If you’re a small business owner, chances are that the success of your business rests heavily on your shoulders. It is your responsibility to make sure that your employees are paid, profits are made, and the business runs smoothly. It’s not an easy job, but if you believe in your business, you’ll make it work. One of the important tools you’ll need along the way is key person life insurance (also known as key man insurance).
As an employer, you are certainly aware of the value your employees are to the success of your business. Perhaps one or more of your employees is crucial to the success of your company and as such, you can’t afford to lose any of them. What would happen to your business if one of those key employees passed away leaving a significant hole in the operation and/or income of the company?
Key Person life insurance policies are taken out by a business to protect the interest of a company when an important employee (“key person” in this case) dies. The business will pay the premiums on this policy because the business’ financial success will be closely tied with this key person and their absence would guarantee a decline in business or, at worse, the end of the company. The purpose of key person life insurance is to ensure the success of a business even if an integral person (key person) dies unexpectedly, or at least help to facilitate the transition of the company after losing a key employee.
The transition process could mean finding a replacement key person to fill the role of the deceased. Or if the business decides to shut down the operation, it would use the death benefit from the insurance policy to pay off debts, pay final salaries, and provide severance for employees—all necessary precautions to ensure smooth closing while avoiding immediate bankruptcy.
How does Key Person Insurance Work?
Setting up a key person or key man life insurance policy on an employee is not difficult and can be transacted by any trusted insurance professional.
The most important steps when setting up key man or key person insurance are to determine who the key person(s) is in your organization and what the cost might be to replace that person(s) if he or she were to die unexpectedly.
The business owner should also consider whether the policy should be purchased for a death benefit only or if the policy will be used also to benefit the key employee at some future date.
If the purpose of the key person life insurance is to provide the funds needed to replace the insured person, term life insurance would be the most affordable choice. If, however, the business owner prefers to use the policy as a benefit to the insured key person as well, cash value insurance like universal life would be more appropriate.
The following two cases demonstrate how key person insurance can be used to protect your business in the event of a key person’s death and how an employer can use key person insurance as an employee benefit as well.
Key Person Insurance to cover the costs of replacing a Key Person
ABC Realtors has five agents that generate the bulk of the company’s sales each year. Of the five, Susan Wilson, who has been with the company the longest, generates more than 50% of the annual commissions for the agency.
Paul Samuels, the broker/owner of ABC Realtors realizes that if Susan were to die unexpectedly, the agency would lose a substantial amount commissions and at the same time, have to spend a considerable amount of money to recruit, hire, and train Susan’s replacement.
While meeting with ABC’s accountant, Paul discusses Susan’s financial contributions to the agency and asks the accountant for a recommendation to mitigate the risk of losing her production if the worst should happen.
Paul’s accountant recommends that ABC Realtors take out a term life insurance on Susan with a death benefit sufficient to cover the costs of recruiting, hiring, and training a replacement and include enough funds to help carry the agency until a replacement agent is on board. The accountant suggests the death benefit should cover the following:
- Replace Susan’s average annual earnings for at least one year
- Enough funds to cover recruiting costs and a sign-on bonus to tempt an experienced and proven real estate agent
- Funds to cover employment advertising costs and training costs
For this example, we’ll consider that Paul and his accountant determine that the amount needed to cover the expected loss of commissions and costs for the replacement to be $350,000.
Susan Wilson is a 35-year-old non-smoker in very good health so the cost of term insurance is very affordable. Here are the top five companies that Paul can choose to do business with:
As you can see by the monthly rates listed above, ABC Realtors can financially protect itself from the risk of losing a key person for about $20 per month over the next 25 years when Susan would be 60-years-old and ready to retire.
ABC Realtors would be the owner and Payor of the key person life insurance policy. Although the premiums would not be deductible for the company, the death benefit would be paid tax-free to the business.
For this example, we’ll consider that Paul not only wants to protect ABC Realtors firm the financial loss of losing a key employee, but he would also like to use the policy as motivation to keep Susan at ABC Realtors in the event a competitor might consider convincing her to leave.
In this scenario, Paul could purchase a Universal Life policy that would not only provide the death benefit needed to mitigate the financial risk to the company but also build cash value over time and when appropriate, Paul could transfer ownership of the policy from ABC Realtors to Susan who could then take the cash out of the policy or continue paying until she was ready to retire and then use the cash value as a tax-free income stream by taking loans from the policy to supplement her retirement.
Although Universal Life premiums are substantially higher, ABC Realtors would benefit in two very important ways:
- Have the funds needed to recruit, hire, train, and replace lost commissions of a key person and
- Offer a loyalty benefit to ensure that the key person remains with the company.
Who needs Key Person Life Insurance?
Any business that has one or more employees who are crucial to the success of the company should have key person life insurance on those employees. Medium to small businesses are the most appropriate candidates for key person life insurance policies. However, these plans are not necessary for businesses where the owner is the sole employee. In those instances, purchasing a personal life insurance plan would be more appropriate.
What are the benefits of key person life insurance?
Small businesses are often labors of love that originate from a single, passionate vision. But they also require a great amount of hard work. For the most part, these business owners would not like their company to die with the death of a key person. For that reason, replacement planning—enabled by a key person life insurance plan—would allow time to find the key person’s replacement, thereby ensuring the future success of the business and its legacy.
Family protection is also a major benefit of key person life insurance, especially for entrepreneurs whose businesses haven’t quite got off the ground. Businesses often require a lot of upfront investment to start, and an inexpensive plan would prevent their family from going into financial ruin if the death of a key employee occurs while the investment assets are tied up with starting the business.