Key Person Disability Insurance: A Comprehensive Guide

One of the most overlooked risks for many small businesses is the disability of a key employee or business owner. Just ask yourself, what would happen to your business if your top salesperson came down with a severe illness and was unable to work for a year? Or worse, a business partner is in an accident that renders her incapacitated for the foreseeable future?

“According to the 2019 Small Business Owner Survey conducted by the Harris Poll, 96% of all questioned stated they had at least one key person.”

If your company is dependent upon an individual with specialized abilities, disability insurance is a smart and economical way to transfer the risk and avoid a potential disaster. The good news is that a policy is most likely attainable and relatively affordable!

Quick Reference Links 

What is Key Person Disability Insurance?
Why Buy?
Who Should Be Covered?
How Does Key Man Disability Insurance Work?
Key Man Disability Policy and Plan Options
How Much Does Key Person Disability Insurance Cost?
How Do You Qualify for Key Person Disability Coverage?
How to Apply for Key Man Disability Coverage?
Business Overhead Insurance Alternatives
Summary

What is Key Person Disability Insurance?

Key person disability insurance, also referred to as key man disability insurance or key person replacement coverage, protects a business from economic loss if a key employee, executive, or business owner suffers a disabling accident, injury, or illness. It is insurance that pays a cash benefit to the business to help them deal with the loss of a significant revenue producer.

This unique form of disability insurance covers the threat of a short-term loss of a critical individual. Benefits can safeguard a wide variety of needs, including:

key-man-insurance-paperwork

  • The cost of hiring and training a replacement
  • Overtime pay for existing staff to cover the added workload.
  • Covering necessary operating expenses such as rent, utilities or insurance
  • Paying creditors
  • Keeping the business viable until it can be sold or closed.

A key-person disability insurance policy provides peace of mind to companies and business owners alike because it makes way for the company to continue operating without significant disruption even under the worst-case scenario.

Why Buy?

Key man life insurance is a common risk management strategy implemented by small businesses to protect them from the death of a key person. For many companies, buying a keyman life policy is a “no brainer.” However, the threat of disability is significantly more likely than death at every age. This the primary reason why key person replacement coverage is so important. The statistics of disability versus death for given ages are tracked annually by the Social Security Administration in the report titled, Disability and Death Probability Tables For Insured Workers.

But what will happen to the company if a key person is disabled?  With a disability, the business will likely confront significant financial anxieties, including:

  • the loss of management skills and experience, particularly in smaller companies that don’t have management depth,
  • loss of business from the disability of the key employee,
  • the disruption of business when clients delay or withhold their activity until the impact of a disability is known,
  • increased expenses that are associated with hiring and training a replacement for the key employee,
  • creditor concerns and waiting to assess how the key person’s disability will impact the company financially,
  • the loss of major “Goodwill” and the uncertainty that comes with it.

A properly structured key person replacement plan protects the business by providing funds to help cover these financial uncertainties. Bottom line: Don’t overlook disability coverage!

Who is a Candidate for Key Person Disability Insurance?

The answer is pretty simple: most businesses that have at least one person who has such an influence on the organization that their temporary loss could threaten the existence of the company. There is likely someone in your organization who makes significant and unique contributions, and whose disability could have a financial impact company. These key people can be employees and employers and may include:

  • Shareholders or Equity Partners
  • Board Members
  • Senior Level Executives
  • Technical and Creative Experts
  • Inventors
  • Software Developers
  • Top Sales Professionals
  • Architects, Engineers or Attorneys who possess niche expertise
  • Business Owners

How Does Key Man Disability Insurance Work?

Key person disability insurance reduces the risk of financial loss to a business.

key-man-insuranceThe key employee is the covered individual under the policy, also called the “insured.” The business buys insurance coverage and makes premium payments. The company also owns the policy and is the beneficiary of any proceeds should there be a disability.

Following are the Key Person Disability Policy Basics:

Elimination Period or “Waiting Period”

The elimination period is the time that must be satisfied after a disability but before benefits become payable. A disabling injury or illness is a triggering event that starts the clock of the initial “waiting period.” The elimination period begins when the key employee is disabled, so if there is a disability, it is essential to notify the insurance company of a potential claim as soon as possible.

Depending upon the insurance company guidelines, the elimination period can be as short as 30 days or up to 365 or 765 days or even longer. The shorter the elimination period, the more you can expect to pay for the policy.

Typical elimination periods for key person replacement plans are 60 or 90 days. If a policy has a 90 day elimination period, in the event of a disability, monthly benefits become payable on day 91. Benefits are paid at the end of every month and continue as long as disability persists until the benefit period expires.

Benefit Payouts

In the event of disability, the proceeds are received either monthly or in a lump sum or possibly both. The type of payout depends primarily upon the needs of the business but also product availability. The key person, disability insurance marketplace, is limited in terms of viable insurance companies and policy options, which we discuss below.

Monthly Benefit Payout

The monthly payout option states that after the initial elimination period, i.e., 90 days, benefits are payable monthly at a fixed dollar amount for the life of the policy, which is usually 6-24 months depending on the company’s need and assumes the disability is ongoing throughout the benefit period.

Several factors determine the amount of monthly benefit available, but the key person’s income is the most significant factor. As a general rule, 150% of the income of the key employee is available under a monthly benefit approach. However, in some cases, additional monthly benefits can be available depending upon the specific situation and the ability to prove further need.

Example of a Keyman Replacement for a Monthly Benefit Plan:

A policy with a $10,000 monthly benefit and a 90 day elimination period with a 12 month benefit period will have a total potential benefit of $120,000. Benefits are payable after the initial 90 days waiting period is satisfied. The first $10,000 benefit payment would be payable to the business on the 120th day (90-day waiting period and payment the end of the month). Each month after that, benefits are $10,000 as long a total disability persists up to 12 months, or the policy pays total benefits of $120,000 policy benefits.

Lump-Sum Benefit Payout

The lump-sum benefit payout option requires a longer elimination period, usually 180 or 365 days before a single lump sum benefit is payable. At that time, if the key employee cannot perform the material and substantial duties of his regular occupation, the lump sum benefit is paid to the company, and the policy terminates. This approach is most appropriate when the business has significant cash flow or savings and can handle a shorter-term disability but will be affected over the longer term.

The lump-sum approach allows for up to 3 times the key person’s annual income as a maximum potential benefit. There are situations where additional coverage may be needed, and this can be considered on a case by case basis based on financial justification.

Example of a Lump-Sum Benefit Plan:

A policy with a $120,000 lump sum benefit and a 365 day elimination period will pay the $120,000 proceed to the business if the key person is disabled after a waiting period of 365 days.  After the payout of the lump sum payment, the policy ends.

Benefit Period

As mentioned, key man disability insurance policies cover short-term situations allowing companies to “buy-time” to adjust to contingencies. The benefit period is the duration of time the proceeds are payable under a covered disability. For monthly benefits plans, the benefit period is at least six months. Different benefit period options are available depending upon the insurance provider. The maximum benefit period for key-person disability insurance plans is two years.

Occupational Class 

Because of the limited availability of key man disability coverage, insurance providers are not overly aggressive in terms of the types of occupations they will insure. In most cases, white-collar professionals, salespeople, technicians, and business owners are the primary candidate. Blue-collar employees may not qualify. To determine eligibility, see the Principal underwriting guidelines below.

What is the General “Definition of Disability” for a Key Man Policy? 

If a disability occurs, benefits will be paid based on the terms of the policy, as long as the key employee meets the general definition of “total disability.”

Total Disability – means, solely due to Injury or Sickness:key-person-insurance-discussion

  1. The Insured (key person) is unable to perform the substantial and material duties of the Key Person Occupation; and
  2. The Insured is not Working in any other occupation which is comparable by duties and earnings for the Owner, and
  3. The requirements of the Claim are satisfied.

In order to be eligible for Disability, there must also be no reasonable job or worksite modifications that would allow the Insured to Work in the Key Person Occupation.

Is the Income from a Key Person Disability Policy Taxable?

The benefits received from key-person replacement coverage are typically not considered as income to the company.

The premiums that are paid by the company for key person insurance are not generally considered a tax-deductible business expense.

How Much Coverage Do I Need?

Ask yourself, if your top employee was disabled for a year, what impact would that have on your business financially? In other words, just remove the key person from your day to day operations and assess the potential damage.

Generally speaking, the amount of the monthly benefits available depends upon the following factors:

  • Key person’s income
  • Replacement costs associated with recruiting, hiring and training a capable replacement
  • Key person’s contribution to the company’s earnings

Depending upon the occupation, up to 150% or more of the key person’s income can is available on a monthly benefit plan. (Note that financial documentation will be required to support these figures at the time of policy application).

For the lump sum plan options, three times income is a reasonable estimate of need. This amount can also vary depending upon the specific circumstances surrounding the need.

Key Man Disability Policy and Plan Options

As previously mentioned, there are limited markets for key-person disability insurance. There are only a couple of insurance providers that offer plans: Principal Financial Group and Petersen International Underwriters (policies underwritten by Lloyd’s of London). That’s right! Lloyd’s of London is one of the only underwriters of key man disability coverage!

Because of the limited policy availability, you aren’t going to have a lot of options. The key is to work with an expert to identify your specific circumstances and craft the best available plan that most efficiently covers your risk. There are pros and cons to each product offering and carrier. We will discuss both companies and policy options below.

Option 1: Principal Financial Group: Why choose Principal®?

Principal Financial has been in business for over 140 years protecting both individuals and businesses with life and disability insurance as well as other financial services solutions.

principal_logo

Principal Financial Group

Des Moines, Iowa 50392

(800) 986-3343

Principal Financial maintains the following financial strength ratings:

  • “A+” Superior with M. Best Company: second highest of thirteen financial rating levels.
  • “A+” Strong with S&P Global: fifth highest of 20 rating levels.
  • “A1 Good” with Moody’s Investors Service: fifth highest of 21 rating levels
  • “AA-“Very strong with Fitch: fourth highest of 19 rating levels

For the proceeding twelve months ending December 31, 2019, Principal reported:

  • $735,000,000 in assets under management, and
  • $16,200,000 in revenues (Generally Accepted Accounting Principal, GAAP), and
  • net income attributable to Principal Financial Group of $1,394.2 million adjusted for net realized (gains) losses of $174.9 million equals non-GAAP operating earnings of $1,569.1 million.

Principal Financial Strength

Key Person Replacement Insurance from Principal Financial Group

Principal Financial Group is one of the only companies offering a product in this niche disability marketplace. Their key man disability policy is called Key Person Replacement Coverage.

See Key Person Replacement Coverage Consumer Brochure here

Principal Financial defines a key person as anyone critical to the livelihood of the business who is actively working-full time (30+ hours per week) and does not own more than 50% of the company. Furthermore, it is a requirement that they have worked with the company for more than a year if fee-for-service or three years if a non-profit.

Principal Financial’s General Key Person Disability Underwriting Guidelines:

  • Issue ages: 18 to 55
  • Income: Minimum $30,000
  • Occupation classes: 3A/3A-M to 5A/5A-M, Examples may include Executive Assistant, Consultants, Top Salespeople, Medical Professionals, and Business Owners
  • Elimination Periods:
  • Monthly Benefits: 90 or 180 days;
  • Lump-Sum Benefit: 180, 365 or 730 days
  • Benefit Periods: 180 days up to 2 years are available depending upon the specific details.
  • Maximum Issue Limits:
  • Monthly Maximum: $20,000
  • Lump-sum: Benefit based on the calculation of three times the key employee’s earned income (salary plus bonus), up to $500,000
  • Combination of monthly and lump sum: Up to $750,000 total

Additional Requirements: 

  • Works at least 30 hours a week in a critical position and has held that position for at least 12 months. The employee can only be covered for key man insurance under one business entity.
  • If the insured is an owner, the business must be in operation for at least one year for fee-for-service companies and three years for others (non-profits, etc.).
  • If both monthly and lump sum benefits are applied fo, the elimination period on the monthly benefit must be less than the elimination period on the lump sum benefit.
  • Discounts of up to 20% for multiple policy purchases may be available when three or more employees with the same employer purchase Individual Disability Insurance from the same producer.

Principal Financial Key Person Disability Sample Policy (Pennsylvania)

Principal Financial Group’s key person replacement policies are NOT available in CA, FL, MT, NY, and VT.

Benefits of Principal Financial Group’s Key Person Replacement Policy:

  • Guaranteed premium rate to age 65: Once in effect, the premium (cost) cannot change, and the policy can only be canceled under certain circumstances (such as the death of the employee or unpaid premiums).
  • Conditionally renewable to age 65: As long as the employee is still working for the business and payments are made, on-time coverage will remain active to age 65.
  • Flexibility in policy design. Benefits can be paid in a lump sum or a combination of monthly and a lump sum, and are generally received income tax-free.
  • Policy Discounts may be available.
  • Interrupted Elimination Period: Principal will combine different periods of disability to help reach the policy’s elimination period.
  • Recurring Disability:
  • Waiver of Premium Benefit: Premiums are waived for the duration of the disability once the elimination period is satisfied. Any premiums paid during the elimination period are refunded. The elimination period is the amount of time the employee must be disabled before benefits become payable.

Option 2 Petersen International Underwriters – Underwritten by LLOYD’S OF LONDON

Keyman disability policies underwritten by Lloyd’s of London are Executed By:

logo_petersen_international_underwritersPetersen International Underwriters

23929 Valencia Boulevard, Second Floor

Valencia, CA 91355 (800) 345-8816

Petersen International Underwriters became a Coverholder at Lloyd’s of London in 1982. Being a Coverholder means that Petersen has the authority to quote, underwrite, and issue policies within the financial security and backing of Lloyd’s.

Petersen International Underwriters is NOT a traditional insurance company. It markets its Surplus Lines products through licensed insurance professionals, helping them realize the crucial fact that to have one’s income underinsured is as dangerous as not being insured at all. Eventual financial ruin is the outcome. Specialty and underserved markets for disability protection is the primary focus of Petersen International Underwriters.

Petersen International Underwriters is a licensed provider in all 50 states, Washington D. and Canada. Not all products are available in all states or countries.

Key Person Disability Insurance Offering from Petersen International and Lloyd’s

One of the only other policy options for key man disability is through Petersen International Underwriters and Lloyd’s of London. The policy is called Key Person Disability Insurance and is in many ways similar to the traditional offering of Principal Financial Group but with more flexibility in some ways but with less long term renewability options. Petersen doesn’t publish specific guidelines but they are willing to consider each case separately.

General Underwriting Guidelines for Petersen’s Plan:

  • Issue ages: 18-60+ (Call)
  • Occupations: Varies, more Flexible than Principal Financial. Examples include a well-known surgeon, hedge fund manager, architect, or executive chef.
  • Elimination Periods:
  • Monthly Benefits: 30,60, 90 or 180 days;
  • Lump-Sum Benefit: 180, 365 or possibly longer
  • Benefit Periods: 12 months up to 2 years, depending upon the specific details.
  • Maximum Issue Limits:
  • Monthly Maximum: 150% of income is a typical maximum issue amount, but in some cases, other factors unrelated to income are possible. Petersen is more willing to review each case based on the potential loss to the business and will offer more coverage if there is a genuine need.
  • Lump-sum: Guideline states three times the key employee’s earned income (salary plus bonus), with no set maximum. However, as with the monthly issue limits, Petersen is willing to consider more coverage if the circumstance dictates.
  • Combination of monthly and lump sum: Benefits may be combined, and a determination of available coverage will be made based on the risk of the potential loss.
  • NOT Available in all states.

Key Man Disability Sample Policy Petersen Underwriters and Lloyd’s of London

Benefits of Petersen’s Disability Policy:

  • Guaranteed policy rates for the initial five-year term.
  • Policies are conditionally renewable to age 65- As long as the employee is still working for the business. After the end of each respective term of insurance, RENEWAL policies are subject to NEW underwriting.
  • Flexibility in policy design. Benefits can be paid in a lump sum or a combination of monthly and a lump sum, and are generally received income tax-free.
  • Interrupted Elimination Period: Principal will combine different periods of disability to help reach the policy’s elimination period.
  • Recurring Disability: If, after a period of total disability, you return fulltime to work, and within six months, you are once again totally disabled, you can elect to continue the previous claim without the need for a new elimination period.
  • Presumptive Disability: If due to a sickness or injury you have totally lost: the use of both hands, or both feet, or one hand and one foot, or the sight of both eyes, or the hearing of both ears, or the ability to speak, the elimination period is waived. The monthly benefit will be paid for the entire benefit period or as long as the loss exists.

Key Person Disability-Consumer Brochure-Petersen

How Much Does a Key Person Disability Insurance Plan Cost?

Key person disability insurance is very limited in terms of companies offering the product. Because of its “niche” status, short-term coverage period, ability to customize, and limited availability, there are not many comparison options. The cost of key person disability insurance can vary broadly because each plan can have its unique requirements. The main factors affecting the price of key person disability coverage are:

  • Age
  • Gender
  • Occupation
  • Tobacco status
  • State of residence
  • Policy structure
  • Discounts

Principal Financial Group-Key Person Replacement Disability Rates

Sample Monthly Premiums for a $200,000 Total Benefit

Assumptions: A Portfolio Manager earning $100,000 annual salary, lump-sum payout, 180-day elimination period, nonsmoker in good health

Sample-Monthly-Premiums-200000

Sample Monthly Premiums for a $300,000 Total Benefit

Assumptions: A Paralegal with $100,000 annual salary, lump-sum payout, 180 day elimination period, non-tobacco in good health

Sample-Monthly-Premiums-300000

All quotes are for general reference only and are subject to medical and financial underwriting. Quotes are a guideline only, and actual rates may vary significantly.

The best way to determine the right amount of key person disability insurance, as well as the premium cost, is to obtain a quote directly from a disability insurance specialist here.

How Do You Qualify for Key Person Disability Coverage?

To qualify for a policy, the insured must be in good health at the time of policy application. Also, before a key man disability insurance policy is approved, it must be proven that the employee is critical to the company’s success and that his or her talents and skills are unique.

The application for key person disability coverage will usually ask some or all of the following questions:

  • Is the key person an owner of the firm? (If so, what is his or her business-insurancepercentage of ownership?)
  • What does this person do that another person cannot do?
  • What financial loss would the company suffer if this person were disabled?
  • How long has this person been working for the company?
  • What was the individual’s income over the last three years (including salary, bonuses, or commissions)?
  • What is the existing coverage currently in force on the key person in which the company is the beneficiary? (i.e., life insurance or other disability coverage)
  • Is the key person or the business a party to any legal proceedings at this time? (If so, provide details.)

See Key-Person Questionnaire here

Underwriting

Assessing the risk for a disability insurance policy is a bit more stringent than for key man life insurance. The chief factors are:

  • Occupation- The duties of the specific occupation dictates the likelihood of disability. As mentioned previously, key man disability coverage is only available for select occupations and these are the types of jobs that tend to be professional or technical.
  • Medical History-Since disability underwriting is more concerned with potential illnesses, past medical history is viewed very carefully. Morbidity is the measure of potential illness in an individual or group and is a significant concern to all disability insurance providers.
  • Income-Earnings play a large part in determining the amount of policy benefit available and to some extent “if” a policy is available.

Learn more about key man life and disability insurance underwriting here.

How to Apply for Key Man Disability Coverage

Applying for disability coverage is much like the process of applying for a key man life policy. There is a formal application required for every policy. Each policy covers only one key person. Information on both the “insured” person as well as the business must be provided.

See Sample Key Person Replacement Application-Principal FInancial-Alabama

For a detailed breakdown of the traditional process from the decision to buy a policy to the actual policy approval and acceptance see The Process of Applying for Key Man Insurance.

Alternatives-Business Overhead Insurance

Overhead insurance is disability insurance on the owner of a business that will reimburse the business for covered expenses IF the business owner becomes disabled.

There are some situations where key person insurance just isn’t a good “fit.” In these cases, it may be necessary to consider business overhead insurance. Business overhead, which is also frequently referred to as overhead expense insurance, can be life-saving to a business if an owner is temporarily down.

This type of coverage reimburses the company for various expenses if the owner becomes disabled. Covered expenses may include rent, utilities, office supplies, inventory, equipment, non-owner salaries, and even other insurance premiums.

Some overhead coverages offer a “Salary Replacement Rider”  that reimburses the business for costs associate with hiring a training a capable replacement. While not exactly the same as key man disability insurance, overhead coverage with a “Salary Replacement Rider” can provide funds to pay the salary of a replacement for a disabled owner.

Learn more about business overhead insurance here.

Summary

If you own or operate a small business, there is probably at least one member of your team who is critical to the companies survival. An unexpected disability to this person could result in significant financial challenges to the business going forward. Keyman disability insurance is a specialty type of policy designed to protect the business in the short-run if a serious situation arises. If your organization relies on one or two people, investing key person replacement coverage is essential.

We specialize in assisting organizations of all sizes with protecting their most valuable assets – their people – with key man disability insurance. In most cases, the cost of a key person insurance policy is negligible and not too difficult to obtain.