Key man life insurance is a standard life insurance or disability policy taken out by the business to compensate for losses incurred with the death or disability of a key income generator. This type of policy is also called key person insurance, key executive insurance, key employee insurance, company-owned life insurance or corporate-owned life insurance.
Key man life insurance covers persons critical to a business operation such as the owner, founders, executives and other decision-makers who are critical to the success of the business. The business owns the life insurance policy, pays the premium, and receives the death benefit if the key person dies.
Key person policy can be used for business protection purposes. It can also be used as an employee benefit since the policy can be transferred to the insured employee by the company.
There are three parties in the key man life insurance:
Owner: This is the business that purchases the life insurance policy and pays the premiums. The owner has the right to transfer and change the terms of the policy, surrender the policy for its cash value and receive participating dividends.
Insured: This is the key person whose death causes the insurer to pay the death benefit to the beneficiary. The life insurance premiums are based on the insured’s age, health, and lifestyles at the time of application.
Beneficiary: This is the business that would receive the death benefit payout if the key man passes away during the period of coverage.
The key man has no rights or active participation in the policy, but the business is required to notify the key man of its intent to purchase coverage on him. The business needs to provide the details of the policy, and obtain the written permission of the key man before buying life insurance. The insurance company will give the Employer-Owned Life Insurance Acknowledgement Form.
WHAT IS THE DIFFERENCE BETWEEN LIFE INSURANCE AND KEY MAN LIFE INSURANCE?
Key man life insurance and personal life insurance function on the same line as its objective is to give protection.
Both policies are paid by the policy owner on a periodic basis either monthly, quarterly, semi-annually or annually. Both life insurance policies provide payout when the insured dies. The difference between key man life insurance and personal policy is the owner and the beneficiary of the policy.
Personal Life Insurance
A personal life insurance policy covers the policyholder and provides a death benefit to the beneficiary who is typically the spouse or children. The policyholder and the insured is one and the same person.
The death benefit can be small enough to cover the end of life expenses, or if the amount is substantial, it can cover lost income and maintain the standard of living of the beneficiaries.
Personal life insurance policies can be used to provide protection or as an investment tool. Its function is to protect the security of the beneficiary who is a family member.
Key man Life Insurance
The key person is the insured in key man life insurance. The business is the policy owner that pays the premium on the policy.
The main difference between the key man life insurance and personal life insurance is the owner, and the beneficiary of the policy is the business. If the key person dies, the death benefit payout goes to the business instead of the key person’s family.
The key man insurance policy is designed to provide funds to the business to protect it from financial losses that may be sustained due to the death of the key person. The death benefit payout facilitates business continuity.
IDENTIFYING YOUR KEY MAN
Key man or key persons are individuals whose skills, experience, knowledge, or leadership are essential to the continuity or survival of the business.
A key man could be one or a number of people such as:
- Managing Director
- Marketing Manager
- Scientist or IT Specialist
- Sales Director
If your company relies on key people, your operation would be negatively impacted by the loss of that individual. Their death or disability will have the following financial consequences:
- Lower income while the business adjusts
- There will be an interruption to the day-to-day business activities
- There will be a loss of clients from failed contracts
- It will be difficult to replace the key person
- Clients and suppliers will lose some confidence in your business
- Difficulty in raising capital or attract new investment.
THE IMPORTANCE OF KEY MAN LIFE INSURANCE
Key man life insurance is vital to the business of any size particularly if the financial success of the business depends on the owner or key persons.
Small or medium-sized businesses need it more since they are more dependent on the key people for its success. Small or medium-sized businesses need key man life insurance because they have fewer resources to cover the loss of a key person, unlike a large company.
Key man insurance is needed if the death or disability of the key person will cause significant financial strain on the business. This strain can be the loss of clients and the cost of recruiting a replacement. If the business has any outstanding loans, the bank or credit agencies will also require key man coverage as protection.
Properly structured insurance will enhance equity and provide financial protection for your business.
The purpose of key man insurance is to help the business upon the loss of the person that makes the business work. The company can use the insurance payout for expenses until they find a replacement. In some instances, it can be used to distribute money to investors, pay off debts, pay employee wages and close the business down in an orderly way.
WHEN TO PURCHASE KEY MAN COVERAGE
You should consider purchasing key man coverage when the following apply to your business:
- If your company needs to obtain a loan or investment. Many banks require key man life insurance as part of their lending criteria.
- If your business is trying to raise money. Investors want assurance that the loss of your key man wouldn’t cause the business to go bankrupt.
- Your business cannot continue when you lose your key man (or key woman). A key man life insurance is important if the loss of your key man would adversely affect the profits of the company.
- You are in a professional services business such as a law firm or accounting firm, and your key man cannot be replaced because of legal restraints.
- Your key man is between the ages of 30 and 55. If your business has a young key person consider this coverage because young people are more likely to be disabled than die.
DETERMINING THE AMOUNT OF KEY MAN LIFE INSURANCE COVERAGE YOU NEED
There are various ways to determine the amount of key man life insurance coverage your business needs.
(1) Determine the Key Man’s compensation
Many key man policies are assessed by getting the five-to-ten-time multiple of key man’s compensation including salary, bonus, and other perks. This approximation assumes the employee’s value to the company is reflected with the amount of his compensation.
The key person’s compensation is multiplied by the number of years the business expects it might take to replace them or recover from their death. For example, the key person earns $100,000 per year times 5 years, then you should consider getting a minimum of $500,000 key man policy.
(2) Determine the cost of replacement
How much would it cost for the business to replace the key person? The biggest factor would be the time and money to find a replacement and train that individual. The company would be losing income while if finds replacement so, the loss of revenue should also be considered.
Calculate the sum of the costs to find, hire and train the new employee to replace the key person. The approximate amount should also include the estimate of revenue lost during the recruitment period, and after the replacement is in place.
(3) Determine the key man’s contributions to business
The contribution of key man may be seen in the areas of intellectual property, valuable customers and profits. Calculate the key man’s contribution to the business by approximating the percentage of company profits the key person contributed multiplied by the number of years it might take to replace him.
For example, the company’s net profits are $1,000,000 a year, and the key man contributes 10% to the company’s net profit, then the key man contributes $100,000 a year times 5 years to find someone to replace him [($1,000,000X 10%) X 5 years] therefore, you will need $500,000 key man life insurance policy using the net profit percentage.
The amount of coverage your business will need will depend on your type of business and the key person you’re insuring. The amount you should purchase must be sufficient that the impact of losing the key man is near-zero.
DIFFERENT TYPES OF POLICY THAT CAN BE USED AS KEY MAN LIFE INSURANCE
Any type of life insurance policy can be used as key man life insurance, includes the primary categories of life insurance term life or whole life.
Term life insurance – this is the most common type of life insurance used by small businesses because it’s more affordable than whole life policy.
Term life insurance provides coverage for a fixed amount of time, such as 10, 20 or 30 years, although 1 and 5-year terms are also available. If the business buys a 10-year term life insurance policy, it will pay premiums for 10 years and will receive the insurance payout if the key man dies during the 10-year period.
Tip for choosing your length of term: The term must be tied to a specific date such as the key man’s expected retirement or projected timeline like how long it might take to double the marketing team.
Term life is substantially less expensive than a whole life policy. The lower cost will let you more coverage. For example, a $250 annual insurance budget will let you purchase a $100,000 20-year term life insurance policy, but you will need $1,000 per year to buy a $100,000 whole life policy.
Permanent Life Insurance – there are two types of permanent life insurance: Whole life and Universal life insurance
Whole life insurance is designed to last a lifetime. Premium rates are locked in for the life of the policy and coverage is guaranteed never to decrease as long as premiums are paid on time.
Whole life insurance builds cash value which can be accessed via tax-free policy loans. It can add liquidity to your business when you need it. Cash value can also be used as incentives to your key man to stay with your company.
Whole life policy can be classified as participating or nonparticipating.
Participating whole life policy entitles the policyholder to participate in the policy dividends after all the claims and expenses of the insurance company have been paid for the given policy year. Policy dividend or surplus is the return of excess policy premiums, and they are not guaranteed. The nonparticipating whole life policy does not pay policy dividends.
If your company is considering buying whole life insurance, purchasing a participating policy from a top-rated insurance company can be your best option.
Universal Life includes Guaranteed, Equity Indexed and Variable
Universal life insurance is the combination of the advantages of low-cost term insurance with a tax-deferred cash value of whole life insurance. This policy allows flexible premiums and face amount which makes universal life adaptable to changing business circumstances.
Guaranteed Universal Life – It provides guaranteed coverage for a set period of time. It has guaranteed death benefit, and it builds cash value. GUL policy is a great option when term insurance cannot be purchased because of the age of the key man or when coverage needs to be extended over his lifetime.
Equity Indexed Universal Life Insurance – combines the benefit of cash value with the ability to earn stock market returns. It has the potential to accumulate more cash value based on the performance of indices, such as the S&P 500, NASDAQ or the Dow Jones Industrial Average. EIUL can be beneficial because the cash value can be used as an incentive to keep you key man to the company.
Variable Life Insurance – this is a variation of flexible premium policy that allows for direct investment into the market via sub-accounts that is similar to mutual funds. VUL policy values can fluctuate based on the ups and downs of the stock market. Since it is an investment that is directly tied to the market the risk is higher than the other types of universal life insurance.
THE COST OF KEY MAN LIFE INSURANCE
The cost of key man life insurance is an affordable business investment, with premiums about $100 annually to a few thousand dollars per year. The cost of premium depends on the number of key people insured and their health.
The cost of key man coverage primarily depends upon:
Types of policy – term life insurance are cheaper than permanent life insurance policies. There are different types of permanent life insurance policy, each with different cost, risks, and benefits.
Face amount – the greater the face amount of the coverage the higher the premiums will be.
Key man’s age, health, and lifestyle – the key man’s age, gender, medical history, family history, driving history, hobbies and general health determine the amount of premiums to be paid. The older the key man and the more pre-existing health conditions he has, the higher the premium.
Company structure and size – The bigger the company and the higher the value of the business plus the higher the key man’s contribution to the business, the higher the premium will be.
As a business owner or a board member, it is your responsibility to the company to make sure that your business risk is minimized and key man life insurance may help you accomplish that.
If you’re looking to get the lowest rates on key man life insurance for your business, we can help you. Life Wealth Win specializes in finding the best life insurance rates for your key persons. We work with the top-rated life insurance companies, and we can find the perfect fit for your budget and needs.
Call us at (888) 435-4342 if you want to get the lowest premiums for your key man life insurance policy.