Key Man Insurance
  • Ensures business continuity
  • Ensure that lines of credit from lenders remain open

Determination
  • Calculate the key person’s total compensation package
  • Cost of replacing that person

Key Man Insurance

The success of an entrepreneurial venture.

The success of an entrepreneurial venture rests to a large extent on the contribution of the founders or owners of the business. However, in the event that the owner of the business becomes incapacitated due to ill-health or an accident or in the event of their death, then the income and general financial health of the business can suffer quite considerably, even if someone else is standing in for the owner. This is where key man insurance becomes essential to compensate for the loss of income that arises due to the absence of the key persons in the business. Without the security offered by key man insurance coverage, the business may well collapse. Between 15% and 20% of business closures can be attributed to key man disability, incapacitation or death.

The odds of a business experiencing key man issues that threaten its existence are quite high making key man insurance a prudent option. The high risk of business failure due to key man related issues often necessitates investor, lenders and business partners requiring that a business has key man insurance cover before they can put any money into it. Key man insurance is not restricted to owners of the business but also other critical employees in the business whose loss can have a material effect on the business. In fact, the need for key insurance is strongest for small businesses because their fortunes depend heavily on the contribution of one person or very few people that if they are removed from the business, then the business will simply cease to exist.

The way key man insurance works is that a business takes out a policy against key persons in the business so that in the event of their disability, incapacitation or death, the organization receives a pay-out that it can use to mitigate the impact of the loss of a key person. It is also possible for the business to prescribe that a certain portion of the benefit it receives goes to the family of the key person. In that case, it can act as a retention tool for key persons when they know that in the event of their disability, incapacitation or death, their family will also be compensated.

Advantages

It ensures business continuity during the transition phase when a replacement is being sought for the key person.

The company can borrow against the value of key person policies in the event of cash flow problems.

It can ensure that lines of credit from lenders and suppliers continue to remain open for a business since it will in a position continue paying its obligations when they become due. Therefore, it guarantees the creditworthiness of the business during the transition phase of replacing a key man.

In a partnership, it makes available money to buy back shares from the family of the partner that has died or become incapacitated.

Disdavantages

It is not a tax deductible expense in most cases.

It is not transferrable in the event that insured key employees leave the business. Even if there is a business exchange rider that allows a new key person to be covered under an existing policy, it generally entails new premiums and adjustments that essentially make it a new policy.

Determination of key man insurance coverage required

In order to determine the size of key man insurance coverage, it is necessary to do the following:

 

  1. Calculate the key person’s total compensation package.
  2. Calculate the cost of replacing that person and the length of time that it will take to replace them.
  3. Calculate how much income the key person’s input brings to the business. For example, if a key person contributes $300 000 and it is estimated that it will take two and a half years to train a suitable replacement to reach that level of proficiency, then, the level of coverage should be: $300 000 X 2.5 = $750 000

In addition to the $750 000 the other two costs [total compensation and replacement costs] should be added to arrive at the total coverage required.

It is also important to notify the key person of the extent of their insurance coverage and to secure written consent from them acknowledging this and agreeing to it for transparency and even for tax purposes as well.

 

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