Savvy business owners know they must take steps to protect their business in many ways so that they can continue to prosper under all conditions.  And one of the ways they do this is by securing key person life insurance for themselves and important employees who are vital components of their operations. This strategy is commonly known as Key Person Life Insurance and is a type of company-owned life insurance (coli). 

Key person life insurance policies are taken out by companies on their employees, with death benefits that are paid to the company, rather than to the insured person or to their estate or heirs.  Businesses pay all the premiums and in return, they receive all of the insurance proceeds. 

It is a smart business move that protects a company from the untimely death of an employee who plays an essential role in the financial health of a company. 

It provides cash flow flexibility during the transition period as the company is the beneficiary of the policy.  It boosts the creditworthiness of a company.  It can be used to help secure business loans to help a business grow and expand.  Satisfy a key business need by using death benefit proceeds to purchase the ownership interest from the deceased person’s estate.  It provides peace of mind to creditors and customers that a company is on stable financial footing.  It is simple to implement and offers businesses complete flexibility as to who they want to insure.  It can help retain key employees who see it as a significant employee benefit when several executives are covered.  It can be implemented no matter what the size of the company is. Policies exist to help businesses large and small.  It remains a very affordable option to provide all of these other benefits. 

Death benefits paid to the business are not taxable and investment earnings derived from insurance premiums grow tax-deferred in the policy, providing a financial cushion for the business as well. 

After determining that buying Key Person Life Insurance is a good business move, the next question then becomes how much insurance coverage to buy.  Placing an exact value on an employee and their contributions can be a difficult proposition.  

While the exact amount of coverage will vary by situation and by company needs, the challenge for a life insurance company and company ownership is to determine what the realistic loss of a key employee would be to a company if they pass away or become disabled to the point of not being able to contribute any longer.  

While many methods exist, there are three that tend to be favored by most businesses: 

Multiples of income.  This is the most simple and straightforward method used to determine a key man life insurance policy Amount.  An insurance company will base the amount of insurance needed on a multiple of the key executive’s salary and benefits.  Typically, the multiple will be anywhere from five to seven times this amount.  For example, if a key executive or top salesperson has a salary and benefits package of $250,000, an insurance company may use a multiple of six and thus issue a policy valued at $1.5 million.  Individual situations will vary, leading to higher or lower values. 

Replacement cost.   This method uses the assumption of how much it would cost to replace the key executive if they pass away or can no longer render services to a company.  Calculating this cost not only includes salary and benefits, but also costs associated with recruiting, training and bringing the new employee up to the same level of contribution as the former employee.  Some insurance companies will also factor in the projected loss of revenues that could occur during the transition time following the death or disability of the key executive. 

Contribution to earnings.   This method attempts to calculate the percentage of contribution that a key person adds to a company’s bottom-line profit.  This can be a preferred method when the key person is a company’s top salesperson who contributes a significant amount of sales volume and profits to a company’s bottom line.  Insurance companies will take into account the actual value of the company’s profits directly attributable to the key person and multiply it by the number of years it would require to replace those numbers by hiring and training another replacement employee. 

In using these valuation methods, many insurance experts agree that a business owner should purchase as much key person insurance as they can afford, providing the greatest amount of protection for their company. 

To save on premiums, it is recommended that a company purchase term insurance versus whole or variable life policies which carry higher premiums and pay out greater commissions for insurance agents.  Because a person’s employment will be for a specific amount of time, term insurance makes the most sense. 

It’s also important to get quotes from several sources, as costs can vary from company to company.  And it’s also wise to get quotes on a variety of amounts ranging from $250,000 to $1 million or more.  The bottom line is to remember that as a business owner, the primary consideration is to purchase the amount that will protect the short-term cash needs of a business until the key person can be replaced, restoring financial health to the company. 

In some instances, a business may not be able to recover from the loss of a key executive.  That key executive may be the owner and the face of the company, or an employee whose contributions will never be able to be fully replaced under any circumstances. 

When this is the case, key person insurance can be an effective component of a broader business succession plan to help provide the funding necessary to the business to continue operating.  Key Person Life Insurance is not the same as funding a Buy-Sell Agreement.  Whether or not key person life insurance is purchased, all companies of any size should have a business succession plan in place no matter what.  A Buy-Sell Agreement ensures that your family or your partner’s family has received a fair and agreed-upon purchase price for the deceased partner’s ownership in the business and provides immediate funding for this.  Having Key Person Life Insurance in place as well as a Buy-Sell Agreement funded with Life Insurance is vital for the health of a company and addresses a variety of contingencies that can otherwise threaten the overall health of the business. 

Without a Buy-Sell Agreement, prudent advanced planning utilizing key person insurance can be an important element of a succession plan that can provide the needed bridge capital and flexibility until the succession plan can be put into action.  

Unfortunately, statistics show that only a fraction of all small businesses have a succession plan in place, often putting extreme stress on the survival of many businesses in times of transition.  

A Study by Wilmington Trust in November 2019 Showed some Key findings:

• 69% of business owners are unprepared to sell their businesses
• Though 89% of business owners say their business will survive without them, only 55% have developed a some version of a transition plan

Key Person life insurance is an important part of the overall long-term protection of your business, but there are also many other kinds of insurance you should consider as well.  In fact, the right kinds of insurance should be a primary part of your business operations to safeguard everything you have worked for, while also protecting your employees, your family, and your financial well-being.  

There are several other aspects of your business you should consider insuring.  Each will have its own unique set of factors that will determine how much coverage you need.   Some of the most common types of insurance include: 

Liability  – There are two types of liability insurance you should consider.  General liability insurance protects your business in instances where a customer is injured on your property.  It will also pay for your legal defense in cases where you are sued due to claims that your product or your service caused a person harm in any way.  Professional liability insurance protects you against claims rising against you by others who claim your service caused them financial loss. 

Property  – Protects the physical assets of your business, including buildings, inventory, equipment and other hard assets. 

Workers’ compensation  – If you have employees you will need to have workers’ compensation insurance to cover medical bills arising from any illnesses or injuries that took place as a result of work activities. 

Business interruption  – If your business is not able to operate due to a property loss, this type of insurance payout will cover lost income during the period in question. 

Health insurance  – With the implementation of the Affordable Care Act, it is critical that you know what your responsibilities are as an employer and how they relate to you and your employees. 

Commercial auto  – If you or your employees drive vehicles that are owned by your company, or that are personal vehicles that are driven during the course of business, you need to have a commercial auto policy in place to protect you from potentially devastating losses that could be the result of an auto accident. 

We have made Planning and Buying Key Person Insurance simple and fast, with our well-thought-out process that you can complete in just a few minutes.  If you click HERE, we will direct you to our planning tool which not only allows you to see a consistent valuation process for a Key Person, but will also allow you to send the application link directly to your key employee where they could be approved in as little as 5 minutes through our process!