Last updated May 28, 2009
Every business has at least one employee whom everyone agrees is “priceless.” Maybe your business was built from the ground up by one person, or maybe it’s run by a small circle of highly skilled, invaluable executives. In any case, it makes sense to think about where you’d be without those employees, and insure against the scenario of losing them. Key person insurance does just that, but it may not be the right product for every company or every situation.
If the success of a business hinges on the well-being of the company’s chief executive, the cost to replace him could put the company in the red, especially a small business.
Let’s take a look a the numbers. According to Salary.com, the average compensation for a chief executive at a Fortune 500 company is $14.1 million. The latest statistics from the Society of Human Resource Management (SHRM) indicate that the cost to recruit and train a new chief executive is typically 250 percent their annual salary. After taking these estimates into account, the afforementioned chief executive would cost $35.3 million to replace.
In contrast, the cost to replace the owner of a small business with an annual salary of $290,300 would cost the company $725,750. This is still an expensive pill to swallow.
In addition to the chief executive, key men and women can include a sales manager who has nurtured accounts that are invaluable to the company, or a software designer whose ideas have critical commercial importance.
Key person life insurance policies name the corporation as a beneficiary if a “key person” dies, which is one way of keeping the company solvent while it recovers from the loss. As the name implies, the “key person” is key to the business’ success; without him or her, the company might fail.
What to examine before you buy key person insurance
A continuation plan outlines how the company will maintain operations if a financial or management disaster befalls it, and having such a plan is a vital step before considering key person insurance; without one, the company is in trouble even if it’s flush with cash.
If you’re all set with credit insurance and a business-continuation plan, but still feel you’d have cash flow problems without the key person, then you’re ready to look at key person insurance.
Source: National Association of Insurance Commissioners
As with any business insurance, whether you take out a key person policy and the amount of coverage you choose should depend on your company’s structure and business plan, as well as the amount of financial hardship potentially faced without its key person.
Key person insurance is a permanent or term life insurance policy that typically provides $500,000 to $5 million in coverage. For example, the New York subsidiary of Lloyd’s of London recently issued a $10 million key person life insurance policy for a client after the company made a $17 million acquisition.
“As a very broad rule of thumb, you can take a one-time multiple of the salary” to determine how much the key person is worth, says Mark Johnson of Johnson Insurance Consultants in Duluth, Minn., and past president of the National Association of Insurance and Financial Advisors. “If your key person makes $200,000 a year, your minimum coverage would have to be $200,000.”
Of course, the key person could be worth a lot more than her salary.
“Maybe you do half your business with one particular buyer, and the personal relationship was developed by the key person. If you suddenly lose 50 percent of your market, what kind of trouble are you in?” asks Johnson. You can use these business relationships, in addition to salary, to calculate the monetary value of a key employee.
The plight of the small businessman
“This insurance is for anyone who would be in danger of losing revenue if they lost executives who help to make up a large part of their market share, or key irreplaceable employees,” says Michael Gray, an independent agent and owner of MEG Financial in Florida. “Small companies and family-owned businesses are the most susceptible to a bad event. Start-up companies are also at great risk because the key person who is also the owner may be the only person responsible for generating revenue at that point.”
Typically, key person insurance is built around a permanent life insurance policy. Term life can be had, too, for short-term needs or for cash-strapped companies. Premiums vary, naturally, depending on the age, physical condition and health history of the key person. Term life insurance is less expensive than a permanent policy and can be bought to cover the key person through retirement. Alternately, a whole life insurance policy can be bought with riders so that the insured’s name can be changed if the key person leaves the company or retires.
When it comes to small businesses, some insurance experts suggest that there are better products for less cost that would cover a key person.
An alternative to key person insurance is a buy-sell agreement. This is a contract that outlines the terms and conditions of selling shares to a business partner if he decides to buy-out a deceased partner’s shares in the company.
“In some cases, small companies think they need key person insurance when they probably don’t,” says Johnson. He suggests credit insurance to cover loans or a buy-sell agreement to protect a business partner, which might fulfill a company’s financial needs without adding key person insurance to the mix.
Credit insurance would pay life insurance proceeds directly to the company’s creditors following the death of an owner.
But Gray says that key person insurance covers the areas where other types of insurance falls short.
“In a buy-sell agreement, policies and cash value are subject to creditors of the business. Because these policies are owned by the business, they are assets that business creditors can tack on,” notes Gray. Gray warns that some credit insurance policies have a number of limitations and, in some cases, those limitations dictate how the person must pass away in order to be covered. In addition, premiums for credit insurance are automatically tacked on to the total cost of the loan and incur interest, which can be costly.
In addition, if an owner has shares in a corporation, partnership interest or business assets that will be disposed at the time of death, this creates a large tax liability to the business.
“Life insurance can provide funds needed to pay tax liability that results from capital gains tax and recaptured depreciation caused by an individual’s death,” notes Gray. “The merits of key person are the same as the reasons why someone would take out a traditional life insurance policy. Proceeds from the life insurance policy are also tax-free and can be used to pay down outstanding business debt.”
The Life and Health Foundation for Education provides helpful tips for protecting your small business:
Obtain the right life insurance and disability coverage for all your assets. To launch a business, small business owners often take out loans that are secured with personal assets. This makes it even more important to protect your income and financial responsibilities with the proper life insurance. You should not overlook the importance of disability insurance. Disability insurance provides income to you and your family if you are unable to work for an extended period of time.
Protect your businesses overhead. If you become disabled and unable to work for any length of time, your business could collapse. Business-overhead expense insurance will cover operating costs in the event you become sick or disabled.
Put a buy-sell agreement in place. This is an agreement between business partners to buy out each other’s share of the business in the event of one of their deaths. Life insurance is essential in providing funds to make the purchase. There is also a form of disability insurance that has the same function.
According to the National Association of Insurance Commissioners, a small business seeking a loan from a bank or trying to raise capital from outside investors may be required to carry life insurance for its partners. The bank may also require the small business to provide a collateral assignment agreement that gives the bank first rights to policy proceeds to cover outstanding loan debt due to the death of one of the owners.
Since the policy is owned by the company, it can be continued even after the key person leaves. For example, if your executive retires at 65, the company can offer him the policy as part of his retirement package. Once the policy is in his name, he can designate a new beneficiary.
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