Most businesses value their employees (or at least they should!).
But inevitably there will often be a few key individuals who are critically important to the success and viability of the company.
These employees can be referred to as “key person’s” or sometimes as a “key man” or “key employee”
This may be a founder that owns a large stake in the business but not always. It could be someone like the following:
- The head brewer at a craft brewery whose recipes and knowledge of hops are critical to the core product.
- An account executive who has developed deep and long-standing relationships with top clients.
- A developer who wrote and maintains the bulk of the most complex code for a SAAS company.
It is really anyone whose loss would be difficult for the company to replace quickly and would have a likely negative impact on the operations or profitability of the business.
For this reason, the Key Person life insurance policy was born.
Quick Article Guide:
- What is Key Person Insurance?
- What Type of Business Should Consider a Key Person Policy?
- What Does Key Person Insurance Cover?
- Tax Considerations
- How Much Coverage Do I Need?
- How Much Does Key Man Life Insurance Cost?
- What Happens if a Key Employee Quits?
- Other Benefits to Key Person Insurance
- Key Man Disability Insurance
What is Key Person Insurance?
A Key Person policy helps the business survive and deal with an unexpected death to the key employee. It will pay out funds that help the business continue and mitigate the loss of the integral person until they can be adequately replaced.
The business purchases policy pays the premiums and also is the beneficiary. The key person is insured upon who the policy is written.
What Type of Business Should Consider a Key Person Policy?
Not all businesses will be a good fit. Small, one-person operations will not need this type of insurance as the business will cease to exist if the individual is gone. In this case, regular life insurance that pays out to the family of the deceased may be more applicable.
Large enterprises with thousands of employees may use key man policies in a different manner than a startup or small or midsize businesses. Having cover against the loss of an important C-level executive may strengthen confidence in investors and shareholders.
Questions to ask yourself about your business:
Do we rely on any specific individuals that would be difficult to replace?
What would the business impact be if these individuals were gone?
Are there a majority of shareholders who work actively in the business?
What Does Key Person Insurance Cover?
In the event of an untimely death of the key employee, the policy can provide funds to recruit and train the replacement. Depending on the direct impact on the bottom line, the payout may also make up for the loss of profits resulting in the death of the key employee.
The policy may be used (and often required upfront) as a guarantee for a business loan. The lender will want insurance that the loan can be repaid if an important employee is lost.
Generally speaking, a business must pay the key person insurance premiums with after-tax dollars so it’s NOT deductible. The IRS covers this in Section 264(a)(1).
This is different from many other types of business insurance such as commercial general liability.
On the flip side, the proceeds a company receives due to the death of the key employee are NOT taxed. On a policy with a $500,000 face amount, the business will receive the full $500,000 with no additional tax liability.
How Much Coverage Do I Need?
If your business is borrowing money, the lender may have a requirement that dictates a certain percentage of the loan amount be guaranteed by a key person policy.
If there is no loan, the amount of coverage necessary depends on the type of business and the impact of losing that employee will have.
Some things to consider:
- Will the business lose any key customers or accounts?
- How long will it take to find and train a replacement?
- Does the employee possess any closely held business secrets such as recipes, code, or business plans that are not documented in detail? If so, what is the value of these?
- How much revenue and profits can you tie directly to this employee?
- Would the brand strength and reputation take a loss and what is that worth?
How Much Does Key Man Life Insurance Cost?
The premium payment will closely mirror a regular life insurance policy done outside of a business.
Several things will determine the cost of the policy.
The death benefit or policy face amount
It will come as no surprise that a policy that pays out 2 million will generally be more expensive than a policy that pays out $100,000.
The medical history and lifestyle of the employee (insured)
Whichever life insurance carrier issues the policy will need to assess the risk of the insured, no different than non-business policies. The employee’s age, gender, medical history (both personal and family), hobbies, driving record, and prescription history, will all be looked at.
Type of policy
Term life insurance policies are common with the key person since they are the most straightforward. They also cost the least. Another reason term is popular is that it can be aligned to a projected retirement date or to the payoff of a business loan.
Whole, universal, or variable can also be used. With the increased cost comes additional benefits and accumulation of cash value.
Be sure to structure your policy correctly in regards to who benefits from cash value accumulation or investment proceeds that come with non-term policies.
What Happens if a Key Employee Quits?
In the event that a key person who is the named insured on a life insurance policy owned by the business quits and leaves (while alive of course) the company has a couple of options.
- The business can simply quit making the premium payment and the policy will lapse.
- The business can continue making the payments and will still receive the payout when that individual dies if it’s within the term of the current policy.
Other Benefits to Key Person Insurance
In addition to the main reasons already discussed above, there are several lesser-known benefits that may be attractive to companies considering this type of investment.
Improve Chances for VC Funding
Similar to some lender requirements, most venture capitalist firms will require key policies when issuing the first round of financing.
These ventures are somewhat risky by nature, to begin with so they like to have that protection built in that should a key player be lost, the business will have a lifeline via the cash payout from the policy.
Boost to Employee Morale
An Oxford University study of multinational firms determined that there is a link between employee happiness and productivity. They found workers to be 13% more productive when happy at work.
If a company takes out a key person life policy on an individual (or group of employees) it may be extra motivation and boost their happiness and morale at work. Workplace happiness is also found to be contagious and may have a ripple effect.
Employers may look to pair a key man policy with a Non-Qualified Deferred Compensation (NQDC) plan. These plans allow the employee to earn income in one year but defer the income tax to a future year, usually planned for retirement years.
The pairing of an NQDC with a key man insurance policy protects the employer from not only the death of the key employee but also discourages the employee from leaving on their own due to these “golden handcuffs”.
Stock Buyouts and Survivorship
In the event that the key person was a major shareholder, it can leave a messy situation if proper planning is not taken.
What if the heirs don’t want to be apart of the business moving forward? Or what if they do but are not capable of filling the role?
Keyman insurance in conjunction with a properly structured buy-sell agreement can avoid this situation entirely and leave both the heirs and the surviving business partners happy.
Key Man Disability Insurance
When a business has identified and admitted to themselves that the loss of a keyman would be significantly detrimental, they may look at not only a key life policy but key man disability as well.
Keyman life insurance will typically only pay out at death unless the policy specified and included provisions known as “living benefits”.
Living benefits allow for a predetermined amount of money to be taken from a policy when the insured is diagnosed with a terminal, chronic, or critical injury. The criteria vary by policy and carrier.
There still is a hole left in the business protection strategy because a valuable talent can be lost to long term disability yet still living. In this case, it’s the worst of both worlds since the business not only is without the services and experience of the key employee but they don’t have the cash payout to offset the loss either.
This is where a key man disability policy can fill that gap in protection.
Whether just starting a business, looking to grow, or strengthening an already thriving business against potential pitfalls, key person life insurance can play an important role in the overall protection and succession strategy.