Many businesses have a key member of their organization who is responsible for the majority of profits, or has a unique and hard to replace skill set that is vital to the organization. Their knowledge, work, and overall contribution to the company is considered uniquely valuable.
So what would happen to the business if that person were to die or become unable to fulfill their duties anymore? Some negative repercussions are inevitable, but there are measures that can be taken to limit the damage.
An organization can take out a life insurance policy on the life or health of that employee. Key person life insurance is an important form of business insurance that could save a company after a tragic loss.
What is Key Person Life Insurance?
Key person life insurance, oftentimes referred to as key man life insurance, is an insurance policy purchased by a business to compensate for the financial losses that could arise from the death or long-term incapacity of an important member of the business. It’s a standard life insurance policy that is used for business protection purposes.
That important person could be the director, a partner, a key sales person, project manager, or someone with the specific skills or knowledge that are deemed particularly valuable to the company. In a small business, it’s usually the owner, the founder, or sometimes a key employee or two.
How do you determine who the key employees are? Look at your business and think about who is irreplaceable in the short term.
How Does Key Person Life Insurance Work?
Key person life insurance works just like individual life insurance. When the insured dies, the policy pays a benefit. If the business owns the policy and pays the premiums, it collects the payout on that policy.
Key person life insurance policies are usually owned by the business and the goal is to compensate that business for their financial losses when a key member of the organization dies. Key person life insurance does not compensate for the actual financial losses. Rather, it compensates with a fixed dollar amount, as specified in the insurance policy, for the losses the employer is likely to suffer in the absence of a key person of their organization.
An employer would want to offset the costs involved with:
- Recruiting, hiring, and training a successor
- Replacing lost profits until a successor has been trained
- Paying off debt
The money from a key person life insurance policy could also be used by the company to buy out the deceased employee’s shares of the business with a buy-sell agreement. Sometimes, companies will fund this policy as a perk for an employee whose family would then receive the benefit if death occurred.
Gerry Scholz, chief operating officer at True Blue Life Insurance, said:
“Determining the key employee’s value to the business is very speculative. The actual evaluation method depends on the characteristics of the employee that creates this key employee status. If they have a significant customer or client base and they attract substantial business, it might be relatively easy. Their work translates directly into a significant amount of business, so their loss could prove to be devastating to the organization.”
Here are the top three ways key person life insurance can save a business after a tragedy:
1. Recruit, Hire, and Train a Replacement Employee
A key person life insurance policy provides income tax-free death benefits that could be used to recruit, hire, and train a key employee’s replacement.
“A key employee might have a specialized skill that’s critical to the success of their business,” Sholz said. “Potential replacements may possess this same set of skills, but they might have to be recruited at a higher salary level. The firm has to consider the salary and the training that will be required for a replacement employee to become effective.”
2. Replace Lost Profits
If something happens to a key person in an organization and they are no longer able to perform their job, the business could lose money quickly. Businesses insure their buildings, machines, and equipment against loss, but oftentimes they don’t insure their most valuable employees. If a key employee died, the business would not only lose some of their profits, they might also run into a variety of other expenses.
A key person life insurance policy provides income tax-free death benefits to replace those lost profits.
3. Pay Off Debt
Lenders and creditors can quickly become concerned about the organization’s ability to continue operating profitably without the key person’s skills.
A key person life insurance policy provides the cash flow that would likely keep banks and other lenders from foreclosing on business loans, reducing lines of credit, or raising interest rates on outstanding loan balances. Customers and employees are also assured of the stability of the company and that it would be in a favorable financial position.
What Kind of Policy? Temporary vs. Permanent
If the primary purpose of the life insurance policy is to pay off a business loan after the death of a key employee—or to provide for any other temporary need—a term policy would be a good investment.
If you want more permanent coverage or if you want the policy to be not only a death benefit but also a business investment with additional options, you will want to consider a permanent life policy—either universal or whole life.
“Term insurance can be purchased if the primary concern is the key employee’s dollar value to the business,” Sholz said. “But, key person life insurance is often coupled with some other benefit such as providing a retirement benefit for that employee. If that’s the case, permanent life insurance is typically purchased to meet this objective. The business receives the life insurance death benefit as compensation for the income loss and/or the increase in expenses resulting from the key employee’s death. If the insured survives to retirement, the corporation can use the cash surrender value to fund a retirement benefit. Another approach is to transfer the policy to the employee at retirement.”
Purchasing Key Person Life Insurance
How much key person life insurance do you need? It really depends on your business, but generally speaking, you should get as much as you can afford. Think about how much money your business would need to survive until it could replace that key person and get the business back on its feet again. Purchase a policy that not only fits your budget but will also address your short-term cash needs in case of a tragedy.
A licensed True Blue Life Insurance professional can help you determine what policy will work best for your particular business and situation. For more information on key person life insurance for your business, call True Blue Life Insurance at 1-866-816-2100.