The “Oops” Moment
The “Oops” Moment
When Benefits Professionals Drop the Ball: Executive Employment Agreements and Disability Insurance
In the hustle and bustle of managing employee benefits, a key component of an Executive Employment Agreement is often overlooked, leaving an Employer exposed to a significant financial liability, and potential legal liability.
Read on, to find out where and how Employers, Plan Administrators, and Employee Benefit Consultants miss the mark, and why this is such an important topic.
But first, what is an Executive Employment Agreement, and why should Plan Administrators be concerned?
Salary
Benefits
Stock options or awards.
Vacation time allotment.
Responsibilities
Compensation
Termination clauses
Competition and confidentiality.
Executive Employment Agreements commonly include the guarantee of disability insurance:
During employment
Up to 60%, without a monthly cap on benefits
Often required to protect total compensation
That in the event of a corporate “change in control” of ownership, merger/acquisition, or Executive termination, that the Employer continue to provide and pay for the same level of disability insurance for a specified period.
The key component of the Executive Employment Agreement often overlooked is the guarantee of disability insurance to replace a percentage of income (ex: 60% to 100% replacement) without a monthly benefit maximum.
Most Employers offer Group Long Term Disability (LTD) insurance. So, what is the issue?
Group LTD by itself often cannot meet the requirements outlined in the Executive Employment Agreement. Here is how:
1. LTD plans include monthly benefit maximums, which limit the amount of coverage paid per month.
a. These maximums result in a lower income replacement level, for highly compensated employees.
b. Agreements do not include a benefit maximum. A guarantee of 60% means just that; it is not subject to a monthly benefit maximum.
2. LTD plans only cover salary 78% of the time, by design. But the Agreement may require that total compensation be protected.
3. LTD plans are not truly portable. This means that upon the Executive’s termination, due to a change in control/acquisition, the Employer cannot provide the Executive disability insurance as promised. LTD plans are convertible, not portable. Conversion permits terminated employees to convert the Group contract, to a very restrictive individual contract. The conversion required medical underwriting, and the cost of coverage is expensive. Moreover, the converted coverage typically provides protection for a limited timeframe, and the contractual definitions are a shell of what LTD provides. Last, most Executive Employment Agreements will guarantee disability insurance for up to 2 years, even if the Executive has secured another opportunity. Conversion doesn’t solve the problem of portable coverage.
Case Study - Fortune 500 Company:
250 SVPs earn between $300,000 - $2,000,000 of base salary.
Target bonus of 30%
Group LTD covers 60% of the salary, to a monthly maximum of $15,000.
This protects salaries up to $300,000 at 60%. Salaries over $300,000 receive less than 60% due to the $15,000/month maximum.
Group LTD does not cover bonus compensation.
The Executive Employment Agreement for the 250 Executives requires that:
60% of total compensation is to be paid in the event of a disability. No monthly maximum stated.
In the event of termination due to a merger/acquisition, the Company must pay for Disability Insurance, providing the same 60% replacement, for 2 years after termination.
Two Issues:
Group LTD does not achieve 60% replacement:
LTD monthly benefit maximum limits protection
LTD does not cover bonus compensation.
Example:
An Executive earning a salary of $500,000 + a bonus of $150,000, or $650,000 in total compensation, only has 28% of total compensation protected. This Executive requires $32,500 on monthly benefit, but would only receive $15,000 from the Group LTD.
2. Group LTD is not truly portable.
Therefore, the Company would need to “self-insure” the risk in the event of an Executive termination due to a change in control (merger/acquisition).
These two issues may require self-insurance, potentially affecting the balance sheet. IRS accounting rules (for C-Corp, FASB 112), require the employer to set aside appropriate reserves for a claim, when self-insuring the claim.
In the example above (Executive earning $650,000), if the Executive were employed while disabled, the LTD would pay $15,000. The employer would be contractually obligated to pay $17,500/month ($32,500 -$15,000). The reserve for a $17,500/month claim, might be $1,750,000, using a reserve factor of 100 as an example. This reserve must be reported on the Company’s balance sheet according to FASB 112.
Now, imagine the Executive was terminated due to a merger. The Company does not have portable coverage to offer, so self-insures the agreed promise to pay for 60% protection, for 2 years after termination. Remember, the agreement was to “pay” for coverage, but the Company needs to self-insure in the absence of a portable product. The benefit duration of the claim could be much longer, such as 5 years, or the Normal Retirement Age. The Executive goes on claim a year after termination. The Company is now obligated to pay $32,500/month, for the duration of the claim. The reserve and corresponding impact to the balance sheet would be substantial, for an Executive that is no longer employed by the Company.
Further, the Company must make determinations on whether to pay a claim, since there is no insurance company providing guidance or advice to pay. With precedent now set, what is the Company pays this claim and mistakenly fails to pay another claim with similar (or different) merits. This creates a possible legal liability.
You may be wondering, why would an Employer include language in the Executive Employment Contract, promising coverage upon termination due to a change in control? Good question. But it happens, and it is often aligned with other promised benefits.
True Story – Fortune 500 Case Study:
I received a phone call from an Employee Benefit Consultant, asking if I could assist her in providing portable individual disability insurance to 100 or so Executives, as they were just terminated due to an acquisition. Unfortunately for the Company, the ships had already sailed on that option. Insurance carriers do not offer coverage to unemployed Executives. Even if they did, the coverage would have required full medical underwriting (good luck with that!) and been extremely expensive.
We were able to help rectify this exposed gap for the 250 SVPs and above, moving forward, however. But the challenge could not be met by upgrading Group LTD alone.
Group LTD carriers provided a higher monthly limit, but the limits were still insufficient to cover the total compensation for most executives.
Further, a super high maximum, on an experienced rated employer (fully credible claims experience due to the number of covered employees and experience years), would create sizable reserve exposure and future LTD pricing spikes in the event of a high benefit max claim.
Group LTD is not portable, so the Agreement’s requirement to offer coverage upon termination due to change in control/acquisition, could not be solved with LTD.
Rather, the gap was solved with a restructured Group LTD plan, coupled with Supplemental Disability Insurance, and Excess High-Risk coverage. Both the Supplemental and Excess coverages were secured with deeply discounted rates, on a Guaranteed Issue Basis, and included true portability at the same rates. Further, the claims experience on the Supplemental and Excess coverages would not negatively impact on the Group LTD claims/reserves, serving as a “stop-loss.” Last, although the portable coverage only protected approximately 30% of total compensation, it also served to provide direction to the Company in making claims determination for the self-insured portion; like an “advice to pay”. This helped limit the Company’s legal liability, in determining when to pay the self-insured portion by following the guidance of the Supplemental and Excess coverages.
Plan Administrators, and Benefit Professionals, should investigate what disability insurance and income replacement requirements are specified in their Company’s key Executives’ Employment Contracts. Chances are you might be surprised, and you will discover that the current Group LTD plan alone does not meet the requirements.
Navis Benefits Group, LLC, can help you address the gaps presented by Executive Employment Agreements, by assisting in the design, and installation, of Supplemental and Excess Disability Insurance Solutions. With over 29 years of experience in specialty benefit solutions, we pride ourselves in being an ally and partner to our clients, customizing solutions unique to their business and employee benefit needs.
James Reidy
Managing Partner
Navis Benefits Group, LLC
860-462-6408
JReidy@NavisBenefitsGroup.com
NavisBenefitsGroup.com
