Does Your Business Need Key Person Insurance?
Coverage for the Loss or Disability to a Key Employee
As its name suggests, key person insurance protects a business against the death or disability of a key executive or employee. A key person policy may include disability coverage, life insurance or both. Key person insurance is also known as key executive, key man, or key employee coverage. It is a type of corporate-owned life insurance (COLI).
When It's Needed
A company may need key person insurance if it depends on one or two individuals to succeed. For example, Bob and Bill are brothers and business partners in a thriving restaurant called Brothers Bistro. Each has special skills that the other lacks. Bob is a creative genius and has an extraordinary talent for combining flavors. Bill has exceptional people skills and a good head for business. The restaurant's success depends on the talents of both men. If either Bob or Bill dies or becomes disabled, the business might not survive. To protect itself, Brothers Bistro purchases key person insurance on both men.
You should consider purchasing key person coverage if your business has any of the following characteristics:
- It is highly dependent on one or more individuals who have special skills and would be difficult to replace.
- Your company relies on a key individual to generate a substantial portion of its income.
- Your business has debt that would be difficult to pay off if a key individual died or became disabled.
- Your business plans to seek a loan or investors. A bank or investment firm may refuse to extend a loan or make an investment in your firm unless it has key person coverage in place.
- Your company plans to merge or go public. Your firm may need key person coverage for top executives and board members before it can proceed with a merger or IPO.
Key Person Life Insurance
A business purchases key person life insurance to protect itself against the death of an important individual. The business is both the policy owner (buyer) and the beneficiary. The key employee is the insured. The insured person does not receive any benefits from the policy.
Key person life insurance is usually written as either a term policy or a permanent policy. A term policy is the cheaper of the two. It applies for a specific period of time, which may be as short as one year or as long as 20 years. Coverage ends when the term expires or the insured person dies, whichever happens first. If the insured dies the firm collects a death benefit. The company can use the money to hire and train a replacement, to pay off debts, or for some other purpose.
Permanent key person life insurance applies for the life of the insured individual. It serves two purposes: it is an asset that can be used as collateral for a loan and it pays a death benefit. A permanent policy can be transferred to the insured, say at the worker's retirement, if the firm no longer needs the coverage.
A firm may have more than one key person. For example, suppose that XYZ is a corporation with five executive officers, all of whom are essential to the company's success. To save money XYZ could purchase a key person life policy that includes a "first to die" provision. The policy will pay a death benefit to the company if any of the officers dies. The policy will then cover the remaining officers.
Key Person Disability Insurance
Key person disability insurance protects a company against the risk that a key employee will become disabled to the extent that he or she is unable to perform his job. Benefits may be payable on a monthly basis or as a lump sum. Benefits are paid after a specified waiting period. This period might be 30 or 60 days for monthly payments and 12 or 18 months for a lump sum payment.
There is no "standard" key person disability policy. Rather, each policy is typically designed to meet the needs of the company.
Amount of Insurance Needed
How much life or disability insurance should you purchase on a key person? To answer that question, you will need to estimate the economic loss (lost revenue or profit) your firm will suffer when a key person dies or becomes disabled. You will also need to consider the cost of recruiting, hiring and training a replacement employee. An insurance agent or broker can help you calculate the amount of insurance you need.
Cost of Coverage
The cost of key person insurance depends on the age, health, and sex of the insured individual as well as the size and nature of the business. Two other factors are the type of policy you purchase (term or permanent) and the limits you choose.
The premiums you pay for key person coverage are generally not deductible for tax purposes. However, the death or disability benefits your company receives generally are tax-free. Consult your tax professional to determine how the purchase of key person insurance will affect your firm's taxes.
Article edited by Marianne Bonner