Written 11th January 2024 | Author: Carlton Crabbe, Chief Executive Officer of Capital for Life - a specialist life insurance broker providing key person insurance policies to business owners.
Imagine that a critical employee in your business suddenly becomes incapacitated or passes away, leaving your company reeling from the loss of their skills and expertise. Would your business be able to survive? That's where a keyman insurance policy comes into play.
In this Capital for Life Essential Guide for 2024, we'll discuss everything you need to know about key man insurance to help you make informed decisions and protect your business from unforeseen financial risks.
Capital for Life is a specialist provider of key man life insurance policies. Capital for Life's Key Life solution is a unique approach to key person insurance. Read more about Key Life below and contact us for a free consultation and we'll show you how you can incorporate Key Life into your business.
In this Article:
- What is Key Man Life Insurance?
- Identifying Key Employees in Your Business
- Understanding the Importance of Key Man Insurance
- Calculating the Right Amount of Key Man Coverage
- Types of Key Person Insurance
- The Cost of a Key Man Life Insurance Policy
- Choosing the best Key Man Insurance Provider Cover
- What happens if a Key individual retires?
- Integrating Business Succession Planning
- Integrating Retirement Planning
- Common Misconceptions about Key Man Life Insurance
What is Key Man Insurance?
Definition of a Key Man Insurance Policy - A key man or key woman insurance policy is a life policy taken out on a key employee in a business. The policy is used to protect the company from financial loss should the employee die or become disabled whilst in employment with the company. The policy can provide financial assistance and resources to help continue company operations without the key person.
Identifying Key Employees in Your Business
A key person is an individual whose premature death could potentially put the ongoing success of your business in jeopardy. A business owner and partners are typically key people without whom the business would suffer a significant financial loss.
However, high-performing salespeople, product designers, supply chain specialists, or vital software developers and engineers can also be key people. Their specialised skills, talents, and expertise are essential for the organisation's continued success. They make a significant and noteworthy contribution to a company's profits and earnings.
To identify key people in your business, assess their contribution to the company's bottom line and determine who your business needs to insure with a key person insurance policy.
By recognising the individuals who contribute most significantly to your company's success and buying a key person policy for them, you ensure your business remains protected if that insured person dies.
Understanding the Importance of Key Man Insurance
For business continuity and risk management, key man insurance should play a critical part. It's an insurance policy designed to shield businesses from the financial repercussions that come with the unexpected loss of a key person.
Here are 8 ways that key person insurance typically acts as a safety net for a business.
- Cover Lost Profits: When a key person dies or becomes incapacitated, the company may experience a sharp decline in profits. This insurance can help in compensating for this drop, giving the business a financial buffer during the transition.
- Offsetting Lost Income: A key person often has unique skills, connections, or insights that drive significant revenue. The proceeds from the key man insurance policy can help replace the income lost due to their absence.
- Pay Off Business Debt: The untimely loss of a key figure may put the company's creditworthiness at risk. Using the insurance payout to settle outstanding business debts can help keep the company solvent.
- Purchase Shares of Deceased Partner: In partnerships, the death of one partner might leave the business in trouble. Key man insurance can fund the buyout of the deceased's shares, ensuring a smooth ownership transition.
- Cost of Replacing the Key Person: Finding and recruiting a replacement for a key executive or specialist is neither easy nor cheap. The insurance can cover the costs of headhunting, relocation, and the often-attractive 'golden hello' packages.
- Cover Business Expenses such as Training: Beyond recruitment, there's the cost of training and assimilation. New hires, especially those filling critical roles, might need extensive training, mentorship, or even upskilling.
- Facilitate the Wind-Down Process: In the worst-case scenario, where the business cannot continue without the key person, the insurance can help in winding down business operations, settling debts with creditors, and ensuring employees' contracts are fulfilled and they are treated fairly.
- Maintain Business Operations: The immediate aftermath of losing a critical employee can be chaotic. Having a cash influx can keep day-to-day operations running, pay salaries, and buy time as the company strategies on the way forward or finds a suitable buyer.
To underscore the significance, imagine a tech start-up losing its visionary CEO, a law firm without its star lawyer, or a medical practice missing its leading surgeon. The ripple effects can be monumental. Therefore, having key person insurance is a financial safeguard and is proactive planning, ensuring that businesses can withstand the loss of the insured person. Ultimately, human capital is at the heart of every successful enterprise and protecting the business and any family members left behind is important.
Calculating the Right Amount of Key Man Insurance Coverage
How do you calculate how much coverage is the right amount of key person insurance coverage for each business-critical employee?
Several factors can influence this key man coverage calculation, including the size of your business, the key person's impact on your financial success, their existing salary, contribution to turnover, and potential loss of profits.
Here are ways to approach key person life insurance calculations that you can action in your business.
Salary Multiplier Approach:
- Advantage: It's straightforward and quick.
- Disadvantage: It may not represent the full value of the key person's contribution.
- Calculation: Annual Salary x (8 to 10)
Total Compensation Package:
Consider the key person's salary, bonuses, benefits, and any other form of compensation.
- Calculation: Add up all the compensation components.
Think about the costs associated with hiring a new person for the same role, including recruitment fees, training costs, and other overheads.
- Calculation: Hiring costs + Training costs + Overhead costs.
Recruiting Costs and Competitive Compensation:
Reflect on the market rates for hiring someone with the same skills and experience.
- Calculation: Market salary (or compensation package) + Recruitment agency fees + Advertising fees.
Time to Find a Replacement:
Estimate the potential revenue loss or added costs during the period the position remains vacant.
- Calculation: (Estimated Monthly Revenue Loss or Cost) x (Number of months to hire)
Assess the period needed for the new hire to become fully effective and the potential revenue loss during this adjustment phase.
- Calculation: (Estimated Monthly Revenue Loss or Cost due to lower efficiency) x (Number of months to reach full efficiency)
Key Person's Contribution:
Assess the monetary value of the key producer's revenue that they bring in, relationships they've built, and specialised knowledge they possess.
- Calculation: Estimate of annual revenue directly attributed to the key person + Value of relationships (potentially in terms of business deals or partnerships) + Value of specialised knowledge (this might be harder to quantify but can be gauged by considering how it impacts business processes or innovation).
Once you've collected all these data points, you can then total them up for a comprehensive coverage amount. Remember, this is just a guide. The specific needs of your business, the industry sector you operate in, and other variables might require adjustments. It might also be beneficial to consult with a financial advisor or a life insurance specialist to ensure that you've fully captured all considerations and risks.
Types of Key Person Insurance
When it comes to the key person insurance coverage options, there are two primary types of policies
- Term life insurance
- Permanent life insurance
The choice between a term life policy and a full permanent life insurance policy depends on the specific requirements of the business.
Here is a comparison of both types of key person insurance to give you a clearer understanding.
Term Life Insurance for Key Person
Term life insurance provides coverage for a specified period or 'term' (e.g., 10, 20, or 30 years). If the key person dies within this term, the business will receive a death benefit. The main characteristics of term life insurance are:
Duration: Coverage is for a set period. If the policy is not renewed or if it expires, there is no payout.
Cost: Generally less expensive upfront compared to permanent life insurance policies. Premiums can be level (stay the same throughout the term) or can increase at regular intervals, usually annually.
No Cash Value: Term life policies do not accumulate any cash value. They are straightforward with a death benefit only.
Use: Suitable for businesses looking for coverage for a specific duration, like until a project is completed, a loan is paid off, or the key person is expected to retire.
Permanent Life Insurance for Key Person
Permanent life insurance provides lifelong coverage as long as the premiums are paid. There are different forms of permanent insurance each with its unique features. Here are the main characteristics:
Duration: Provides lifelong coverage.
Cost: Typically more expensive than term life insurance, but the premiums might be level for life.
Cash Value: These policies can accumulate cash value over time. This cash balance can be borrowed against, withdrawn, or even surrendered in certain situations. The presence of a cash component makes these policies more complex than term life insurance.
Flexibility: Some types, like universal life, offer flexibility in premium payments and death benefits.
Use: Suitable for businesses that anticipate a long-term need for key person coverage. The accumulated cash asset can also be a financial resource for the business.
Which to Choose?
The decision on which type of key person insurance to choose should be decided on by the following criteria:
Duration of Need: If the need is short-term (like covering a key person until they retire in a few years), term might be more appropriate. For long-term needs, permanent insurance could be a better fit.
Budget: Term insurance generally has lower premiums because it is only providing cover for a short period of time.
Financial Strategy: Some businesses value the cash reserve of permanent insurance as a part of their financial strategies, especially if they're considering the policy as a potential asset. The cash value savings account of a life insurance policy can be used for business loans or even provide retirement benefits for key employees. The Loan for Life and Pension for Life strategies are both available from Capital for Life.
Flexibility: If the business wants the option to adjust premiums or death benefits, certain types of permanent insurance might be attractive.
In conclusion, it's essential to evaluate the specific needs of your business, budget considerations, and long-term goals when choosing between term and permanent key person insurance.
The Cost of a Key Man Insurance Policy
The cost for key person life coverage depends on various factors. Here is a breakdown of the factors that can affect the cost of a key person insurance policy:
- Age: Younger individuals typically get more affordable rates than older ones, given the associated health risks with age.
- Gender: Statistically, in many regions, women tend to live longer than men, which can result in slightly lower premiums for women in some insurance plans.
- Smoker Status: Non-smokers almost always get lower rates than smokers. Smoking significantly increases health risks and, consequently, the probability of the insurer having to pay out a claim.
- Medical History: Pre-existing conditions or a family history of certain diseases can increase the premium rate.
- Occupation and Industry: Some jobs and industries are riskier than others. For instance, a construction worker might have a higher premium than an office worker because of the daily risks associated with their job.
- Coverage Amount: The more coverage a company wants, the higher the premiums. A policy for $100,000 will cost less than one for $1 million.
- Type of Policy: Some policies have fixed terms (e.g., 10, 20, 30 years), while others may be whole-life policies that accumulate cash value. The nature of the policy can affect its cost.
- Additional Coverage: As you mentioned, if a policy covers other events, like critical illnesses or disability, the premium is typically higher. However, the added expense might be justifiable, given the comprehensive protection.
- Policy Riders: Some insurance policies offer riders or additional provisions that enhance the coverage, like an accelerated death benefit rider. These can also increase the cost.
- Insurance Provider's Rates: Different insurance companies have different risk assessments, administrative costs, and profit margins. It's always a good idea to shop around and get quotes from various providers to ensure you're getting a competitive rate.
Remember that the objective of key person insurance is to protect the company from financial losses due to the sudden absence of a pivotal player. The right amount of coverage and the associated cost should reflect the perceived financial risk associated with that individual person's death or absence.
The next step is to compare key man life insurance quotes from different providers so you can find a policy that offers the necessary protection at a price that fits within your company's budget.
Choosing the Best Key Man Insurance Provider
Selecting the best key person provider involves comparing quotes from established insurance companies and brokers to find the best coverage. A life insurance broker like Capital for Life can connect businesses with financial professionals across the world who can help explore the purchase of key person insurance policies and obtain coverage that best suits your business's needs.
By thoroughly comparing quotes from different insurers and considering the reputation, the structuring, and the advice, you can make an informed decision that ensures the best possible protection for your key employees and your business.
What Happens if a Key Person Leaves or Retires?
If a key person in your business leaves or retires, the business could do one of the following:
- Stop paying the life insurance policy premiums. The life cover could then lapse or in some cases, the policy's monetary value means it will continue to provide benefits.
- Continue paying the policy premiums. In the event of a claim, the business would receive a capital sum from the policy death benefit.
- Change the life insured under the policy. If the business recruits a new key executive the existing policy can be switched to the new employee subject to underwriting.
- Assign the policy to the retiring key person. The retiree would then own the policy and they could receive the benefits. They can use the policy to provide an Income for Life - a retirement and estate planning strategy available from Capital for Life.
It is worth noting that in some countries, the assignment of a key person insurance policy could have tax consequences for your company and your former employee, so we recommend you seek tax advice before changing the key person policy's ownership.
Integrating Key Man Insurance with Business Succession Planning
Integrating the cost of key person insurance with business succession planning is crucial for ensuring that your company can continue operations in the event of a key employee's death. This involves incorporating key person insurance with other risk reduction measures, such as business continuity plans, buy-sell agreements, and succession planning. Assessing and eliminating the financial vulnerabilities in your business from your key people is a critical piece of planning.
By taking a proactive approach to risk mitigation and integrating key person insurance with your corporate structure and business continuity planning, you can significantly enhance your business's resilience in the face of unforeseen challenges. This comprehensive strategy helps safeguard your business's future and protects the livelihoods of your employees, shareholders, and other stakeholders.
Integrating Key Man Insurance with Retirement Planning
Integrating key man insurance with your retirement planning is an often overlooked financial planning opportunity. A permanent whole-of-life policy that has cash value, like a universal life policy, can be used to provide retirement benefits. It involves the business assigning the ownership of the life policy to you so that you can enjoy the benefits after you retire from the business. Capital for Life's Income for Life or Pension for Life strategies can help you.
Common Misconceptions About Key Man Insurance
Misunderstandings about key man insurance can stop business owners from getting a policy. Some of the most common misunderstandings of key person life cover are:
- Keyman insurance is only for business owners or founders. Keyman insurance is not just for business owners and founders. Any individual whose loss would have a significant impact on the company's operations or profitability can be considered a key person. It might be a top salesperson, an IT specialist, a project manager, or anyone else whose skills, knowledge, or leadership are crucial to the company's success.
- Keyman insurance is too expensive. While the premiums for key person insurance can be relatively high, they must be compared to the potential financial loss the business would face if the key person suddenly passed away. The cost of the key person insurance itself is often much less than the financial risk to the business. In addition, some whole-life policies can be surrendered for their cash value in the future if they are no longer needed. A company can often get back all, or most of the premiums it has paid if no claim has been made on the policy.
- Key person insurance is only for large businesses. This is not the case, as keyman insurance can be advantageous for businesses of any size. While it's true that large businesses often have key person insurance, any business that relies heavily on one or a few individuals for its success should consider it. A small business is likely to be even more severely impacted by the loss of a key person's contribution, making a policy potentially valuable.
- Personal life insurance will cover me. While both personal life insurance and key person insurance offer financial compensation if the insured person dies, they serve different purposes. Personal life insurance is designed to protect the individual's family and dependents, while key person insurance will safeguard a business if the insured dies.
- Key Person Insurance only covers death. As well as life cover, it's also possible to get coverage for a key person's disability or serious illness, which could also prevent them from contributing to the business. This is often referred to as key man disability insurance.
In summary, a key man insurance policy is a valuable tool for a business seeking to protect itself against the potential risks associated with the loss of key employees. This essential coverage can help businesses cover employee's compensation expenses, training, lost income and ownership transitions in the event of a key employee's death or disability.
With a solid understanding of key person insurance, its benefits, and the various factors to consider when selecting a policy, you can make informed decisions that safeguard your business's future and ensure its continued success. Don't wait until it's too late; take action now to protect your business from the unforeseen risks associated with the loss of a key employee.
Capital for Life is a specialist provider of key person life insurance policies. Capital for Life's Key Life solution is a unique approach to key person insurance. Contact us for a free consultation and we'll show you how you can incorporate Key Life solutions into your business.
Frequently Asked Questions (FAQs)
What is a Keyman Insurance Policy?
Keyman insurance, often referred to as a key person insurance policy or key employee insurance, is a crucial form of business insurance. It is designed to financially safeguard a business in the event of the death of a key individual within the organization.
The keyman insurance policy provides a cash payout upon the death of a key individual whose skills, knowledge, experience, or leadership are critical to the company's financial success. The cash injection ensures that the business can continue to operate during a potentially challenging period whilst a replacement is found. Key individuals can include the chief executive, a partner, a top salesperson, or a lead engineer, for instance.
How much is Keyman Insurance?
The cost of keyman insurance can vary greatly depending on several factors, including the insured individual's age, health, occupation, and the amount of coverage required. Typically, premiums can be thousands of dollars per year. It's important to get quotes from multiple insurance providers and understand the features and benefits of each type of policy available. Term insurance will be cheaper than a permanent life policy but the benefits will differ. It's about finding the right coverage for your business needs.
Is Keyman Insurance Tax Deductible?
Keyman Insurance premiums may be tax-deductible under certain circumstances. If the policy is deemed to be a business expense and the company does not stand to receive any benefit from it, then the premiums could potentially be deductible. However, the tax consequences can be complex, and depend on specific factors, such as tax law in the country your business is based and the purpose of the policy. Therefore, it's recommended to consult with a tax professional or a life insurance broker to understand whether keyman insurance premiums are tax-deductible in your specific situation.
How does Keyman Insurance work?
A keyman policy works by providing life insurance coverage to a business' important key executives or people. When the insured key leader passes away, the business receives a cash amount - the death benefit - as compensation for the financial losses incurred as a result of their death. The key person insurance cost is paid for by the company. The company typically owns the policy of the life-insured employee and receives all the lifetime and death benefits.
What is Relevant Life Insurance?
Relevant life insurance is a type of life policy that provides a lump-sum payment to the family of an employee in the unfortunate event of their death or diagnosis with a terminal illness that offers a life expectancy of less than a year.
Relevant life insurance policies are particularly beneficial for smaller businesses that may not be able to afford the premiums on larger group life schemes or for businesses looking to supplement an existing group policy.
The difference between key person insurance and relevant life insurance
- Key person life insurance safeguards the business itself, covering the potential financial loss that a business might face if a critical employee dies.
- Relevant life insurance provides benefits to the employee's family in case of their untimely death.
Relevant life insurance and key person insurance serve different purposes but are both crucial components of a comprehensive business insurance strategy. The former protects the employee's family, while the latter protects the financial stability of the business.
Secure your business future with Capital for Life—Your go-to life insurance broker for Key Man Insurance. Protecting business owners and high-net-worth individuals in over 220 countries, we partner with financial advisors, tax advisers, lawyers, wealth managers, trust companies, and private banks. Enhance your business continuity and financial planning with our specialised guidance on Key Man Insurance. Reach out to us today.
This article is authored by Carlton Crabbe, Chief Executive Officer of Capital for Life, a specialist indexed universal life insurance broker. The information provided in this article is for educational and informational purposes only and should not be construed as financial or investment advice. While the author possesses expertise in the subject matter, readers are advised to consult with a qualified financial advisor before making any investment decisions or purchasing any life insurance products.