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- Key man insurance is a type of life insurance policy that a company purchases on the life of a founder, owner, executive or other essential employee of a business.
- Key man insurance can be structured as either term or permanent life insurance policies, with the latter offering additional cash value benefits.
- Key man policies may also have options for an owner to use a buy-sell agreement.
- The cost of key man insurance depends on the term, death benefit, age, health, and lifestyle of the insured person.
Although life insurance is more commonly known to cover personal needs, it can also be an effective solution for certain business needs. Key man insurance is one way companies can continue to operate after a key person, whether an owner, executive or other employee, passes away. The company can use the death benefit proceeds to recoup the loss of that person’s contribution or hire and train the next person to fill the essential role. Not all companies offer key man life insurance and there are considerations to weigh in determining if this is the right solution to keep a company solvent during transition.
What is key man insurance?
Key man insurance is a type of life insurance policy that a company purchases on the life of a founder, owner, executive or anyone else who is essential to the running of the business. The beneficiary of the policy is the company and the premiums are paid by the business. This type of policy may also be referred to as key person or a key employee insurance policy. It also falls under the umbrella of a corporate-owned life insurance policy, where a company takes out a policy on a specific employee or group of employees.
A key person could be considered an owner, founder, top executive, salesperson or even someone with special knowledge and skill sets. The idea behind key person insurance is that the company would receive the death benefit to add a financial buffer in case of the sudden loss of someone critical to company operations. The payout could potentially buy the company time to strategize and determine the next steps for the business.
How is key man insurance taxed?
Key man insurance is purchased with after-tax dollars and the premiums are not tax-deductible. Like other types of life insurance policies, if the key employee passes away, the company will receive the death benefit tax-free in most cases. There are exceptions to this and a trusted tax advisor would be able to walk the company through the regulations and documentation needed. The tax forms would have to include how many employees have the key person insurance, if there was consent given by each employee and the amount of coverage in place.
Key man insurance policy types
Much like personal life insurance policies, key man insurance can be structured under different categories of life insurance. The most common categories are term and permanent life. There are pros and cons to both term and permanent life insurance, with the latter offering several different policy types.
- Term life insurance: Term life policies provide coverage if the policyholder passes away within a certain term or time period. Typically this is a 10-, 20- or 30-year term. However, with key man insurance, the policyholder is the company and the term period could be tied to any key date, such as retirement. Term life is usually a much less expensive option than a permanent life insurance policy.
- Permanent life insurance: Permanent life insurance provides lifelong coverage as long as premiums are paid. The policy builds cash value over time, in addition to providing a death payout. Because the policy builds cash value, the business is able to access this and use it as collateral for loan purposes. A permanent life policy can also be sold if the company no longer wishes to maintain the policy or surrendered back to the insurer for the cash surrender value. However, these benefits make the policy more expensive than term life options. Permanent life insurance offers several policy types, including whole and universal life insurance.
Key person insurance may also have options for an owner to use a buy-sell agreement. This is a buyout agreement for the life insurance policy and there are two common options. A cross-purchase plan is a buyout option used when an owner of a company dies and the remaining owners use the death payout to purchase the deceased owner’s share of the company. This option is most commonly used by small companies.
The other option is an entity purchase agreement, which requires the company to purchase the owner’s share of the business from the heirs of the estate at a pre-agreed upon price. By doing so, the deceased’s family can get the money they need right away while the company maintains control over the business.
How much key man life insurance should you purchase?
There is not one specific method to use to determine how much key man life insurance you should purchase, unless it will be used for business loan collateral. In this instance, the life insurance face amount should be at least the amount you need to repay the loan.
For other situations, it can be difficult to determine the amount. You might want to start by considering the overall cost of losing a key employee, including losses to productivity, sales, operations and recruiting efforts.
You should consider working with a licensed life insurance agent or certified financial planner to determine whether and how much key man insurance is right for you and your business. A few common estimation figures to consider when determining the amount of key man employee insurance to purchase could help you get started:
- Cost to replace: Consider an approximate figure the company will bear to recruit, hire and train a replacement employee, including revenue and sales losses.
- Compensation multiplier: Take the number of years the company expects it to take to recover from the death and replace the key person. Then multiply this by the employee’s annual compensation.
- Percentage of profits or revenue: This figure is the amount of profit or revenue the insured person contributes, then multiply by the number of years it could take to replace them. The company and structure will determine whether profits or revenue is the best metric to use.
Companies that offer key man life insurance
When purchasing key man life insurance, there are a few considerations. The first major one is budget. Term life policies are typically less expensive than permanent life options and may be a better fit for the company budget. The second consideration is how much of a death benefit is needed. The higher the death benefit, the higher the premiums. The age, health and lifestyle of the insured employee will also influence the cost of premiums.
Several life insurance companies offer key person insurance and can walk a business through these considerations. Like other life insurance policies, you can compare several carriers to determine which would suit the company’s needs best, including the carrier’s reputation for claim payouts and customer service. Some of the companies that offer key person life insurance include:
Who should have key man insurance?
Determining if you need a key person insurance policy will depend on how your business operates. Key man insurance may be a way to cover a business loan, lost profits, a partnership or shareholder or losses from extended absences. In these situations, employee insurance or a key person policy may be worth the cost, especially for small businesses at greater risk of closing the business if a key person dies. Those who run their business alone typically don’t need key man insurance, but might benefit from a personal life insurance policy.
A lender may require a company to have key person insurance in place for the top executives or other specified key employees. This is especially true if the company is solely dependent on one or two owners.
These policies can also be a form of financial protection for a company. If a company’s profits would be devastated by the loss of a certain employee, a key person insurance policy could help prevent financial disaster. The loss may not always be directly related to profits, either. Instead, a company may consider a policy if the business’ line of credit or performance were dependent on an individual.
Key person insurance can also be an employee benefit. Since these policies are often portable, it could be used to retain top talent with the option for the employee to take over ownership of the policy. Where key person insurance may not be necessary is if you are a small business owner and sole proprietor. It would likely be more beneficial to a sole proprietor to have a personal life insurance policy set up for your family to receive versus key person insurance.
Frequently Asked Questions
For business owners, having a key person insurance policy may be worthwhile in order to help cover outstanding loans or cover lost profits that might occur from the loss. A lender may require business owners to have a key person insurance policy in place as a guarantee that funds will be available to repay the loan. Sole proprietorships likely do not need to have key person insurance, but any business with multiple partners in which the loss of one person may result in significant changes in the business may want to consider having key person insurance.
The cost of key person insurance depends on a number of factors. The term of the policy, including the death benefit, will be the primary determiner in how expensive the policy will be. The age, health and lifestyle of the people who are covered under the key person insurance policy will also play a factor in determining the cost of the premiums.
While key person insurance can be essential, it also has disadvantages. This includes the fact that the amount on a claim under key person insurance is not exempt from income tax if the company is paying the premiums. Additionally, if the policy is surrendered, then the amount endorsed is considered taxable as profit.