Key man life insurance, also called key person life insurance, is protection designed to sustain a business or organization in the unfortunate event it loses one of its most valuable employees, executives or owners to a sudden and untimely death.
In many cases, the death of one key person can devastate a business. Key man life insurance policies give a business the assurance of knowing if it lost one of its most important contributors, funds would be available to maintain the stability of the organization.
Key man life insurance provides immediate cash to the company at a most critical time. If death strikes, the death benefit proceeds may be the difference between a company’s demise and its survival.
How Does Key Person Life Insurance Work?
The basic premise of key man life insurance policy is rather simple.
- A business entity purchases a life insurance policy on the life of an employee, executive or business owner who is invaluable to the continuation of the business.
- The business applies for and owns the life insurance policy, pays all premiums and is the beneficiary of the policy in the event of the death of the key person.
- If the key person unfortunately dies, the business generally receives the proceeds of the key man policy tax-free and can use the funds as it so chooses.
To assure the policy proceeds are received tax-free, all companies must follow the IRS reporting requirements for business owned life insurance policies.
In most cases, a simple level term life insurance policy is used.
The chief reason why term insurance is used for key man policies is its low cost. Many organizations needing key man insurance are small businesses with cost concerns, and term life is the cheapest way for a business to protect itself.
Many start-up companies and small businesses who desperately need key man insurance find term insurance extremely affordable, making the decision to buy it a “no brainer.”
Wait, What’s the Difference Between Key Man Life Insurance and Ordinary Life Insurance?
Quick Test: Do you know the difference between traditional life insurance and a key man life insurance policy?
We work with business owners on a daily basis and one of the most common questions asked is, “what is the difference between a regular life insurance policy and a key man insurance policy?”
Well, it’s kind of a trick question. 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. With both life insurance and key man life, there is a policy owner who makes premium payments to a life insurance company for the guarantee a specified amount of money, referred to as the death benefit, will be payable to the beneficiary.
The biggest 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.
If the key person dies, the death benefit is payable to the business and not the key employee’s family. This is the major distinction.
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.
What Types Of Businesses Need Key Man Life Insurance Protection?
Key man life insurance plans are needed by a wide range of companies, and for many reasons, but generally is a critical financial pain point 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 of one of these key employees or executives may well result in the demise of the firm, or, at minimum, catastrophic hurdles to overcome.
Examples of businesses who must consider key man life insurance include:
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 past achievements, these business executives, salespeople and scientists bring instant credibility to a new company. In fact, in many instances, the entire company’s success may depend on only one person.
These key people possess special abilities to raise capital, have established key relationships with suppliers and vendors, hold a technical expertise which 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 of this single key employee will result in significant financial hardship, and in many cases business failure.
Therefore, having key man life insurance is critical to protect your company from a catastrophic loss. The costs to secure key person life insurance are negligible when compared to the economic loss caused by the demise of the company.
Why take a chance?
Companies Needing to Secure Financing
To get to the next level, most companies rely on financing or investment capital for the cash flow needed to fund expansion, or research and development.
To secure these much needed funds, lenders, as well as investors, will normally require the business to purchase key man life insurance on their key people.
In fact, one of the country’s largest lenders to small businesses, the SBA, requires key man insurance, and, in most cases, prior to funding any small business loan.
If you are applying for an SBA loan and need key man life insurance, here are the best practices to securing coverage, which are critical to getting the best results.
Even if key man life insurance is not a requirement to secure financing, the cost 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 regarding your company’s key man life insurance.
Generally, when using a key man life insurance policy to secure a loan, a collateral assignment is utilized to ensure the bank or lending institution receives funds to cover the loan balance due in the event the key person or business owner dies.
A collateral assignment is a legal document familiar to all lenders and in effect is a lien against the policy which guarantees insurance policy proceeds are first payable to the “assignee”, in this case the lender, with the balance of proceeds going to the named beneficiary of the policy.
With a collateral assignment, in the event of the death of a key person, the lender gets the exact loan balance amount due with the business receiving the remaining insurance proceeds.
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 a key employee or business owner.
What happens to the company if one of these niche people dies unexpectedly?
Non-Profits and Churches
Even non-profits are candidates for key man life insurance.
The most common non-profit organizations who need life insurance are churches and religious institutions. While they are not in business to make a profit, churches still expand and grow as their ministry and congregations grow. A result of this growth is the need for a new worship center, classrooms or a gymnasium.
In order to borrow the funds necessary, many lenders will require a key man life insurance policy on the pastor of the church, or their elders. This makes very good sense as the growth of the church is in large part related to the vision of its pastor or minister.
All Other Business Owners Scenarios
Small business owners have multiple needs for key man insurance, including:
- Providing income to the business to replace the skills and experience one of the key owner
- Creating liquidity to buy-out a deceased partner or shareholder’s family
- Providing funds for the successful transition of the company when an owner retires
One of the most important concerns for any business partner or shareholder is the second scenario.
In this situation, the last thing any business person wants is to have a deceased partner’s spouse or family as their new business partner.
For this reason, smart businesses have prearranged agreements called buy sell agreements which include the instructions for what to do in the event of the death of a shareholder or business owner.
In nearly all cases, term life insurance is the most efficient and cost effective means to fund these agreements.
Key man life policies can also be an effective tool for business succession planning, like in the third scenario.
In most cases, a large percentage of a business owner’s assets are tied up in the business itself. In these cases, life insurance with a cash value component can provide the liquidity needed to successfully transition the ownership of the company without a dramatic effect on its earnings ability and cash flow.
Why You Should Consider Buying Key Person Life Insurance
The primary uses for key man life insurance include:
- Providing funds for recruiting and training a replacement key employee. Replacing a key person is the number one reason why companies buy key man life insurance policy. In most cases, the key employee has special skills and abilities which make it very difficult and time consuming to find a substitute. The recruitment process can take considerable time and resources. The proceeds of a key man life insurance policy can make this difficult process less stressful and buy the time needed to find the most qualified candidate.
- Paying any expenses or bills while the company stabilizes. What if a key owner of the company passes away unexpectedly? Could the company continue to move ahead? Key man life insurance provides instant liquidity to meet cash demands for ongoing operations.
- Securing loans for business growth and expansion. Loans are necessary to help finance opportunities, and banks and other lenders usually want collateral as security. The death of a key person is a real risk to a small company’s ability to pay back a loan. Therefore, it is routine for lenders to require key man insurance on any person who is crucial to the viability of the company.
Strengthening the company’s credit position.
- Purchasing stock from the deceased owner’s estate. A most important use of key man insurance is for buying out a deceased partner’s equity in the company. Let’s say there are 2 equal owners of a manufacturing company with a fair market value of $4,000,000 and one of the owners dies. This immediately creates two major issues:1. How does the deceased partner’s family get their share of the equity in the company without selling it?2. How does the surviving owner pay off the deceased owners family to avoid being in business with them?By establishing a buy-sell agreement funded with key man life insurance this problem can be easily solved.
- Paying off debt obligations such as mortgages or lines of credit. Key man life insurance proceeds can help payoff large obligations, such as a loan taken for the purchase of a business or the mortgage for the facilities associated with the business.For example, two dentists purchase an existing practice for $750,000 and also finance the acquisition of the office building for $1,200,000. If one of the dentists dies unexpectedly, how would this impact the ability to pay the notes?Key man insurance can be purchased on each dentist in the amount of $1,950,000 to effectively satisfy 100% of the obligation if one dies.
- Salary continuation arrangements to surviving spouse. A salary continuation plan is an agreement between an employee and employer, whereby the employer agrees to continue the employee’s salary death or disability. The benefits are normally expressed in terms of a percentage of salary and length of service. Key man life insurance can provide funds to the company to honor prearranged salary continuation agreements in the event the key person dies.
- Executive compensation planning. Retaining key employees is crucial to the success of any business. As an incentive, businesses routinely offer executive benefits to those most important to its success. Key man life insurance with a cash value component can be very attractive to any executive. The business may use non-qualified deferred compensation plans to tie the executive to the company through what is commonly referred to as “golden handcuffs.”
- Transitioning the company to successor owners.
The Major Benefits to Owning Key Man Life Insurance
Below are just a few of the many advantages of key person insurance you gain from life insurance:
- Easy to acquire.
- Peace of mind.
- Choice of which employee(s) to insure.
- Tax free proceeds. (as long as IRS guidelines for Corporate Owned Life Insurance (COLI) are satisfied.)
- Funding key executive compensation plans.
- Deferred compensation and executive benefits.
Important Questions to Ask & Answer
Once the need for key employee life insurance has been established, there are a few questions which should be answered before you begin to shop for a policy.
These questions will be helpful in addressing three very important factors: the type of insurance needed, how much insurance is needed and how long the policy should be maintained. Or, you may find an alternative method is best.
QUESTION: Why are you considering key employee life insurance?
ANSWER: Did your attorney recommend it to you? Were you doing research on the internet and found out that you should have it? Maybe your banker is requiring a policy? Are you putting together a business plan? In order to uncover your best solution, you need to identify exactly why key man life insurance is needed. Once you know why you need it, you can narrow down your options to identify the exact amount of coverage required and for how long. You can then work to find the most competitive rates.
QUESTION: What are the contingencies for the company if a key employee dies?
ANSWER: If a key person dies, what would happen to the company? Or, to state it another way, what would you want to happen to the company? Would the business continue operations or be liquidated or sold? If the company is going to continue, how much insurance is required to stabilize the company until it can recover from the loss? How long will it take the business to rebound? In some cases, funds are needed to payoff notes and obligations for a period of time until the business can be closed. If the company is going to be sold, what is the fair market value and how easy will it be to sell the business? Some businesses aren’t easily marketable and you will need more cash to keep things going until the right buyer can be found. Key man insurance can help avoid the “Fire-Sale” of your company.
QUESTION: Can a capable replacement employee be easily located?
ANSWER: Depending upon the expertise of the key person, it may be very difficult to find a capable replacement quickly. How much will it cost to locate and train a replacement? What type of compensation will it take to hire the new employee? In some cases, more than one person will be needed to cover the responsibilities of the key person. How much money is going to be required to meet these requirements? You need to think this through carefully and even have a plan in place for this contingency.
QUESTION: What percentage of revenue is directly attributable to the key person?
ANSWER: What would be the impact on the cash flow of the business? Would the key person’s death result in the loss of clients? How long will it take to stabilize the company’s revenue? It may take 6 months or even a year to get back the lost income. Or, the company may not be able to ever regain the lost momentum? Every possible outcome should be carefully considered before determining the amount and type of key man life insurance.
QUESTION: Would the key person’s death result in the loss of clients?
QUESTION: What would happen to your company if your business partner died?
ANSWER: How would the business continue? Would you be in business with your partner’s spouse or family? How would you replace your partner’s experience? How would your partner’s family get the income/equity of their interest? Would revenue even be there to pay them? Key man life insurance is a perfect way to transition a business. It provides instant liquidity to buy-out a deceased partner or shareholder’s interest while allowing for the surviving partner to maintain control of the company.
QUESTION: Is the company willing to self-insure?
ANSWER: What are the actual costs of not doing the insurance? Does it make sense to forgo key man insurance? In nearly all cases, the cost of a key man life insurance policy is a small fraction of the cost of self-insuring. Doing a simple cost comparison will lead you in the right direction.
QUESTION: Where do I locate a competent professional insurance agent that has experience in working with companies such as ours?
ANSWER: The internet is a great tool for shopping for key man life insurance. However, you do not have look further than Right here! Since, 1994, we have helped thousands of business owner’s and companies of all shapes and sizes find the most competitive key man life insurance policies.
The answers to the questions above will provide a good starting point in your efforts to secure the best policy. With this information, you will know exactly what you are trying to accomplish, making it easier for us to help you find the best solution to your specific situation.
How Much Coverage Do You Need?
In many cases it is hard to put an exact monetary value on how important a key person is to a given business.
The goal when valuing a key person for life insurance is to get the correct amount of coverage (not under-insured or over-insured) based on the specific needs of the business.
However, the amount of life insurance you request needs to be closely associated with the realistic loss to the company if it loses this key person.
The general insurance company guidelines for the amount of key man life insurance available are as follows:
For an employee who owns no equity in the business, the maximum amount of key employee life insurance a business can buy is 10 times the employee’s annual income.
EXAMPLE: If the employee earns $100,000, the maximum amount of life insurance which can be purchased is $1,000,000.
This does not necessarily mean your business should buy 10 times your key person’s annual income; it’s the stated maximum. You may well find 5 to 7 times the key employee’s annual income may be adequate and there is no reason to have a dime more insurance than you really need.
Employees with Equity Ownership:
For an employee of the business who is also an equity owner, the maximum amount of life insurance a business can purchase is 10 times the key person’s income, plus the fair market value of their ownership interest in the business.
The fair market value is defined as what a reasonable person would be willing to pay for the business.
If the key person owned 15% of a business with a fair market value of $2,000,000, the maximum an insurance company would be willing write would be $300,000 for the equity interest plus 10 times the key person’s annual income.
The following are few examples:
EXAMPLE # 1:
A company wants to insure its top salesperson for $5,000,000 because they would have a hard time finding a capable replacement if she died.
In this case, if the sales person doesn’t have equity in the company or at least earn $500,000, the insurance company will not allow this amount of life insurance to be written.
EXAMPLE # 2:
A company is borrowing $10,000,000 for a project expansion and the business has two partners who are equal owners.
In some cases, lenders may request $10,000,000 of life insurance be purchased on each owner.
However, this doesn’t necessarily mean the insurance company will be willing to write $10,000,000 of life insurance on each owner. Specific details will be required by the insurance company to justify the amount requested, including comprehensive financial information on the company and the transaction.
Some of the requests we receive are based on an arbitrary amount which was determined by an investor.
If a start-up company with very little revenue or assets attempts to purchase $7,500,000 of key man life insurance on an individual because they have an investor who wants to protect his investment, the insurance company is NOT going to permit this amount of coverage, as it is unreasonable.
No life insurance company will base the amount of key man life insurance allowable on a Pro-Forma projection which may, or may not, come to pass.
Common Key Employee Valuation Methods
There are several valuation methods commonly used to determine the proper amount of key person insurance needed.
These valuation methods include:
- The replacement cost method
- The contribution to earnings method
- 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 and most common way of determining the value of a key employee.
As previously noted, most life insurance companies use a common multiple of 8-10 times the key person’s current annual salary, including benefits, as a general guideline. Of course, depending on the specifics of the position, a higher or lower multiple may be justified.
The key man valuation methods discussed above are not set in stone. Each case merits specific consideration, and therefore should be reviewed based on their individual circumstances.
How Underwriting Works: 5 Steps To Securing Coverage
Underwriting is the process whereby an insurance company gathers all of the required information to formally review and approve an individual for key man life insurance.
The following five steps are the general criteria every insurance company will require to assess, approve and issue a key man life insurance policy.
- The Application
- The Medical Exam
- Final Review
- Acceptance Signatures and Payment
- Collateral Assignment
The Initial Application Process
Every insurance company will require a completed application for life insurance. Each company has its own specific application forms and some are more comprehensive than others, and this will likely be the most time consuming part of the process for you.
If a company requires an exam, the application can be in paper form or completed electronically. Most insurance companies allow you to skip it will have an online application process which will require a 15-20 minute telephone interview.
Included on the application are general questions about the key person such as:
- date of birth
- social security number
Insurance companies will also want to know about other things such as:
- hazardous sports
- driving record
- criminal record
- foreign travel plans
Depending on the insurance company, some may ask about the specific health details of the key person (others will simply get this information from the insurance exam).
Since the business will own the key man life policy and be the beneficiary, every insurance company will want specific information about the business, too.
Basic information such as:
- the exact business name
- business address
- telephone number
- tax id
Additionally, the type of business entity:
- Sole Proprietorship
The nature of the business, its inception date and the type of industry are also required, as not all businesses have the same inherent risks.
Finally, financial information will always be required.
In most cases:
- gross sales
- net worth for the last 2 years
For larger cases, tax returns may be requested.
The insurance companies will can ask about the fair market value of the business and the number of shareholders and their equity percentages.
Depending on the state, other supplemental forms will be required such as a policy replacement form, HIV consent, HIPPA Authorization and Accelerated Benefits.
Most every company will require an Employee Consent Form.
To submit it, the application will need to be signed by both the key person (the insured) and a representative of the business as the policy owner (applicant).
IMPORTANT: In order to get the best results and to have a smooth and efficient underwriting process, it is critical to provide as much detail as possible on the application. Any questions or “gray areas” need to be addressed specifically to give the underwriter a clear picture of the circumstances. A properly completed application can make a huge difference in the time it takes to get a policy approved as well as the actual rates of the policy.
The Medical Exam
Unless you are applying for a no medical policy, an insurance exam will be required.
The insurance exam is a “mini-physical” exam which includes:
- a height and weight measurement
- blood pressure check
- resting heart rate
- a blood and urine specimen
- 12-15 medical questions
An EKG may also be required for older applicants or larger case sizes, or where a previous heart condition is known.
The exam is usually completed in the convenience of the insured’s home or office and administered by a Registered Nurse or trained Phlebotomist. If the policy is very large, the exam may need to be completed by a Physician.
The exam is paid for by the insurance company and the results are provided to the insured for free.
The most important part of the exam will be the blood and urine results, so it will be important for the insured to be prepared for the exam.
Once the application is submitted and the exam is completed, the insurance company can begin the evaluation process to approve the policy.
This process involves reviewing all of the application and exam material, including lab results.
Routinely, the insurance company will order medical reports from physicians to get specific details of medical conditions and treatment history.
This process may take a couple of weeks depending upon how quickly doctors and medical facilities respond to the request for records. Working with an experienced agent will make a huge difference in getting the most efficient results.
Acceptance Signatures and Payment
Once the underwriting has been completed, the policy will be approved. At this point, a policy will be issued, and all that is required is payment and a few signatures to make the policy effective.
Once the policy is in force, and the insurance was purchased to secure a loan, a Collateral Assignment can be submitted to the insurance company.
The Collateral Assignment needs to be signed by the lender as “Assignee” and the policy owner as the “Assignor.”
How You Can Buy Today At The Lowest Possible Rates
The following are the exact action steps you need to take to get the best possible results in your search for a key man life insurance policy.
- Identify why you are buying key man life insurance.
Think it through carefully.
Recognizing your purpose for buying key man life insurance is likely not “rocket science”, but taking the time to clearly understand what you are trying to accomplish will assure you find the right solution.
- Determine how much insurance you need to protect your business.
We’ve given you examples above how to figure this out, but if you are not certain or have questions, call us!
Our independent agents, many of them business owner’s themselves, will take as much time as necessary to help uncover the appropriate amount of insurance you should buy.
Not enough could be detrimental later, and too much is just a waste of money now.
- Decide how long you will need to maintain the insurance.
The purpose of the insurance will help you to identify just how long you need to keep a key man life policy.
A 10-year term plan is by far the most commonly purchased policy. The reason is a 10-year term insurance is, in most cases, the cheapest way to protect any business.
However, in many cases, it doesn’t cost much more to get a longer term. We don’t advocate keeping the insurance longer than you need it, but don’t be shortsighted.
- Categorize the health of the key person.
The health of the key person is the most critical factor in determining the price of a key man life insurance policy.
Our experience is invaluable to you, and if you lean on us, we guarantee you the best possible premiums available to you! If you have a health issue, call us first and we will help you identify your top options.
- Disclose potential lifestyle issues.
Sports and hobbies, like scuba diving and foreign travel, are very relevant in calculating your final rate. These “little things” you may think are irrelevant can potentially result in thousands of dollars in unnecessary added costs.
By disclosing this very important information, an experienced agent can identify the insurance company who will offer you the best price.
- Find the right agent.
Working with an experienced agent who represents multiple insurance companies is the only way to know you will find the best key man life insurance policy at the lowest possible rates. Period.
That’s what you need to let us help you!
Work With The Best In The Business
Our name says it all. Since 2002, we have been the dominant online provider in the key man insurance marketplace. Early on, we made a focused commitment to be specialists in the key man life insurance business.
You owe it to yourself to do business with a specialist who has the experience to get you covered!
Since 1994, we have helped tens of thousands of individuals and businesses uncover their best options in life insurance. During this time, we have written well over $3,000,000,000 of life insurance and key man life insurance.
Our free advice has saved our website visitors and clients millions of dollars collectively. In addition, our efforts have helped many avoid headaches and pitfalls and more importantly wasted time. Why not let us help you uncover your best key man life insurance options?
Don’t just take our word for it. Call us today.