Keyman insurance, also known as key man or key person insurance, can help protect businesses financially if an individual who is critical to the company dies or becomes permanently disabled. That's important, considering that 71% of small businesses rely on just one or two people to oversee day-to-day operations. Keyman insurance may also be necessary when executing a buy and sell agreement to transfer ownership of a business if one partner dies.
- Keyman, or key person, insurance is designed to cover critical individuals within a business organization who make significant contributions to its revenue.
- With a keyman insurance policy, the business, rather than an individual, is typically the beneficiary.
- Keyman insurance policies can be term life or permanent life, depending on the preference of the business. It can also take the form of disability insurance.
What is Keyman Insurance?
Keyman insurance is a specific type of insurance policy primarily for small businesses. These policies are designed to compensate the business when a key person dies or becomes disabled and can no longer fulfill their role.
A key person is generally anyone whose skills and/or knowledge contribute significantly to the business's revenues and profitability. That may include:
- Business owners or partners
- Members of the executive leadership team
- Top salespeople
Keyman insurance is essentially a risk management tool. If a key person passes away or becomes disabled, then the policy could provide funds to continue day-to-day operations, clear outstanding debts, and/or recruit a suitable replacement.
In a keyman insurance policy, the business is typically the primary beneficiary and is responsible for paying the premiums.
How Much Keyman Insurance is Necessary?
There's no precise formula for determining how much keyman insurance is necessary to have. The final figure can depend on a number of factors, including:
- The size of the business and number of employees
- How much revenue or income the person being insured generates for the business
- How much outstanding debt the business has
- How much it could cost to hire and train a replacement for a key person
- Whether the business will continue operations should a key person pass away
If you own a family business founded by your parents, for example, then you may want to purchase a larger policy to ensure that the business can continue should one or both of them pass away. On the other hand, if you run a sole proprietorship and have no employees, then you might only need enough coverage on yourself to pay off any remaining debts owed by the business.
If you're purchasing keyman insurance to cover an employee, then that employee must give their consent in writing.
Keyman Insurance and Small-Business Loans
A primary function of keyman insurance is covering key individuals within a business organization. But it can also have other uses, including serving as collateral for a Small Business Administration loan. The SBA doesn't offer loans directly but guarantees them for approved lenders.
As such, the SBA has a number of insurance requirements that must be met when guaranteeing loans to small-business owners. If you're interested in an SBA 7(a) loan, for instance, then you may need to purchase a keyman life insurance policy when the loan is not fully secured by other types of collateral. This requirement is for 7(a) loans of $350,000 or more when the business is operated as a sole proprietorship, a single-member LLC, or otherwise relies on one owner's active participation.
Keyman Insurance and Buy and Sell Agreements
Buy and sell (or buy-sell) agreements specify how ownership interest in a business can be transferred from one person to another in the business. For example, say you own a business with a lifelong friend but anticipate wanting to retire before they do. You could draft a buy and sell agreement outlining what will happen to your share in the business once you're ready to leave.
A keyman insurance policy can be used within a buy and sell agreement to ensure that each co-owner is protected if something happens to the other. For example, the proceeds of a keyman policy could be used by your co-owner to buy out your share of the business if you pass away. This can allow the business to continue after you're gone.
Limitations of Keyman Insurance
While this insurance can cover a range of scenarios, there are some situations where it isn't applicable. For example, keyman insurance does not cover:
- A key person leaving your company to work for a competitor
- Nonemployees, including independent contractors
- Employees who are not critical to business revenue generation or operations
Also, an insurable interest has to exist for keyman insurance to be necessary and useful. If the loss of a particular person wouldn't potentially cause financial harm to the business, then you may not be able to get a policy.
How to Buy Keyman Insurance
If you're interested in purchasing a keyman insurance policy for your business, then you must ask a few important questions first, including:
- Does the insurance need to cover death, disability, or both?
- How much keyman coverage is necessary and appropriate in your situation?
- Will this policy be incorporated into a buy and sell agreement?
- How will the proceeds be used should the key person who is covered die?
- If you're insuring an employee, then has that employee given their consent or are they likely to do so?
- Is term life insurance or permanent life insurance the better option?
There are numerous companies that offer keyman life insurance and keyman disability insurance. When comparing companies, consider the types of coverage they offer (e.g., term life, permanent life, disability), the available coverage amounts, and the estimated premiums you might pay. Talking to an insurance agent who specializes in these kinds of policies can also be helpful.
Keyman insurance premiums paid by the business are generally not tax-deductible as a business expense.
The Bottom Line
A keyman insurance policy can help provide financial protection for your business. Before purchasing a policy, read through it carefully to understand what is and isn't covered. And bear in mind that as personnel changes occur in your business, it may be necessary to update your coverage accordingly.