Key Man Insurance
What Is Key Man Insurance?
Key man insurance, a.k.a. key person insurance or key employee insurance is coverage that will protect a company in the case of an untimely death or disability of a top salesperson, executive or business owner. Key man insurance provides peace of mind to business owners and shareholders alike knowing that the business can continue operations without major disruption in the event of the loss of a key employee. If death or disability strikes your company, key person insurance may be the difference between the company’s demise and its ultimate success. See Bruce Cohen’s article What will happen to your business when you pass away?
Many people and especially insurance agents themselves make the mistake of thinking key man insurance is simply life insurance. Yes, life insurance is one of the necessary elements of a good key man insurance plan, but in most cases key man disability insurance is equally important. While the risk of death is always present, with most ages the risk of disability is much higher. Therefore, to achieve adequate protection, most companies should secure both key man life and key man disability on their key employees and executives.
Is your business adequately protected?
In many cases, and especially in small to medium size businesses, success depends upon a few top individuals that posses niche talents, skills and experience. These key employees are critical to the long term performance of the company. Losing one of these essential people due to a death or disability can have a damaging effect on any business.
The solution to protecting your business is key person insurance. Key person insurance provides the financial means to stabilize a company during the adjustment period after the loss of a key employee or executive. When a death or disability occurs, the business may lose critical management skills and may experience periods of falling sales and productivity. Additionally, significant costs will be incurred identifying and training the person or persons that have the ability take the place of the key employee. If your business would be dramatically impacted by the loss of one or more of your top people, key man insurance can effectively protect against this risk and you should consider purchasing key man insurance policies to protect your company.
How does Key Man Insurance work?
Businesses and business owners regularly use life insurance and disability insurance to protect themselves from the risks associated with the death or disability. Using life and disability insurance, a business can buy policies on the key employees to cover the amount of funds needed to adequately replace them in the event of a death or disability. In most cases, the cost associated with securing key man insurance policies is very small relative to the potential benefit if a key worker dies or is disabled.
With both key man life and disability insurance, the business secures the policy on the life of the key person. It will own the policy, pay the premiums and be the beneficiary in the event the key employee dies or is disabled. The premium payments made by the company are not tax deductible but in most cases, the proceeds received are income tax free.
Key person insurance policies are designed to protect the business not the key employee. If a key employee dies or is disabled, the policy proceeds can be used by the company for any purpose. Normally, businesses will use the funds received from a key man policy to cover expenses associated with finding capable replacements or to cover short term revenue deficits.
How much Key Man Insurance is needed?
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.
Contribution to earnings method. The contribution 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 to 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.
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.
Once you decide on the amount of life insurance you need simply enter the appropriate information in our online quote engine. The results are instantaneous. If you are happy with the price then give us a call and we’ll walk you through the underwriting process.
Still have questions? Need more help? Feel free to call.