Life insurance serves a wide variety of purposes in the business world, but most of the services can be grouped under these four headings:

Perhaps the most direct application of the principles of family insurance to the business world is key person insurance. Its purpose is to indemnify a business concern for the loss of earnings caused by the death of a key officer or employee. In many business concerns, there is one person whose capital, technical knowledge, experience, or business connections make him or her the most valuable asset of the organization and a necessity to its successful operation. This is more likely to be true of a small organization, but innumerable examples can also be found in large organizations. A manufacturing or mining enterprise may depend on one or a few individuals whose engineering talents are vital to the concern. An employee with unusual administrative ability or the ability to develop and motivate a superior sales organization may also be a key person. An educational institution or other organization that depends partly on charitable giving may regard a highly successful fund raiser as a key person.

It is difficult to estimate the economic loss that the organization would suffer in the event of the key person�s death. In most cases the loss is measured in terms of earnings, but occasionally it is based on the additional compensation that would have to be paid to replace the key employee. In some cases, the reduction in earnings is assumed to be temporary (5 years, for example), while in other cases, a permanent impairment of earning power is envisioned. The basis for indemnity can usually be established rather accurately when the key person protection is required in connection with a specific research project or other undertaking of temporary duration.

Insurance is purchased on the life of the key employee by the business and is made payable to the business as beneficiary. In most cases, some form of permanent insurance, usually ordinary life, is purchased, and the accumulating cash values are reflected as an asset on the business�s books. If key person protection is needed for only a temporary period, term insurance is normally used. Premiums paid for key person insurance are not deductible as a business expense, but in the event of death, the proceeds are received free of federal income tax.

Life insurance can enhance a business concern�s credit in two general ways: by improving its general credit rating and by making collateral available.

The first credit function of life insurance is closely allied to (if not identical with) key person insurance. Anything that stabilizes a business concern�s financial position improves its credit rating. Insuring the lives of key personnel not only assures banks and other prospective lenders that the business will have a financial cushion if a key person dies, it also improves the firm�s liquidity through the accumulation of cash values that are available at all times. As a result, the firm is able to command more credit and obtain it on better terms.

A more specific use of life insurance for credit purposes is pledging it for collateral. It is important to note, however, that the collateral can serve two different purposes. It can protect the lender only against loss arising out of the death of a key person or the borrower, or it can provide protection against the borrower�s unwillingness or inability to repay the loan.

An example of the first situation is a firm that has borrowed as much as is justified on the basis of conventional operating ratios but would like to borrow additional sums to take advantage of an unusual business opportunity. If the bank has confidence in the business and feels that the only contingency to fear is the death of the business head or other key person, it can safely extend the additional credit upon assigning to the bank a life insurance policy in an appropriate amount on the life of the proper official. The policy need not have cash values; therefore term insurance is frequently used. The basic security behind the loan is the earning capacity of the business and the integrity of its officials. The policy provides protection only against the death of the person whose business acumen assures the loan�s repayment. Such loans, secured only by the assignment of a term insurance policy on the borrower�s life, are common in personal or nonbusiness transactions�for example, an aspiring doctor who borrows money from a benefactor for medical school, repaying the funds after establishing a practice. In the interim, the benefactor is protected by a term insurance policy on the budding physician�s life. This is a character loan, pure and simple; the only hazard to repayment is premature death.

A loan based on cash values is in a different category. The basic security lies in the policy values; the amount of the loan therefore is always less than the cash value under the policy assigned to the lender. If the borrower dies before the loan is repaid, the lender recovers funds from the death proceeds, with the difference paid to the insured�s designated beneficiary. If the borrower lives but the loan is not paid at maturity, the lender can recover the funds by surrendering the policy for cash or by exercising the policy loan privilege. If the loan is repaid at maturity, the policy is reassigned to the borrower. Life insurance policies are widely used for this purpose in both business and personal situations. Policyowners frequently borrow from an insurance company through the policy loan privilege, rather than through assignment to a bank or other lender.

One of the important forms of business organization in this country is the general partnership, which is subject to the rule of law that any change in the membership of the partnership causes its dissolution. In accordance with this rule, the death of a general partner dissolves the partnership, and the surviving partners become liquidating trustees, charged with the responsibility of paying over the deceased�s fair share of the business�s liquidated value to his or her estate. Liquidation of a business, however, almost invariably results in severe shrinkages among the assets. Accounts receivable yield only a fraction of their book value, inventory is disposed of at sacrifice prices, furniture and fixtures are sold as secondhand merchandise, and goodwill is lost completely. Moreover, liquidation deprives the surviving partners of their means of livelihood.

In the absence of a prior agreement among the partners, any attempt to avoid liquidation is beset with legal and practical complications. Even if the surviving partners can raise the cash to purchase the deceased�s interest�an unrealistic assumption in most cases�they have to prove, as liquidating trustees, that the price paid for the interest is fair. In some states, their fiduciary status prevents their purchasing the deceased�s interest at any price since it is virtually tantamount to trustees purchasing trust property. Furthermore, it is seldom practical for the widow(er) or other heir to become a member of the reorganized partnership or to purchase the surviving partner�s interests.

In order to avoid this impasse, it is becoming increasingly common for the members of a partnership to enter into a buy-sell agreement. Such an agreement binds the surviving partners to purchase the partnership interest of the first partner to die at a price set forth in the agreement and obligates the deceased partner�s estate to sell his or her interest to the surviving partners. The various interests are valued at the time the agreement is drawn up and revised from time to time thereafter. Each partner is insured for the amount of his or her interest, and either the partnership or the other partners own the insurance. Upon the first death among the partners, the life insurance proceeds are used by the partnership or the partners, as the case may be, to purchase the deceased�s interest. Thus the business continues in operation for the benefit of the surviving partners, and the deceased�s heirs receive the going value of his or her business interest in cash.

All parties benefit by the arrangement. After the first death, the surviving partners can enter into a new buy-sell agreement, or they can continue under the original agreement with the necessary valuation and insurance adjustments. Life insurance is uniquely suited to financing such agreements since the very event that creates the need for cash also provides the cash.

The same sort of agreement is desirable for the stockholders in a closely held corporation. Closely held corporations are so similar in basic characteristics to partnerships that they have been described as "incorporated partnerships." Although the death of a stockholder does not legally dissolve the corporation, the same practical difficulties may be encountered in any attempt to continue the business. These difficulties arise because stockholders of a closely held corporation are also its officers, earnings are distributed primarily in the form of salaries, and no ready market exists for the stock.

Upon the death of a principal stockholder in a closely held corporation, the surviving stockholders are faced with three choices (apart from liquidation), all of which may prove undesirable: (1) to accept the widow(er) or other adult heir of the deceased into the active management of the corporation, (2) to pay dividends, approximately equivalent to the salary of the deceased stockholder, to the widow(er) or other heir without any participation in management on the heir�s part, or (3) to admit outside interests to whom the deceased�s stock may have been sold into active management of the company. The surviving spouse faces the possibility of having to dispose of the deceased�s stock at a sacrifice price, either to the surviving stockholders or to outsiders, neither of whom would normally be inclined to offer a fair price, or of retaining the stock and receiving no dividends. These difficulties can be avoided through a binding buy-sell agreement financed by life insurance. Under such an agreement, the surviving stockholders will get the corporation�s stock, and the widow(er) will receive cash for a speculative business interest.

Similar agreements can be arranged between a sole proprietor and one or more key employees. Life insurance can provide at least a portion of the purchase price, and the remainder can be financed by interest-bearing notes to be paid off from the business�s earnings after the proprietor�s death.

Employee benefit plans provide three broad types of benefits that can be financed through insurance:

The plans that provide such benefits are usually referred to, respectively, as group health insurance, group life insurance, and pensions, including group annuity plans. While accidental death benefits may be�and usually are�provided under a group health plan, life insurance contracts, per se, are used only in connection with group life insurance and certain forms of pensions. Suffice it to say that death benefits under a group life insurance contract may be provided in the form of yearly renewable term insurance, permanent types of contracts, or a combination of the two. The employer always bears a portion of the cost, and some may pay it all. The benefits payable on behalf of any particular employee are determined by a formula that minimizes selection against the insurer. In other words, the employees are not permitted to choose the amount of coverage since those in poor health could be expected to apply for the largest amounts of insurance.

For a complete discussion of the business purposes of life insurance, see chapter 12.