- Ensures business continuity
- Ensure that lines of credit from lenders remain open
- Calculate the key person’s total compensation package
- Cost of replacing that person
Key Man Insurance
The success of an entrepreneurial venture.
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.
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 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:
- Calculate the key person’s total compensation package.
- Calculate the cost of replacing that person and the length of time that it will take to replace them.
- 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.