Key man life insurance differs from other life insurance policies in that the business is both the owner and the beneficiary of the policy. The key person essentially has no active participation in the policy. However, the business is legally required to notify the insured employee of its intent to purchase the coverage, provide them with details of the policy, and obtain their consent.
Key Person Life Insurance
Embroker helps you get key leader insurance, a life insurance policy on an executive, founder, or other critical employees whose death or disability would adversely affect the company’s finances and stability.
In an increasingly flexible, technology-driven economy, key person insurance is more broadly applicable than ever. It’s especially important for companies built around complex technological processes, proprietary apps, or specialized technical knowledge. Such competencies may represent a company’s entire competitive advantage — and often reside in the mind of one key person, or with a handful of key people.
Key Leader Life is a contractual requirement of outside shareholders to protect their investment. Private Equity, Venture Capital and Banks all require life insurance on key leadership before entering into a contractual agreement.
We wrote this guide to help you, the reader, understand both the basics of key man insurance as well as some more advanced considerations. Our hope is that you walk away from this article a more empowered buyer, with a better understanding of the risk you can transfer to other parties via the key man insurance product.
If you’d like help, we’d invite you to talk with a broker. Our highly experienced insurance experts will work with you to gain a deep understanding of your unique needs before negotiating a customized policy on your behalf.
What is Key Man Insurance?
Key man insurance is purchased by a business to insure the life of one of the company’s most vital employees. It’s intended to help the company recover from the loss of a key contributor whose death or disability would reduce the company’s value or operational capabilities. Employees that are typically covered include high-level executives and other decision-makers, employees who are highly visible, top salespeople, and employees with unique knowledge or skill sets.
As with any life insurance policy, key man policies have three primary roles:
This is the person or company that purchases the key person insurance policy and typically pays the premium. The owner has the right to transfer, sell, or change the terms of the policy.
This is the person upon whose death or disability the policy would pay the benefit. Therefore, premiums are directly tied to the health and lifestyle of the insured.
This is the person or entity that would receive the benefits should the insured pass away during or be incapacitated during the period of coverage.
Why Do Businesses Need Key Person Insurance?
The repercussions of losing an important business contributor can be devastating. University of Central Arkansas researchers cite the loss of a key person among the top causes of small business bankruptcies.
Key man insurance will ensure that your company is financially protected from the fallout of a key person’s death, so you can recover and move forward. Your company will be better able to cover hiring or training a replacement. You can also make up for loss of profits or any debt that you may incur while the company is recovering.
Key man insurance is necessary even if your business plans to shut its doors after the loss of a key person; the money can be used to cover the closing costs, pay off investors, and provide severance packages for employees.
Key Person Life vs. Disability Insurance
There are two basic types of key person insurance: life insurance and disability insurance.
Key person life insurance is applied either as a term policy or a permanent policy. A term policy applies for a specific period of time, which may vary from as short as one year to as long as 20 years. Coverage ends when the term expires or the insured person dies, whichever event occurs first. Term policies are considerably cheaper than permanent policies.
Sometimes, a key person doesn’t actually pass away, but does become incapacitated and unable to perform his or her duties. In this case, key person disability insurance will compensate a company for the costs associated with the partial or total absence of the key individual. This coverage applies regardless of whether the person is temporarily or permanently unable to contribute.
What Does Key Person Insurance Cover?
A key man insurance policy can provide financial coverage for a period of time after a key person dies unexpectedly. The policy can be used either to provide a temporary substitute for your company or to hire and train a permanent replacement. It can also be used to make up for any loss of profits or debts resulting from a key person’s death.
Additionally, a key person insurance policy can be used as a guarantee for business loans. The policy can be put toward shareholdings or partnership interests.
What Doesn’t Key Person Insurance Cover?
It’s important to understand the exclusions in your key man policy. The most common key man insurance exclusions are fraud, misrepresentation, and suicide. A claim can be denied in case of a proven instance of intentional dishonesty.
During the first two years of every life insurance policy, there is a contractual clause known as the contestability period. If a claim is made during those two years, the insurance company will conduct an investigation to determine if there were fraudulent statements or deliberate omissions made during the application process. Also, key man insurance will not cover suicide during the two-year contestability period.
Tax Considerations for Key Person Insurance
Any company purchasing key person insurance for its employees may claim a deduction for premium payments as they are classified as business expenses.
The benefits also extend to the payouts. However, this is contingent on the employee being notified and consenting in writing that the employer intends to take a life insurance policy out on them and that the business will be the beneficiary. Also, the employee must consent to the employer having the option of keeping the policy in force even after they cease being employees.
If these conditions are not met prior to issuing the key man policy, the insurance payout will not be tax exempt.
What Happens if the Key Person Leaves the Company?
In the event that a key person leaves a company during the coverage term, the business can cancel the policy with no downside risk.
Ownership of the policy can be transferred to a Key Employee after the insurance is no longer needed for business protection. The employee simply assumes the premium for the remainder of policy term and change the beneficiary for their personal needs.
Hypothetical Examples of Key Person Insurance at Work
“Key Leader Life is critical to outside shareholders to protect their investment. Private Equity, Venture Capital and Banks all require life insurance on key leadership before entering into a contractual agreement.”
Example 1 : Protecting for loss of revenue
Peter owns a successful and rapidly growing small business. His top salesperson is James and he relies on him for the intellectual capital behind their proprietary technology company. Peter understood that James was a key person in his business so he took out life and trauma insurance on him. When James tragically died in a car crash, the business was deprived of his vital expertise and its ability to continue operating was in jeopardy. Luckily, Peter was able to use the payout from the key person policy to weather the loss and hire and train a new person to replace James, enabling him to continue operating the business.
Example 2: Protecting business debts
Colin’s business needs to buy expensive equipment in order to expand its operations. He takes out a business loan to purchase suitable equipment, backing the loan with a personal guarantee, a mortgage over the equipment and his home. Colin takes out key person insurance on himself, realizing that if he were to get seriously ill or passed away, the company would have no means of repaying the loan. Two years after taking out the insurance, he suffers a serious illness that prevents him from working. The insurance pays out the loan, leaving the business and Colin debt free.
Key Person Life Insurance Costs
The cost of key man life insurance primarily depends on the following factors:
Type of policy and amount of coverage
Limited term life insurance policies are less expensive than permanent insurance as they offer coverage for a fixed period of time and don’t accumulate a cash value.
Policy death/disability benefit:
The greater the amount of coverage that’s in place the higher premiums will be.
Key Person’s Age, Gender, and Health:
In general, the older the key person is and the more pre-existing health conditions they have the higher the premium will be.
Company Structure and Size:
Premiums are higher for more valuable companies and also rise with the value of the key man’s contributions.
Premiums will be higher for riskier industries because of the increased risk of premature death or disability.
It’s important to understand that the cost of insuring an older or less healthy employee can be very high and in certain cases impossible.
Additionally, the cost of key man insurance usually becomes more manageable, but also more important, as companies move beyond the development phase and start to scale. Pressure to purchase key leader policies often comes from investors who want to know that their investments are protected before coming on board.
Now that you have a better understanding of key person insurance, you may be wondering how all of this affects your business and where to go from here. If you need more help or information, you can reach out to our team of expert brokers. Or, if you prefer to get started on intelligent quotes, create your Embroker account today.
Having a quality key person insurance policy in place and a broker who can help you navigate the terms and conditions, as well as the claims process, can save you money and, more importantly, time. Because of our 50-company inventory and ability to accurately quote people who have health issues, the Embroker purchase experience should result in maximum savings along with the comfort that comes with knowing that you are being serviced by professionals with deep knowledge and experience.
Embroker is the easiest way to intelligently insure any business. We’re here to help!