March 22, 2021

Key Man Insurance: What It Is And Why It Is Important

Life insurance may not seem critical, but it can be one of the biggest gifts you can leave to your partners and employees. This article will review a type of life insurance called Key Man insurance, and why it’s important for your business.

What is Key Man Insurance?

Key Man insurance is a life insurance policy you take out on a person who plays a vital role in the business. This person is usually the owner or founder, but it could also be an employee whose role is critical in running the business. Without this person’s active involvement, the business would likely go under. To get started, the company will determine who this individual is and take out a life insurance policy on them. The business will pay the premiums and will act as the beneficiary of the policy. In the event that your business experiences the sudden loss of an employee or other key person, the company would receive the life insurance payment. The insurance proceeds helps the company absorb the financial blow while management figures out their next steps. Key person life insurance can be used to pay down debt, hire a replacement employee, repay investors, or pay employees. If necessary, it can also be used to close the business in an efficient and timely manner. However, the insurance coverage won’t apply to the deceased individual’s family. Keyman insurance isn’t a personal life insurance policy; instead, the company purchases a life insurance policy that will benefit the business entity itself.

Types of Insurance Policies

Insurance is complex, and there are many different ways to structure your Key Man life insurance policy. Listed below are the three main types of policies you can consider.

Term Life Insurance

Term life insurance is a policy you take out for a certain number of years before it expires. For instance, you could take out a 20-year term policy. This type of policy is often less expensive because it has a definite ending point.

Whole Life Insurance

Whole life insurance never expires, as long as the company continues paying the premiums. These policies also come with a cash savings value, which can be accessed by the business if it falls within the scope of the policy.

Disability Insurance

Death isn’t the only thing that could take away a founder’s ability to run their company. Often, it’s more likely that the individual will become disabled and be unable to perform at work. According to the CDC, 26% of all adults in the U.S. have some type of disability. Over 13% of disabled individuals experience mobility issues, and more than 10% experience cognitive difficulties. Key Man disability insurance will protect the company if a key person becomes disabled and is unable to perform their regular job functions. Disability Key Man Insurance

Does My Business Need Key Man Insurance?

If you’re looking to obtain funding or a small business loan, you’ll probably need to purchase Key Man insurance. Most banks will require that businesses take out Key Man insurance since most small businesses are dependent upon the owners. In addition, most investors require this insurance as well since they want to protect their investment. But beyond that, Key Man insurance may not be necessary, depending on the type of business you run. For instance, if you run a solo consultancy business and don’t have any employees, Key Man life insurance may not be necessary. Your family may depend on the income, but that’s what a personal life insurance policy is for. So, how do you know if Key Man life insurance is something that you should pursue to protect your company? Ask yourself the following questions:
  • Would the loss of a key employee affect the company’s brand or reputation?
  • Does one individual bring in the majority of the company’s business and revenue?
  • Are daily tasks and projects tied to one specific individual? Would these tasks be hard to complete without that person?
If you answered “yes” to any of those questions, then your business should probably consider purchasing Key Man insurance.

Categories of Insurable Losses

Anytime you take out a new policy from an insurance company, it’s important to understand the policy coverage. For Key Man insurance, four main situations are covered:
  • Inability to perform: The policy will kick in if the key individual is unable to perform their usual duties, and can’t help find and train a replacement.
  • Protecting profits: Key Man insurance is designed to protect the business if the loss of one individual would result in the company losing a source of revenue.
  • Protecting the interests of shareholders: Often, businesses will purchase Key Man insurance to protect the interests of its shareholders.
  • Business loan insurance: Similarly, if your business has obtained funding through a bank or the Small Business Administration (SBA), you’ll likely be required to purchase Key Man insurance.

Determining Attribution of Worth

The amount of coverage needed is dependent on the company’s needs and how much that individual is worth to the company. If that person were to pass away unexpectedly, how much would it hurt the company’s profits? Would the company lose clients and revenue, and could its brand suffer? How much would it cost to find and train a replacement for that key employee? All these factors can help your business determine the amount of coverage needed. One good way to determine attribution of worth is to look at the key person’s yearly salary and obtain coverage that’s five to 10 times that amount. For instance, if the founder currently earns $200,000 a year, then you should get at least $1 million in Key Man insurance. [cta-freequote]