Key man life insurance is needed by a wide range of companies, and for many reasons, but generally is most important for small and medium size businesses.
These companies depend on the expertise and talents of a small number of individuals for their success. The death or disability of one of these key employees or executives may well result in the demise of the firm.
What Companies Would Need Key Man Life Insurance?
Other businesses who must consider key man life insurance include:
- start-up companies
- those needing to secure financing
- companies in niche markets where replacement employees may not readily be available
- structures looking to protect and retain an exceptional sales person
- companies where the business owner desires liquidity in the event of their death or disability
Below we explain a few of these scenarios so you can see how a loss might impact each situation differently.
All companies have key employees but the start-up company more than any other relies on the abilities and skills of a select number of people. Based on their past achievements these business executives, salespeople and scientists, etc., bring and instant credibility to a newly founded company. These individuals may possess special abilities to raise capital, have established key relationships with suppliers and vendors, hold a technical expertise that is very rare or own an extraordinary track record of past sales. Whatever the specific case, a start-up company’s most valuable asset is likely its key employee(s).
In a start-up company, the death or disability of a key employee will result in significant financial hardship and in many cases business failure. Therefore, having key man life and disability insurance on your key people is critical to protect your company from a potential catastrophic loss. The costs to secure key person life insurance are negligible when compared to the economic loss caused by the demise of a company. Why take a chance?
To get to the next level, most companies rely on financing or investment capital for the cash flow needed to fund expanded operations or research and development. A chief requirement of lenders as well as investors to secure these funds is key man insurance. In fact, the SBA, one of the country’s largest lenders to small businesses, requires key man insurance, in most cases, prior to funding any loan. Even if key man insurance is not a requirement to secure financing, the cost of key person insurance is negligible compared to the added credibility your company will have with your financiers and investors. When attempting to secure financing, do not be surprised if one of the lender’s first questions is, “Does your company have key man life insurance”?
Generally, when using a key man life insurance policy to secure a loan, a collateral assignment is utilized to ensure that the bank or lending institution receives funds to cover the loan balance due in the event the key person or business owner dies or is disabled. A collateral assignment in effect is a lien against the policy that guarantees that proceeds are first payable to the “assignee”, in this case the lender, with the balance of policy proceeds going to the named beneficiary of the policy. With a collateral assignment, in the event of the death or disability of a key employee, the lender gets the exact loan balance amount due with the business receiving the remaining insurance proceeds.
Niche Businesses Needs
More than any other type of company, key man insurance is crucial to niche businesses. For example, hedge funds, research and bio-medical firms, companies with special contracts and other businesses with patents and proprietary systems all rely heavily on the niche expertise of key employees or business owners. What happens to the company if one of these niche people becomes disabled or dies unexpectedly? Insuring these key people is imperative to the continued success of these businesses. If your business falls into this “niche” category, you need key man insurance.
Typical Small Business Scenarios
Small business owners have several needs for key man insurance including:
- to provide income to the business to replace the skills and experience one of the key owners
- to have the available liquidity to “buy-out” a deceased or disabled partner or shareholder’s family
- to provide funds for the successful transition of the company when an owner retires
Typically businesses have prearranged agreements called “buy sell agreements” that include the instructions for what to do in the event of the death or disability of a shareholder or business owner. In nearly all cases, key person insurance is the most efficient and cost effective means to fund these agreements.
Key man insurance is also an extremely valuable tool for business succession planning. In most cases, a large percentage of a business owner’s assets are tied up in the business itself. In these cases, key man insurance using cash value life insurance can provide the liquidity needed to successfully transition the ownership of the company without a dramatic effect on its earnings ability and cash flow.
Wait, What’s the Difference?
Quick Test: Do you know the difference between life insurance and key man life insurance?
We work with business owners on a regular basis and one of the most common questions asked is, “what is the difference in a regular life insurance policy and a key man insurance policy?”
The fact is, ordinary life insurance and key man life insurance are identical in terms of how the policies work.
In both scenarios the general concept is the same. An insurance policy is purchased on the life of an individual, referred to as the insured, and is designed to pay a death benefit to a named beneficiary in the event of the insured’s death. With both life insurance and key man life there is a policy owner that makes premium payments to a life insurance company for the guarantee that in the event the insured dies, a specified amount of money, referred to as the death benefit, will be payable to the beneficiary.
The big difference between life insurance and key man life insurance is in how the policies are structured.
For example, with most ordinary life insurance policies, the policy owner and insured are the same person and the beneficiary is usually a spouse or other family member. In other words, most individual life insurance policies are purchased by the insured to provide financial security for the his/her family or to cover a specific personal need.
With key man life insurance, the key employee is the insured and the business is the policy owner, premium payer and beneficiary. So if the key person dies, the death benefit is payable to the business and not the key employee’s family. Key man life insurance policies are purchased by companies to provide financial security to the business. Proceeds from these policies can be used for any purpose, but in most cases, businesses use the funds to identify and hire a capable replacement for the deceased employee.
Even beyond a regular life insurance policy, there are even alternatives which still accomplish the same goal.
Why Would Someone Need A Key Person Policy?
Key man insurance is a simple solution to a potential catastrophic problem. It is an inexpensive tool to protect a corporation or other business entity from the damaging effects of the loss of a key employee or business owner. It is also a logical way to insure that a business can retain options if a key employee dies or is disabled.
The options provided by key man insurance may include hiring and training a replacement employee, paying the businesses debt and liquidating the company, or selling the company at fair market value. Without key man insurance in place, most businesses have no option other than to close the business or sell it to a competitor at a significantly reduced “fire sale” price.
There is no reason to postpone planning for this potential crisis. The relatively low costs to acquire key man protection make purchasing this insurance an easy decision.
Help Retain Key Employees
One use of key man insurance is to protect the company from the loss of a key employee due to death or disability but just as important to any business is retaining their key people. Most small to medium size companies have key employees that generate large percentages of revenue annually. Losing one of these key contributors to a competitor can potentially be devastating.
Key man insurance can be purchased as a benefit for the employee while at the same time providing some security to the company essentially tying the executive’s benefits to continued service. Life insurance policies can be purchased on key employees for the mutual benefit of the company and the employee. Some plan options include executive benefit plans and non-qualified deferred compensation arrangements.
Advantages To Owning It
Included below are just a few of the many advantages of key person insurance:
- Affordability. Both key man life and disability insurances are inexpensive. In fact, key man life can be funded with inexpensive term insurance.
- Key employee insurance policies are easy to acquire and do not require any special filings or IRS disclosures.
- Peace of mind to business owners and investors/creditors alike.
- The business has the choice of which employees to insure.
- Proceeds of key man life and disability are generally received by the business tax free¹.
- The business has the option of using universal life insurance to fund key executive compensation plans. These permanent policies build cash value that may be used, if needed, by the business.
The primary uses for key man insurance include:
- Providing funds for recruiting and training a replacement key employee.
- Paying any expenses or bills while the company stabilizes.
- Securing loans for business growth and expansion.
- Strengthening the company’s credit position.
- Purchasing stock from the deceased owner’s estate.
- Salary continuation arrangements to surviving spouse.
- Executive compensation planning.
- Transitioning the company to successor owners.
How Much Coverage Is Best?
In many cases it is hard to put an exact monetary value on how important a key person is to a given business. Most of the requests we receive are based on the amount of funds being borrowed by the company via loan or some other arbitrary amount that was determined by an investor.
The goal when valuing a key person for life and disability insurance is to get the correct amount of coverage, using the right type of life insurance policy, based on the specific needs of the business but that also corresponds to the realistic loss associated with the death or disability of the key employee from the insurance company’s viewpoint.
In many cases the amount of key man insurance requested is dramatically higher than is available from the life and disability insurance companies. For example, just because a firm is borrowing $10,000,000 for a project expansion doesn’t mean the insurance company will willingly write $10,000,000 of insurance. Specific details will be required by the insurance company to justify the insurance amount requested.
There are several valuation methods commonly used to determine the proper amount of key person insurance needed from both the business and insurance companies perspective. These valuation methods include: the replacement cost method, the contribution to earnings method and the multiples of income approach. A brief explanation of each valuation method follows below.
Replacement cost method.
The amount of key man insurance needed is based upon what it would cost to replace the key executive. The replacement cost of a key person is determined by the salary and other ongoing expenses required in hiring, training and completely replacing the key employee or executive. Costs associated with decreased or lost revenue may also be factored in when determining a key employee’s replacement cost.
Contributions to earnings method.
The contributions to earnings method is calculated based on the percentage contribution the key employee makes to the company’s bottom line profit. For example, a top salesperson in a small business may contribute 50% or more of the sales of the company directly resulting in half of the company’s profits. In this case, the actual value of half of the company’s annual profits would be multiplied by the number of years needed to train an equivalent replacement.
Multiples of income method.
The multiple of income method is the simplest most common form of determining the value of a key employee. Most insurance companies use a multiple of 5-7 times current salary including benefits as a general guideline. Of course, depending on the specifics of the position, a higher or lower multiple may be justified. An example of the multiples of income approach would allow $1,000,000 of key man insurance on an executive making $200,000 in compensation and benefits assuming a 5 times multiple.
How About Executive Benefits
Smart companies realize the significance of providing competitive compensation packages to their executives and key employees.
In fact, studies show that the chief reason why executives leave companies is compensation. A non qualified deferred compensation plan is a strategy companies use to provide additional supplemental benefits to their key people.