Everyone likes to think of themselves as critical to the success of a business. But let’s face it: some workers are just a little more essential. In the insurance world, there’s a name for someone whose contributions are so vital to a company that their death or incapacitation would cause severe losses. It’s called a “key person.” And—you guessed it—there’s insurance for that. Key person insurance allows a business to take out a life insurance policy on high-value individuals and receive a death benefit if they pass away. In a small business, these types of policies are typically purchased for owners, founders, or other mission-critical roles. Key person insurance is the rare policy where businesses pay the premiums and receive the benefits–although the company can decide to share their settlement with the deceased’s family or even use the policy as a hiring incentive.
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Because of the obvious financial benefit for businesses to take out a key person insurance policy, insurance company underwriters require a thorough justification to insure a key person, including proof of a company’s “insurable interest” in this super-special human. To determine a company’s risk exposure in the event the key person can no longer work, underwriters use a variety of factors that companies must provide thorough documentation for to avoid any perception of malfeasance. While no amount of money can bring back an important contributor, key person insurance can provide much-needed funds to keep a business operating until a replacement is found. As such, it’s a smart policy to include in your arsenal of business insurance coverage, along with a business owners policy (BOP), professional liability insurance, Director’s and Officer’s (D&O), and Errors & Omissions (E&O).
What is Key Person Insurance?
Key person insurance, also referred to as corporate owned life insurance (COLI) or by the archaic term “key man” insurance, is an extension of life or disability insurance. The premise is the same as two-income spouses who have life insurance policies on each other. In the event one dies, the surviving spouse has financial support. With key person insurance, the policy owner is the company or individual who purchases the policy and pays the premiums. The insured is the “key person” whose death or disability directly and immediately impacts a company’s ability to function. The beneficiary of the policy is the policy owner or company who receives death benefits if the key person dies or becomes incapacitated during the coverage term. Disability insurance can be added onto the policy.
Here are the basic eligibility criteria for key person insurance:
- It must be a term policy. These types of policies apply only to a specific period of time.
- “Key person” doesn’t mean “only person.” The key person being insured can’t own more than 51% of the company or have more than 70% shares in the company. If you’re a sole proprietor or one-person LLC, you wouldn’t need key person insurance, because in those situations your company would cross the rainbow bridge when you do.
- The key person must really be key. You’ll need to submit lots of proof that your company would be financially devastated if your key person dies.
- Proof of insurable interest. You’ll need to show evidence that you have a financial dependency on the key person and would suffer substantial loss if they died.
- Written consent. The key person must be aware that you’re insuring them.
Why Do Companies Need Key Person Insurance?
From a financial standpoint key person insurance can keep the lights on–and much more if necessary. It can help pay for finding a replacement, keep revenue coming in, and allow you to continue to pay your debts. But key person insurance also allows you to steady the company in a time of stress, which can help your company maintain its value to stakeholders. It could take a lot of time and money to replace your key person. Appearing stable will send the message that the company can still manage without them.
If you are in the process of seeking funding from venture capitalist or other investors, key person insurance might be required. To a large extent, funders are betting on the people leading the company—not the product itself. A lot is riding on the abilities of the founders to work together harmoniously. If their specific chemistry is critical to the success of the company, the loss of one of the team members could impact the company’s bottom line.
Here are few criteria to consider for key person insurance:
- Does a significant portion of your revenue and income depend on the unique skillset of one particular individual?
- Do you have company debts that you wouldn’t be able to pay off without a key individual?
- Is your company’s reputation tied to one key person’s name and reputation?
- Is your company seeking a loan or investment?
What are the Tax Implications of Key Person Insurance?
With its cross-over between business and a person’s personal life (quite literally, their life), key person insurance has presented difficulties for the IRS. As the tax code was originally written, it had the potential for abuse, which some large corporations took advantage of. But over a series of revamps to the IRS tax code in the late 1990s and 2000s, government regulations for these types of policies strengthened.
Although the IRS has gotten stricter with key person insurance, there are still some financial benefits of key person policies to companies. Companies can deduct the costs of premiums as a business expense and the benefits count as income even though you don’t have to pay income tax on them. Also, key person policies are worth something. They are part of a company’s overall valuation and can be legally used as collateral.
What Does Key Person Insurance Cost?
As with any insurance coverage, lots of factors impact the final cost. Underwriters look at the health of the key person, including their age and gender, but also consider the size and structure of the company and the type of industry it’s operating in. When it comes down to it, calculating the value of the key person is a challenge. Underwriters try to nail down the exact dollar amount the loss of the key person would cost a business. There are a few different methods of identifying this amount. Here are the top three valuation methods:
- Earnings multiple. With this widely used method, underwriters use the key person’s salary as the starting point for determining their value to the company and the deficit the company would suffer if the key person were no longer living. The calculation is typically a multiple of five to seven times the employee’s current total compensation, including benefits. For example, if the key person makes $200,000 per year, the insurance policy would pay $1 million.
- Replacement cost. With the replacement cost valuation method, companies factor in the expenses required to recruit, hire, and train the key person’s replacement along with their salary.
- Contributions to earnings. This method attempts to determine the key person’s contribution to a company’s bottom line. If the key person brings in a lot of revenue, the company will pinpoint the amount they’re individually responsible for and add the amount that they’d have to pay to train someone to replace them.
Who Should Get Key Person Insurance?
U.S. businesses are in a unique era that celebrates the out-of-the-box-thinking genius company founder with the power to make a company’s stock go up based on their mere existence (or Tweet, ahem, Elon Musk). If you’re pitching your small business or startup to investors, you might be emphasizing your founders’ brilliance as much as your product idea. And if your team is really that good, they bring a lot of value to a company—value that would be lost should they meet an untimely demise. Key person insurance is a smart business expense with some potential business benefits that could help you stay afloat while you replace the irreplaceable.