Key Man Life Insurance
Your business may own real estate, inventory, and equipment, but most companies depend even more on their people.
What would happen, for example, if your business partner or a key employee died unexpectedly? How would you regroup if this death meant you’d lost your best sales contacts or critical pieces of business knowledge?
Key man insurance exists to help answer these questions.
IN THIS ARTICLE:
What Is Key Man Insurance?
Key man life insurance — also known as corporate life and key person life — works like any other kind of life insurance policy:
- Purchase a Policy: Buy and maintain the life insurance policy on your key staff member.
- Pay Premiums: Pay regular premiums to keep the policy active.
- Receive Protection: Name your business as the beneficiary to receive the policy’s death benefit if the critical staff member died.
This death benefit — typically a lump sum of tax-free cash — could buy some time while you regrouped and rebuilt your business without the person you’d depended upon for so much.
You can find other ways to protect your business from this kind of uncertainty. You could save up enough reserves to absorb potential losses, for example. But key man life offers a particularly elegant solution.
Your policy wouldn’t require a lot of care and maintenance. You’d keep it active by paying the annual premiums, and you may even forget you have the coverage. But when needed, the policy could kick in and become a game-changer during what could be one of the most hectic times your businesses faces.
And, you’d have a claim on this coverage as soon as the policy becomes active. You wouldn’t have to wait to save money.
Types Of Key Man Insurance
With any kind of life insurance shopping, the first question is often: term or whole? Key man life is no exception.
Term Life as Key Man Life Insurance
Getting a term life policy to protect your business if a vital member of your team died has a few advantages:
- Term is Temporary: Maybe you’d like coverage for just long enough to build up the cash reserves needed to absorb unexpected losses. A 10-year term policy could provide this coverage.
- It’s Cheaper: Because it’s temporary, term life costs significantly less than whole life, which has no expiration date.
- Term Life Offers More Coverage: Term life policies can also unlock higher coverage amounts in most cases. As with any coverage, your eligibility will depend on the health and age of the employee you’re covering.
Whole Life as Key Man Life Insurance
Businesses tend to prefer whole life policies for key man protection because of these advantages:
- Policies Accrue Value: Premiums cost more, but the company will earn an ownership stake in the policy over time. Later, you could borrow against this value, cancel the policy and claim the cash, or transfer the plan and its value to the employee as a bonus or benefit.
- Tax Protections: Life insurance premiums aren’t tax-deductible, but a policy’s growth in cash value tends to be tax-free.
- Whole Life Is Permanent: Whole life insurance doesn’t expire. You should, however, make sure your policy is transferable so you can assign the coverage to a different team member as needed.
Who Needs Key Man Insurance?
Just about any business owner who depends on key personnel can make a case for buying key person life insurance.
However, if you’re getting a business loan, you may have even more reason to buy this coverage. A lot of business loans, including many backed by the federal Small Business Administration, require borrowers to have this kind of coverage in force.
Why? Because lenders know businesses with this kind of built-in safeguard can better weather the turmoil created by the loss of essential personnel.
Consider key man life if your business is:
- A New Start-up:
If your startup has a lot of promise, but you still depend on your partner’s long hours and personal sacrifices to stay on track, key man life is probably a good investment.
Businesses whose debt is connected to a partner’s personal credit history should have key man life insurance on that person.
When a member of your team has unique skills you depend on, consider key man life. Here’s an example: A bakery with an employee who has perfected all the famous and most successful recipes may want coverage on that person.
Some people just have a way with sales. If someone on your team has this skill and you depend on it, key man life could buy some time to regroup after a tragedy.
Why Get Key Person Life Insurance?
Any sensible business — and new startups especially — resist unnecessary expenses. This is an essential part of keeping costs low.
To many smart business people, key person life insurance seems like an extra and unnecessary expense, a solution to a hypothetical problem that’s abstract compared to today’s reality.
I hope tragedy always remains a hypothetical problem for your business. Sadly, this can’t be true for every business.
You can never know for sure whether you’ll use key man life, but that’s true for just about any kind of insurance.
Key Person Life Helps the Most Vulnerable
One of the ironies of key person life insurance is this: The companies that resist buying coverage are the companies that need coverage most.
Think about it — if you’re struggling to keep your business open, non-essential expenses have to wait. This is understandable and sensible, yet if you’re struggling, the loss of a key employee or partner could harm your business even more than it would hurt a well-established company.
That’s why I recommend — even if your day-to-day situation is hectic and uncertain right now — to take a step back and see your business from a broader perspective.
From a broader point of view, you can make better long-term decisions about products such as key person life insurance.
How To Structure A Key Man Policy
When you’re ready to buy life insurance on key members of your team, it’s time to think about building your policies.
Try to keep your coverage flexible. For example, consider these three factors:
1. Transferable Insurance
Ask your independent insurance agent about buying transferable life insurance coverage for your key employees.
As the owner and beneficiary of the policy, you should be able to assign coverage to different employees over time.
This could become a big deal if an employee left the company or became less important to your business over time.
2. Helpful Insurance Riders
Riders can customize your life insurance coverage to make it more responsive to your business’s needs.
What would happen, for example, if the key staff member you’re protecting became terminally ill and couldn’t work?
Because the staff member hadn’t passed away, you couldn’t claim the death benefit. In this case, an accelerated death benefit rider could let you claim part of the benefit.
Riders have to be purchased before you need them, so there’s always some guessing involved.
3. From Key Man to Bonus Plan
Some corporations use life insurance policies as a way to reward high-level executives. This is a different application than key man life.
You could, however, get key person life coverage that can later be eligible for use as an employee bonus.
Getting a whole life policy that accrues cash value over time will be the first step. Ask your agent about a rider for converting your key person coverage to an executive bonus.
How Much Key Person Insurance Coverage Should I Have?
Life insurance policies range in coverage from a few thousand to a few million dollars. All else being equal, buying more coverage requires more in premiums.
So how much coverage do you need on your key staffers and business partners?
You won’t find a ready-made answer to this question, but you can get into the ballpark with a quick analysis of the following:
- Debt: When the finances of your business are intertwined with the personal finances of the person you’re protecting — which isn’t that unusual with startups — you might need a lot of coverage to help sort things out. Consider all the debt your business would suddenly owe if this partner died.
- Operating Expenses: If your key staff member generates all or most of your new business, how long would it take to recover? Two months? Six months? You may want coverage to compensate your firm for the amount of money lost in that period of time.
- New Hires: It’s not uncommon for a valuable staffer or partner to do the work of several people. If you lost this essential leader, would you need to hire two or three people in a hurry? Your key man life coverage could help finance these initial costs.
- Research Needs: You may have to recreate business processes from the ground up if a key person died, and this would take time and money. Let’s build off our earlier example of the bakery whose co-owner has the magic touch with all the famous recipes: If this expert died, the business’s key person coverage could help hire a team of bakers to recreate those recipes.
Calculating how much insurance to buy on your key personnel will require you to consider each staffer’s monetary value to your business.
This calculation may take some effort and out-of-the-box thinking, but it’s never a bad idea to try to put a hard number on an abstract concept. You may be surprised how much you depend on certain people.
What Does A Key Person Insurance Policy Cover?
The beauty of life insurance is its simplicity. Yes, coverage comes in all sorts of varieties and with countless nuances that make shopping for coverage confusing.
But when you have to file a claim, the death benefit should be paid with no strings attached, assuming the cause of death wasn’t excluded from the policy’s fine print. The payout would be tax-free because premiums were paid with after-tax money.
Your business would most likely use the money to help keep the business going while you adjusted to the loss of the indispensable staff member.
But if something had changed and you no longer needed as much money for day-to-day survival, you could find other uses for the cash, such as:
- Charitable Donations: Your company could use the payout to start a scholarship or a foundation in memory of your deceased colleague and friend.
- Business Development: The payout could help finance new business developments to grow your company.
- To Grow a Reserve: Your business could put the money aside for weathering other unpredictable changes in the days ahead.
What Impacts The Cost Of Key Man Life?
As with any type of life insurance, the cost of key person life will depend a lot on the person insured.
- Age & Health: Coverage for older employees will likely cost more than coverage for younger employees. If your key staffer has significant health problems, expect to pay higher premiums for this coverage.
- Lifestyle Choices: Even the employee’s driving record and personal credit score can impact the cost of coverage. Dangerous hobbies like scuba diving or rock climbing can drive up premiums.
- Policy Type: Whether you buy whole life or term life makes a big difference: term is typically much more affordable. If you go with a term policy, the length of your term will help set your premiums. Longer terms cost more almost all the time.
Can I Deduct Key Man Insurance?
Since your business — and not your key staff person him or herself — would be the policy’s beneficiary, premiums for key person life are not considered part of the employee’s compensation.
So in the vast majority of cases, life insurance premiums are not tax-deductible.
The death benefit you’d receive if the key staffer died, however, would be tax-free. And, the growth in value of a whole life policy over time should also be sheltered from taxation.
Who Owns A Key Man Policy?
This question gets at one of the anomalies built into key person life insurance: The business owns the policy and is the beneficiary of the plan.
This is relatively unusual in life insurance. Most of the time, the policy owner names someone else to benefit from the policy.
Companies could transfer ownership of a policy to the employee when he or she leaves the business. In this case, the employee may want to name another beneficiary.
And remember, the transfer would likely be considered taxable income assuming the policy has accrued a cash value before the transfer of ownership to the employee.
You can buy and maintain a key person policy on anyone in your company; however, you will need to inform the employee about the plan.
Key Person Life Protects Your Business
Staying in business requires you to walk a path of uncertainty. The economy is dynamic and ever-changing. What makes sense now won’t work so well in three years.
You already know this, or you wouldn’t be reading a post about key person life insurance. Am I right?
Using key man life to protect your business against the loss of sales, the loss of leadership, the loss of research, and the loss of expertise make good sense and you can compare quotes on policies from some of the top life insurance companies to make sure you are getting the best rates.
Other Ways to Protect Your Business
- Cross Train: Can you make a key individual’s unique knowledge more common around the office? The more you distribute knowledge, the better you’ll be able to weather the storm.
- Leave Good Records: There’s nothing like an expert guide to a process. Have your employees write down step-by-step guides to their individual tasks. Include passwords. Keep this information in a shared drive or another safe place.
- Share Files: Unless there’s some reason for only one employee to have access to a file, keep file-sharing active so that unknown passwords and other unnecessary confusion don’t become big problems.