As a business owner, the loss of one of your most experienced and skilled employees as a result of disability or death could disrupt the management and productivity of your business and negatively affect your bottom line. In this situation, having suitable key person insurance can help your business avoid these financial stumbling blocks. In this article, we'll take a look at key-person insurance as a way of safeguarding the financial growth of a business.
TUTORIAL: How To Write A Business Plan
Key Person Insurance
A successful business typically reflects the presence of adept and valuable employees. These proficient workers contribute to the company's progress. In the unfortunate event that a key person is lost, it may cause instability and heavy financial setbacks to the company. This is why many companies today purchase key person insurance on the life of a vital employee whose loss would ultimately have a negative impact on business.
Key person insurance protects the business in the event of the death or disability of valued employees. The policy will provide funds in either a lump sum or in monthly benefits, and can be used to do one or more of the following:
- Acquire, employ and train a replacement for the lost employee.
- Restore the company's depleting profits in absence of the key person, such as through lost clients or customers.
- Repay the business's debt or assure lenders of financial continuity.
The key person can be a managing director, computer programmer, an executive or even the owner of the company. The company is the sole owner of the policy and pays all the premiums for the policy. Thus, the company acts as the beneficiary upon death or disability of the key employee and receives the entire death benefit. It is important to note that the key employee is not the owner or the beneficiary in this policy, so his or her family does not receive any form of benefits. Premiums paid by the company are not tax deductible, but the death benefits are typically free from corporate income taxes. (For more on deciding who should be your beneficiary, read, Life Insurance Distribution And Benefits.)
The amount of insurance purchased is decided upon after considering the size of the business, any outstanding debts owed to banks or other lenders, and the potential financial loss to the business while finding a suitable replacement. Typical policy amounts vary from $50,000 to $1 million and up, depending on several factors and business needs. Premiums vary based on the key person's age, physical condition, health history and the company's current structure. Although it is almost impossible to calculate the value of a valued employee, estimated profit losses, replacement costs and compensation-multiple formulas are all used by attorneys and planners to best estimate the potential losses. Normally, insurance companies use the replacement cost method, the contribution-to-earnings method and the multiples of income approach to determine the suitable amount of key person coverage needed for the business.
Similarly, key person disability insurance is designed to protect the business in the event that an employee becomes disabled through sickness or injury. Here too, the policy is owned and paid for by the company and the company receives the funds if the key person becomes disabled. Consequently, the policy will pay a preset monthly benefit for the remaining term or for as long as the key employee remains disabled. The company uses the monthly income from the policy to finance lost profits or to obtain and train a temporary or permanent replacement for the disabled key employee.
If the business owner or his or her partner dies, funds are needed to buy out the deceased's share of the business from his or her estate. Key person insurance is the most efficient way to fund repurchase agreements as well as for overall business succession planning. Typically, buy/sell agreements include instructions for what to do in the event of the death or disability of a shareholder or business owner. (For related reading, see How To Create A Business Succession Plan.)
In business succession planning or business continuation planning, a large percentage of a business owner's (or other key person's) assets are invested in the business itself. In these cases, key person insurance using cash value life insurance can provide the funds to successfully transfer the ownership of the company to its successors without causing a negative effect on the company's profitability and cash flows. (For more insight on life insurance, read Buying Life Insurance: Term Versus Permanent.)
When securing a loan for the business, the key person policy is often used as collateral, whereby funds from the policy are used to cover the loan balance due on the death of the key person or business owner. Many lending banks and financial institutions insist on key person insurance for specific members of the management team when lending funds to a new business. Lenders may want the policy assigned to them and in an amount covering the principal amount loaned to that business. In the event of the death of the key member, the policy proceeds will be used to reimburse the lending bank's remaining loan.
It would be unfair to exploit the key employees without rewarding their valued contributions. In the absence of proper financial incentives, some key employees may eventually leave the company and offer their valuable services to a rival company. Hence, companies need to set up executive compensation plans to provide financial incentives like bonuses and additional retirement income to the key employees. A cash value life insurance policy can be used to fund these executive perks; some companies even turn over the cash value of an unused key person insurance policy to the employee upon retirement. (To learn more about executive compensation, see Evaluating Executive Compensation and Executive Compensation: How Much Is Too Much?)
The Bottom Line
It takes the total dedication and hard work of a handful of talented employees to build a successful business. In the absence of these special employees, the business can suffer in terms of finances, stability and relationships. Proper key person insurance becomes expedient for recruiting and training a replacement employee, repaying the business debts or even buying shares of the company to retain business control. In addition, key person insurance provides strong incentives to encourage key employees to stay with the company. By insuring employees, business owners can better protect the financial health of the business.