Key Person Insurance
Do You Need It?
Business owners have long recognized the importance of protecting their company’s assets, both physical and monetary. They also know that replacing a key person,
one who plays an integral role in the success of the business, can take an exorbitant amount of time and money that could inevitably cost a business valuable clients.
There is, however, a way to protect a business in transition.
“Key person insurance is a life and/or disability insurance policy that a business may purchase to protect itself from the loss of an essential employee,” said Ryan Rodrigue, senior group sales director with Hollis Companies. “These policies are most often used for business succession or business protection purposes and are usually owned by the business and compensate the business for damages incurred by the loss of the key person.
“This could be a partner, owner, majority stockholder or any individual that is crucial to the business,” he added. “If an organization employs individuals who are integral to its success, key person life insurance can safeguard them from the turmoil caused by their unforeseen absence. These insurance solutions provide options other than bankruptcy should you lose your key person without warning.”
Key employees are those critical to the profitability of the business. These individuals may have a direct impact on company earnings or have skills, talents and expertise that contribute to the continued growth of the organization.
Key person insurance, often term life insurance, is designed to protect the business if that employee dies unexpectedly. To secure key person insurance, the business must apply for a life insurance policy on that person. Once secured, the business is the premium payer, policy owner and beneficiary. In the event that the key employee dies, the proceeds of the policy are paid to the business, usually tax-free. The business can use the proceeds at its own discretion, but the primary use of these funds is to hire a capable replacement.
In order to obtain key person disability or life coverage, the individual must be a consenting employee, and the business must demonstrate that it would incur substantial financial loss without the employee. To qualify as a key person, most insurers require that the employee’s salary be in the top 20 percent of the company, and all policies of this type are written specifically for the employee in question.
“If an organization employs individuals who are integral to its success, key person life insurance can safeguard them from the turmoil caused by their unforeseen absence.” – Ryan Rodrigue, senior group sales
director with Hollis Companies
“Key person insurance can be a very inexpensive way to protect a business and is almost always a smart investment when a business’s financial well-being depends on a select few people,” said Jack Duvernay, vice president of Eagan Insurance Agency. “Most small businesses’ success depends heavily on a small number of key employees.
“Key person insurance has been a common business planning tool since the inception of the life insurance industry,” he added. “While this type of insurance can be an asset to any company that understands the importance of financial planning, generally speaking the types of companies that typically purchase it are the law firms, CPAs, insurance agencies and banks. But really, the businesses that are at the most risk if they do not have key person insurance in place are the smaller businesses that stand to lose everything if a key player leaves.”
But What If the Employee Decides to Leave?
Coverage in the case of an employee death is only one kind of key person insurance.
“If a company has a really talented chief operating officer who runs things, chances are other companies are looking at him too, so it is a good idea for the company to set up key person insurance to cover this individual in the event they get another offer and leave,” said Catherine Hales, producer for Gillis, Ellis and Baker. “Sometimes companies take out this type of insurance to incentivize key employees. They can take out a term policy, commonly referred to as ‘golden handcuffs,’ which provides the employee with a payout at the end of the agreed-upon term if he/she stays with the company the duration of the policy. The company is the beneficiary of the policy and pays the premiums, but the employee will benefit monetarily if they stay for the agreed amount of time.
“Probably not enough businesses in the New Orleans market have this type of insurance,” she said. “Currently I have about three companies to talk to on my to-do list. Really, this is one of those things that when a company thinks about it, they know they need it; they just don’t take the time to follow through.”
“The businesses that are at the most risk if they do not have key person insurance in place are the smaller businesses that stand to lose everything if a key player leaves.” – Jack Duvernay, vice president of Eagan Insurance Agency
There are two basic types of life insurance used for key person life policies: term life insurance and universal life or whole life insurance. The type of policy selected mostly depends on the specific needs of a business. For example, a startup business that does not have a steady cash flow would benefit from term life insurance because of its relatively low cost and high flexibility. Conversely, a more established company with significant earnings may opt for a universal life or whole life insurance since these policies have the ability to build cash value over time, which is an asset on the company’s balance sheet and can be accessed anytime at the discretion of the company.
“Purchasing key person insurance can be done affordably. Premium prices will vary based upon the employee’s age, overall health and how much the company wants to insure him for,” said Duvernay. “A company has to determine the length of time that this employee will be important to their operations: 15, 20 or 30 years.
“For example, it is very reasonable to purchase insurance for a healthy 40-year-old man, which is a common key person age,” he added. “If a company wants to cover a 40-year-old man for 20 years, and they decide that the cost to replace this person, or the lost revenue from losing him, is $500,000, the premium cost would be approximately $500 a year. Also, if a company takes out a $1 million cash value policy on a 53-year-old male who stays at the company for 20 years, then their premium would be $50,000 annually and the cash value would be the value of the policy.”
“This is one of those things that whena company thinks about it, they know they need it; they just don’t take the time to follow through.” – Catherine Hales, producer for Gillis, Ellis and Baker Inc.
According to Rodrigue, if a company purchases key person insurance on an employee and the employee subsequently leaves, typically the policy is transferred to the departing key employee as a retirement benefit or to a different key employee upon retirement of the original key employee. It can also be used to buy out the key employee’s shares or interest in the company.
“Another benefit of this type of insurance is that it does have a cash value and may be made available to a business for a withdrawal or loan if needed,” he added. “When most business leaders think of purchasing key person coverage, they turn to life insurance. However, industry leaders point out that the chance of losing a key person to disability is 17 times greater than losing a key person to death, and the costs of hiring a recruiter to replace the key person and training him or her for a short period of time could be much higher than finding a permanent replacement. Key person insurance policies provide business owners with options other than bankruptcy should they lose an important employee without warning.”
Things to Consider
Company executives should ask a few questions before they begin to shop around for a policy that suits their distinct requirements. The following questions can be helpful in helping a business determine the type of insurance they need, how big of a policy they should take out and the number of years the policy should be maintained.
• Why do you think you need key employee life insurance?
• What contingencies are already in place for the company if a key employee dies?
• Would the business continue operations after the loss of a key employee or would it be forced to liquidate or be sold?
• Can a capable, comparable replacement employee be easily secured?
• How much will it cost to locate and train a replacement?
• What type of compensation will it take to hire the new employee?
• What percentage of the company’s revenue is directly attributable to the key person?
• Would the key person’s death result in the loss of income, as well as clients?
• Is the company willing to self-insure?