Protecting your business from the loss of a key contributor
Key person insurance can help you maintain business continuity.
Your business, like many others, may rely on someone for the majority of its earnings. This someone is often referred to as a “key person” because their knowledge, skillset or contribution is critical to the company’s success.
It’s important to protect your company against the sudden loss of this individual. Key person insurance can help you maintain continuity and cover any losses that may occur from a decreased ability to conduct business while you identify and train a successor. It can also serve the secondary purpose of benefitting the insured in retirement.
Types of key person insurance
Key person insurance isn’t a type of insurance policy in and of itself, but it’s the name given to life insurance that pays upon the death of a specified individual within the company to help a business survive financially.
The company usually chooses between two types of policies.
- Term life insurance: a policy purchased for a specified period – five, 10 or 20 years – that only pays a benefit if the insured dies during the term of the policy.
- Permanent life insurance: a policy in which the face value of the policy is paid upon the death of the insured. It also accrues a cash value that may be paid out at the end of the policy.
Determining who is a key person
A key person can be a founder, owner, partner or any employee whose death may result in catastrophic financial losses to the business. A business identifies a key person using several factors such as:
- Special knowledge of the operations and products
- Vital for meeting sales goals
- Loss would give competitors an advantage
- Builds customer relationships
- Has contacts to get results in an emergency situation
How key person insurance works
With key person insurance, the business is owner and beneficiary of the life insurance policy, both paying the premium and receiving the death benefit. The proceeds from key person insurance can be used in several ways:
- Keep the business running
- Assure customers that business will continue as usual
- Assure creditors that bills will be paid
- Cover the expenses associated with hiring and training a replacement
The business can also access the potential cash value of the policy to use as a retirement benefit for the key person.
Determining the right amount of coverage
Key person coverage typically ranges from five to 10 times the individual’s annual pay. Also consider a person’s replacement costs, their value to the business and the extent of company losses you’re willing to insure.
You can also use this formula:
- 1. Estimate the key person’s average income over their lifespan (deduct federal and state taxes)
- 2. Determine years until retirement
- 3. Select a discounted rate of interest for future earnings
- 4. Multiply the result of #1 by the present value of $1 per year for duration form #2, discounted at the rate from #3
Talk to your financial advisor about the potential benefits and options of key person insurance for safeguarding your business’s financial stability.
