1.5 billion in revenues, also eschews the policies.

But vendors stick to their guns on the merit of the strategy. Putting his money where his mouth is, Smith notes that The Hartford owns a key-person life insurance policy on its CFO, David Johnson, as part of a wider corporate plan to provide such coverage for The Hartford's executives.

Sidebar: The Case for Key-Person Life Insurance

The death of a key person can have a devastating effect on a business, especially if that employee controlled substantial accounts and profits, or had established relationships with suppliers, manufacturers, or buyers, which are often irreplaceable.

The insurance proceeds of a key-person life insurance policy can fill several needs:

  • They can stabilize the stock of a publicly held company, because creditors and shareholders generally look favorably on the business use of key-person life insurance.

  • They can be used to help find and train a new employee to replace the deceased.

  • They can provide the funds to purchase stock belonging to the deceased shareholder.

  • They can be used to fulfill any contractual agreement to continue to provide the employee's salary to his or her family for a certain number of months.

Source: Willis Group Holdings

Sidebar: What's Your Worth?

As with any insurance, figuring out appropriate limits of protection for key-person policies is a delicate proposition — too much insurance means you've overpaid; too little means you're financially vulnerable. But insurers and brokers have devised specific methodologies to gauge the right amount of insurance coverage for the life of a CFO — or of any executive.

The first is the valuation approach, a calculation based on a CFO's average annual earnings over his or her working life. "Say the CFO of a company with a book value of $900,000 earns $100,000 a year and has 10 years left until retirement," says Patrick Smith, director of advanced marketing at insurer The Hartford. "This CFO would earn $1 million for the remainder of his or her tenure. Once you deduct federal and state income taxes, the CFO would net about $64,000 annually, or $640,000."

Here's where the calculations get protracted. "Subtract $640,000 from the $1 million, leaving $360,000, and multiply the difference by the present value of $1 per year for the 10-year period, discounting the earnings over this time by a reasonable rate of interest, say 5 percent," says Smith. "The CFO's value is $392,904."

Another method is the contribution-to-earnings approach, based upon two financial-statement metrics — average book value (or shareholders' equity) in a company measured during a five-year period, or the average net income before taxes for the same five-year period. This method determines limits by estimating the CFO's contributions to net profits. Using the same CFO example, here is a short primer, provided by Smith:

Multiply the average book value by a selected percentage that represents a fair rate of return. Eight percent of a $900,000 book value yields $72,000.

Subtract this amount from the CFO's average five-year income to obtain the portion of the business income representing his or her contribution. Since the CFO's annual salary is $100,000, subtracting $72,000 leaves $28,000.

Multiply $28,000 by the number of years it would take the business to hire and train a replacement for the key person; for example, it would take a replacement CFO five years to become as proficient. Multiplying $28,000 by five yields $140,000 — the contribution to earnings of the key person.

Yet another way to measure a CFO's worth is the cost to replace his or her expertise, a test that focuses squarely on the salaries of the CFO and the potential replacement. To calculate this value, start by subtracting the replacement CFO's salary from the former CFO's, the difference "being the value of the key person's special attributes," says Smith. "Subtracting $70,000 from $100,000 leaves $30,000. You then multiply $30,000 by the number of years it would take to hire and train a replacement to become as proficient as the CFO. If it's five years, the limits of protection should be $150,000."

Since the three methods produce different limits, what's the point? "You want to do all three calculations and then average them out," says Smith. "The methodologies give you a means to assess a person's value in dollars and cents. The true value of an employee cannot be tagged to any single arithmetical method."


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