Excerpted from New Mexico Employment Law Letter, written by attorneys at Tinnin Law Firm, A Professional Corporation

Don't worry. We're talking about a technicality here. All of your employees are key players in your organization (or they should be if they are still employed by you), but when it comes to purchasing life insurance for your most valuable employees to protect against the economic loss that would occur after their untimely death, that type of insurance is commonly referred to as "key person" insurance. (Sometimes, it's also called "key employee" or "key man" insurance.)

But can you extend key person insurance to cover any employee? At least one company thought it had found tax advantages to doing that, but it later learned from the Tenth Circuit (which covers WY, UT, CO, NM, KS, and OK) that employers don't have insurable interests in rank-and-file employees.

Facts

In an effort to take advantage of a provision in the Internal Revenue Code, Camelot Music, Inc., purchased approximately 1,400 corporate-owned life insurance (COLI) policies on the lives of its full-time employees, to whom it extended medical benefits. Camelot's stated reason for purchasing the COLI policies was to ease its tax burden, which would help offset the cost of employee health insurance premiums. The company actively concealed the existence of the COLI policies from its employees.

When Filipe Tillman, one of its rank-and-file employees, later died, Camelot received approximately $340,000 in life insurance proceeds. After learning about the life insurance policy and payout, Tillman's estate sued Camelot under an Oklahoma statute to recover the proceeds.

No insurable interest in ordinary employees

The most interesting aspect of the Tenth Circuit's opinion was whether Camelot had an insurable interest in the lives of its rank-and-file employees. It's widely accepted that companies have an insurable interest in the lives of key employees who are important to the success of the business, and key employees are commonly insured. But do you have an insurable interest in ordinary employees?

Camelot convinced the district court that it did, pointing out that it spent valuable resources recruiting, screening, training, and retaining its employees in an effort to generate profits. Tillman's estate appealed the court's ruling to the Tenth Circuit.

The appellate court recognized that employers expend resources that are undoubtedly valuable to them in an effort to recruit and retain employees. Without evidence of considerable expenditures in proportion to the overall budget or other evidence of the substantial nature of the expenditure, however, money spent attracting and keeping employees is a general cost of doing business. It therefore isn't sufficient to support the requirement that the employer have a substantial economic interest in a specific employee's continued life.

Camelot failed to present the evidence required to demonstrate Tillman's special importance. The company spent money hiring and retaining him and providing him with medical benefits, but those were costs associated with all its employees. There was no evidence that he added significant financial benefit to the company, so Camelot didn't have an insurable interest in his life. Tillman v. Camelot Music, Inc., No. 03-5172 (10th Cir., May 11, 2005).

Bottom line

Although this case was decided under Oklahoma law, it involved general legal principles that probably apply in any jurisdiction. No employer can expect to have an insurable interest in ordinary rank-and-file employees, so don't get cute with your tax tricks and try to insure all your workers. Reserve "key person" insurance for employees you truly have a substantial economic interest in.