Business owners have unique life insurance needs. Because both their families and their businesses rely on them, they need to make sure their coverage protects both.
For three years, Carol Smithem ran two small businesses from her home in Folly Beach, S.C. When she met with a financial adviser, she realized there was a missing piece in her business plan: life insurance.
Smithem wanted life insurance to make certain her husband, William, wasn't stuck with the mortgage and outstanding credit line on her condo -- which she bought before the couple married -- if she suddenly died. Smithem decided to buy $250,000 worth of term life insurance, which will last until after the condo is paid off.
"I wanted to make sure if I was hit by a bus, my husband wouldn't be turned out of the house," Smithem says.
How life insurance protects your family
Even though it endangers their families' financial security, business owners often put off buying life insurance, says Leonard Wright, a San Diego financial planner and CPA.
One reason for this is confusion about the many types of life insurance on the market today, some of which aren't a good deal. Wright recommends that business owners get details about the commission structure of any life insurance policy they consider.
"I saw one policy where the insurance agent was paid $300,000, and the buyer had hardly any cash value (from the policy)," Wright says. "Sometimes business owners get a sour taste in their mouths after hearing what happens to friends who had unsuitable products peddled to them."
For young entrepreneurs in the early years of their businesses, term life insurance, which provides coverage for a specified number of years, is the right choice, says John Going, a certified financial planner at Going Brothers Financial in Houston. Coverage is affordable then because younger people present a smaller risk to insurers -- only a small portion of them will die before the end of the term. Business owners in their early 40s might consider a 25-year term life policy, which would help their families recover lost income from business activity if the breadwinner dies before retiring.
The other forms of life insurance -- whole or universal life -- are more expensive because they cover the owner until he or she dies. Therefore, all such policies are assumed to require a payout eventually. Moreover, unlike term policies, whole life policies build cash value over time -- in a way, they're like a retirement account.
If a business thrives and its assets increase, it may make sense at some point to add either a whole life policy or convert the existing term policy to a whole life policy, Going says. The key advantage: Some term policies can be converted to whole life later without the business owner having to undergo a physical exam. Some of the term premiums also may be refunded in the process.
Going advises buying a term life policy from a major insurer with a stellar reputation that offers the option of converting to a whole life policy down the road.
How 'key man' insurance can save your business
While basic life insurance is essential for making sure family members are provided for if a business owner dies, it won't ensure that the business survives.
Financial planner Wright had an experience early in his career that illustrated this problem. He once interviewed for a job at a successful regional retail chain whose CEO and chief financial officer both had been killed in a plane crash. Soon afterward, the job opening disappeared.
Without the trusted leaders of the company at the helm, Wright says, "the banks got spooked, cut their lines of credit, and the company went out of business. They didn't have the cash to keep it going. I've seen this happen over and over."
So, if you're a business owner or a key figure at a business, additional insurance is needed to protect the business in case of your death. As Wright saw, banks may sever relations with a company after the sudden loss of the leader who built those banking relationships, despite the company's strong financial record.
"Key man" insurance addresses this issue. This insurance pays out cash that can finance the business while new bank relationships are developed.
In a partnership, when one owner dies, the family of that owner often retains the person's share of the business, Wright says. But if banks turn their backs and there is no insurance to provide cash for keeping the business afloat, the business can die as well, robbing the family of their share of what might have been many years of future profits.
"So many business owners don't understand that key man insurance is just incredibly important to the survival of their businesses," Going says.