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March 30, 2010
Private Equity firms understand risk. Managing risk on all levels is a critical component to driving and protecting shareholder value. In today's economy, human intellectual capital reigns supreme. Intellectually rich companies tend to be highly dependent on the human capital of one or two key leaders that drive shareholder value. Most corporations respond to the risk by securing Key Person Life Insurance. The greater risk is the exposure to a disabling injury or illness that prevents these leaders from executing their plan and completing their vision.
Statistically, the risk of disability during the working years is significantly higher than the risk of death. A 45-year-old executive is 3½ times more likely to suffer a disability lasting greater than 90 days than to die before age 65. In either event, the employing corporation faces significant loss. Why is it that less than 15% of all companies with similar exposures purchase key person disability coverage? In today's competitive business environment, protecting the value of a star executive is more critical than ever. Using markets once reserved for elite athletes and entertainers, carriers such as Lloyd's of London and other domestic niche market players have developed key person disability products designed to protect a company's most critical assets. These specialty carriers have the ability to deliver disability benefits exceeding $500,000 per month and lump sum benefits to $100,000,000, thus allowing companies to insure those whose vision, knowledge and experience are critical to a business's continued success.
- A Private Equity firm purchased a highly successful service company. The transaction was split in two parts. Part A was a cash payment upon close of the investment paying nearly $10,000,000 to each partner, Part B was a cash payment made to each shareholder over time based on certain performance targets. The acquisition agreement called for $10,000,000 of key person insurance on each owner. The intent of this provision was to secure Key Person Life Insurance; however, when the Private Equity firm understood the risk of disability was the greater exposure to the corporation, disability contracts of equal value were purchased to protect the firm.
- In order to expand a start up company, an entrepreneur of an international cosmetics company required additional capital. The private equity investors were hesitant to release funds, as the success of the enterprise rested exclusively on the CEO's extensive network of industry contacts. The private equity firm required $3,000,000 of Key Person life and disability insurance as a safeguard against the loss of the key executive. Since there was strong financial justification for the $3,000,000 limit, the underwriting process with respect to the Life exposure was straightforward, and the client had hundreds of Life companies and products to choose from. Utilizing a custom designed Key Person Disability Policy, a contract paying the corporation $50,000 per month for up to 12 months in the event the CEO became totally disabled was placed. If the executive were deemed totally disabled after that period of time, the company would receive an additional $2.4 million in one lump sum.
- A recently launched fund required institutional investors to commit their capital to a 5-year "lock up" period. The fund received over $1,000,000,000 in capital, which generated in excess of $10,000,000 in annual management fees. The investors could only liquidate their position under specific circumstances, and in the event of death or disability of the named managing partner, accelerated divestiture was a possibility. We designed a reducing key person disability contract which would pay the fund $50,000,000 at inception, reducing by $10,000,000 per year over a five year period. Coverage paid a lump sum benefit in the event the executive became totally disabled for the elimination period, and was unable to perform his contractual duties to the fund, thus causing the liquidation by investors and loss of fees to the fund. The client paid a significant premium for such a customized definition; however, since the exposures were very large and specific, both the policyholder and the carrier left the table satisfied.
- A well-established specialty retailer sought a $20,000,000 loan from a private lender. Since the CEO was the namesake and key manager, the lender required adequate life and disability insurance protection to be put in place to cover the loan. The loan was to be repaid in 60 equal installments of $33,333 (plus interest). Since cash reserves were low, the elimination period was established at 60 days, and the benefit structured was $33,333 per month for 60 months, reducing by one month with each policy month. Placing coverage in this manner enabled the CEO to keep his existing personal disability coverage, which he was going to assign prior to applying for this coverage.
The statistics bear out the need for the coverage, and justification for the cost. Key person disability protection is more expensive than key person (term) life insurance; however, the risk is greater, and the premiums tend to be in direct proportion to the added risk exposure. Countless early and mid-stage companies exclusively depend on key leadership for success. If you have purchased or are considering purchasing key person life coverage on one of your portfolio company executives, consider adding key person disability protection.
David N. Richter, CLU, ChFC
Richter Insurance
An Equity Risk Partners Strategic Partner
3000 Citrus Circle, Suite 130
Walnut Creek, CA 94598
(925) 899-3269 - cell
drichter@equityrisk.com
CA License: 0711251
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