4 Reasons to Consider Key Person Insurance

February 15, 2021 by - How to, How to Start Your Company

Key Man Insurance

The reality of life when it comes to business partnerships, and what’s at stake if your key man is removed from the company.

Key Person Insurance (a.k.a. Key Man Insurance)

Definition: Life insurance on a key employee, partner or proprietor on whom the continued successful operation of a business depends. The business is the beneficiary under the policy. – Entrepreneur.com

Part 4 in our series titled, “Your partnership will fail!“

Sooner or later, your partnership will come to an end. What you do today makes a huge difference on how well things will go for you when that time comes. Thus far, we have discussed:

Our final topic of this series acknowledges the fact that some partnerships come to an end when everything is going great and a breakdown in the relationship is completely unforeseen. As death has no respect for your partnership or business needs, let’s talk about 4 ways that key person insurance can be utilized to mitigate its effect.

4 Reasons to Consider Key Person Insurance:

  1. A Sole Proprietor who Cares
    Most information on key person insurance states that it is unnecessary for a small business with a single founder upon whom the business relies. In the case of her death, the business will naturally die with him/her; however, a closure of this sort will most likely leave a wake of unfulfilled credit obligations and uncompensated layoffs. A sole proprietor may consider key person insurance ascribed to a company trust to be distributed toward debt, investors, and severance for employees allowing the business to close down in an orderly manner.

  2. Specialized Employee(s) is Crucial to Business Offering
    Many startups find themselves heavily invested in one or more key employees. Key person insurance on these employees enables the organization to seek, recruit and hire a comparable replacement without a devastating impact on limited bank accounts and lines of credit.

  3. Founding Partners are Essential to Success
    The founding partners of most small businesses are critical to the ongoing success of the company. Most partnerships include complementary skills that are not easily absorbed by other partners. Key person insurance offers the time and resources to assess unexpected deficiencies in partner capabilities – outside sales, financials, legal, customer support, HR, project management. From here, remaining partners have the ability to hire for these needs.

  4. Funding a Buy-Sell Agreement
    This one is most relevant to the heart of our series. Not many people like the idea of replacing their business partner with their partner’s spouse or estate after death. Without an appropriate buy/sell agreement and key person insurance, you may not have a choice. You chose your partner when you were creating your business, be sure to protect that choice as you move forward.

Key Man Insurance Exclusions

Insurance is a great safety net to protect your business and assets, but there are limits to your coverage. The most common reasons you will be denied a claim for this type of insurance is if fraud or misrepresentation is committed, intentional dishonesty, and suicide. Remember that with every life insurance policy there is a two year contestability period. If a claim is filed within the first two years of obtaining the insurance policy then the insurance agency has the right to investigate for fraud or deceptive statements.

Cost of Coverage

The cost of covering a Key Person(s) can vary, but it is based on four core factors.

  1. Industry
    The cost to cover a person in a high-risk industry will be higher than that of a low-risk industry.
  2. Company Size and Structure
    A highly valuable business with a significant contribution from the key person equals a higher premium as you will need more coverage.
  3. Age, Gender, and Health
    The older you are and the more health conditions you experience when you purchase your policy will create a higher premium. Men tend to pay a higher premium than women, and smokers can pay nearly double that of a non-smoker.
  4. Policy Terms and Coverage
    More coverage equals a higher price. Term life insurance may cost less than longer-term life insurance.

The Bottom Line

Determining how much Key Person insurance you may need will be a difficult task. To start you should determine the amount of compensation received annually then multiply that by 5 or 10. So an individual who earns $60,000 per year should invest in a $300,000 policy. Next, determine the time and effort it would take to replace the individual and potential loss in revenue. Finally, calculate the individual’s contribution to the business. Have they contributed profits, IP, or developed a network for the business? Collect the data and calculate the percentage of the company profits the key person has contributed and multiply that by the amount of time it would take to replace the person. Once you have done the math, consult a financial advisor or insurance agent to find the next steps forward to protecting your business.

 

Matthew Cleek

Matthew Cleek is a serial entrepreneur and is a co-founder of FundingSage, which provides valuable information, tools and resources to entrepreneurs seeking to start, grow and fund a business. Matthew's business ventures include Intellithought, theEclassifieds, Spectrum20, Theme Spectrum and more.