The people that work for a company are its biggest strength. Losing a key person can devastate a company’s sales, profits, reputation, and ultimately its worth. Since most small and medium-sized firms rely heavily on a few key people, they face substantial financial risk if anything happens to them. What you need to know is whether or not your company would be able to survive the loss of a key person due to death or incapacity caused by an extended sickness or accident. If you answered “no” to this question, you might want to look into purchasing insurance to cover the potential loss. You can accomplish this with the assistance of your financial advisor, who can also address any questions or concerns you may have concerning key person insurance. This article will inform you of all the details you should know about key person insurance.
List of contents
- What Is Key Person Insurance?
- Understanding Key Person Insurance
- How Does a Key Person Life Insurance Policy Work?
- When Might an Organization Need to Purchase Key Man Insurance?
- What Amount of Key Person Insurance Protection Is Necessary?
- What Are the Tax Ramifications of Key Person Insurance?
- The Type of Policy Also Matters
What Is Key Person Insurance?
A key person insurance policy is a type of life insurance purchased by a business for the life of an owner, a key executive, or another key member of the company’s management team. The policy’s premiums are paid by the corporation, which is also named as the policy’s beneficiary. Key man insurance, key woman insurance, and business life insurance are all names for the same thing.
Understanding Key Person Insurance
If the unexpected death of a key employee would have a catastrophic effect on business, key person insurance can provide a financial safety net. The money from the death benefit will give the company breathing room while they look for a replacement or formulate a plan to keep going (or close down).
It is common for a small business’s owner or founder to be its most important employee, but it could also be one or two other employees. The primary criterion is whether or not the company’s bottom line would take a significant hit in its absence. If this is the case, buying key person insurance might be wise.
How Does a Key Person Life Insurance Policy Work?
When a key employee passes away, the policy’s proceeds will go directly to the company rather than to the employee’s heirs. A “key person” may be an owner, partner, or employee crucial to the company’s success due to their unique talents or experience. The person responsible for bringing in a disproportionate amount of money to the company could likewise be considered a crucial employee. These plans are often only offered to high-value employees who would be difficult and expensive to replace if they suddenly leave their positions. If the insurance includes a disability rider, it might help assure the company’s survival if a key employee dies or becomes handicapped.
It is common practice for the policyholder or a close relative to the life insurance policy. This is an example of company-owned life insurance (COLI), in which the company owns the procedure, and the business covers the premiums. The company will receive the death (or disability) payout if the insured dies or becomes handicapped. Nevertheless, the insurance provider will need the employee’s signed approval to purchase COLI coverage for a key employee.
When Might an Organization Need to Purchase Key Man Insurance?
When applying for a business loan or other form of funding, it is not uncommon for the lender or investor to insist on seeing proof of life insurance as collateral. The proceeds from a “collateral assignment” policy are typically used to pay off the loan first and then benefit the company. Although these are the most common instances in which a company might want to insure a key employee, there are other scenarios and circumstances in which it might make sense.
- If the business bears the name of its founder or another significant figure, such as a current or past shareholder or board member,
- If the company’s survival is contingent on the continued presence of an individual whose absence would be disastrous, then that individual should be protected from termination.
- If the firm’s revenue or finances would be severely impacted if the key person left suddenly, the organization might consider key person insurance.
- If you own a small business as a sole proprietor and want to ensure that, in the event of your death, your heirs will be able to liquidate the company and settle any outstanding debts, you may want to consider purchasing life insurance.
- In the event of the untimely death of either partner, the surviving partner may wish to have the ability to purchase the deceased’s interest in the business. The partners usually do this as part of a formal buy-sell agreement.
What Amount of Key Person Insurance Protection Is Necessary?
The benefit amount on a life insurance policy used as collateral for a company loan must be sufficient to pay off the debt. In other cases, however, pinpointing an appropriate coverage quantity may be more challenging. The death of a primary employee will likely have a significant financial effect on the company, so you must plan accordingly. While there’s no foolproof method, consider the following potential outcomes should the crucial individual pass away:
- The time and energy spent by management in recruiting and finding a replacement
- compensation for finding and bringing in relief, including salary, bonuses, and executive search fees
- Price tags associated with a halt in operations
- Lost time and effort
- A drop in revenue
- Longer time until launch (if the key employee has a unique skill set)
Suppose you find it difficult to put a dollar amount on the abovementioned intangibles. In that case, you could always start by multiplying the person’s compensation by at least five times the amount they directly contribute to your company’s bottom line.
What Are the Tax Ramifications of Key Person Insurance?
The premiums paid for a key person policy are not considered a company expense and, thus, are not tax deductible. However, the cash value of permanent insurance grows tax-deferred, increasing the policy’s overall rate of return. In most cases, a business can borrow against the cash value of a permanent policy without creating a taxable event. In other cases, the death benefit is not taxable either, depending on the amount of the procedure and the state in which it is owned.
Consult a financial advisor
There are a variety of life insurance policies that can aid safeguard and fortify a company, and key person insurance is simply one of them. Your requirements are likely more nuanced than can be accommodated by a straightforward term life insurance calculator for company owners. It may be worthwhile to consult with a financial expert who can assess your company’s needs and provide insight into the range of solutions that can help you achieve your short- and long-term objectives. A trusted insurance agent or broker may be the ideal location to begin your search. If you prefer, Guardian can contact a financial advisor to help you learn more about and choose the best life insurance and other wealth-building solutions to safeguard your loved ones, business, and legacy.
The Type of Policy Also Matters
You must also decide if a term or permanent life policy is more appropriate for your needs.
Term life insurance
Temporary coverage is less expensive for a healthy worker but is not permanent. Term insurance policies are bought and paid for over a set time (the term), which can be anywhere from one year to thirty years. Once your current insurance expires, you may be able to get a new one. However, the prices will skyrocket with the advancing years, and there’s always the risk that the individual won’t qualify for coverage due to their health. Term insurance, on the other hand, may make sense if the key person is not the business’s owner or a partner, as it can be purchased for a set length of time that covers the key person up to the time they are expected to retire or separate from the company.
Permanent life insurance
The premiums are more expensive, but the added benefits may be worth it for firms. As long as payments are kept up, these plans will remain in effect indefinitely, unlike term insurance. 1 Permanent insurance is preferable because it accumulates cash value that can be used for present or future business needs. 2,3 Borrowing against permanent insurance is convenient because it doesn’t need filling out a credit application, and the interest rates are usually cheaper than those offered by banks. The insurance company will not require repayment of the loans, but any remaining balance will diminish the payout in the event of death. Permanent insurance can be broken down into two categories:
Whole life insurance
It offers a tax-deferred cash value accumulation at a fixed interest rate and a premium that is guaranteed to remain unchanged for the duration of the policy. Mutual insurance firms like Guardian may also offer dividends on whole life plans. 5 Although their effects on growth are not assured, they can be beneficial.
Universal life insurance
In addition to giving you greater leeway, these policies can help you save money on taxes by allowing you to adjust your monthly premiums within a predetermined range.
Insurance plans will let you link your cash account’s growth to investments in the market, exposing you to the market’s volatility and risk while also increasing your potential for gain.
Even though term life insurance is an option, permanent coverage may be preferable if the key individual is the owner or a company partner. The insurance’s cash value can serve as a retirement benefit for the key individual in the event of their departure from the company or as the basis for an ongoing buy-sell arrangement among partners.
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