Life insurance funding of buy-sell arrangements in family businesses

Abstract

Purpose

Buy-sell arrangements for the death of a co-owner may be funded with life insurance. Although many factors may enter the decision of whether to fund the buy-sell with life insurance, the degree of tolerance to risk is a major factor. The purpose of this paper is to estimate the risk aversion necessary to make life insurance funding the preferred option.

Design/methodology/approach

The decision whether to use life insurance was modeled using the expected utility theorem under state-dependent utility. Aversion to risk was varied to determine at what risk aversion levels insurance was preferred. Analysis was done for difference ages and thus mortality risk and for difference levels of insurance markups.

Findings

Life insurance funding is preferred at relatively low amounts of risk aversion, especially if the surviving partner becomes more risk averse upon the co-owner's death. A lower percentage of life insurance would be used if insurance premiums are significantly above actuarially fair premiums.

Practical implications

Given currently available insurance rates, most closely held small businesses probably should fund their buy-sell arrangements activated upon death of a partner with life insurance. However, cash flow constraints may hinder insurance purchase and planning may be myopic in that more imminent strategy issues may be present that a future death.

Originality/value

Although the use of life insurance to fund buy-sell arrangements is typically suggested for the small closely held business, little economic or financial analysis has been completed to date.

Citation

W. Tauer, L. (2013), "Life insurance funding of buy-sell arrangements in family businesses", Journal of Family Business Management, Vol. 3 No. 2, pp. 108-116. https://doi.org/10.1108/JFBM-02-2013-0005