Key man insurance is not a sexist policy providing only for the male population of a company. It is a term that refers to any employee, partner, or owner who makes a significant contribution to a business. The intent is to provide financial assistance to a business suffering loss after a key employee dies.
Key man life insurance is an excellent employee benefit if the company pays for the policy using tax-free money. The premiums are not tax-deductible as a business expense. The employee’s family does receive the money without having to pay any income tax.
What are the benefits of key man business insurance? Keep reading for information about this unique type of policy.
1. Why You Need Key Man Insurance
Many businesses, especially those that are small or medium in size, heavily rely on one or two significant people. Not only can the loss of that person affect employee morale, but it will also cause a significant financial impact. Key employees include the owner, business partners, and key executives.
A study found that following a founding entrepreneur’s death approximately 60% of a business's sales are lost. The death of a key employee drops the business survival rate by 20% for two years following the loss.
When determining whether you need key employee insurance, consider the impact the loss of a particular employee would have on your company’s success.
2. Who Is a Key Person?
There are no specific rules for who a business considers a key person. It is an owner or employee that provides a direct contribution to the company’s bottom line. They may also be a key man in their operations.
People to consider when purchasing a key man insurance policy include:
- Difficult to replace personnel
- Heads of product development
- Leading sales personnel
- C-suite executives such as a CEO or COO
- Partners or co-owners of a firm
You may want to write down the names of your employees, what they do, and how their loss would impact the company. This review will provide information on who you need to purchase key man insurance policies for.
3. Types of Life Insurance
Any life insurance policy may be structured for use as a key man insurance policy.
Term life insurance provides coverage for a specific period of time, usually between 10-40 years. The premiums are less costly and usually have a term tied to the anticipated date of retirement.
Permanent or whole life policies provide coverage for the lifetime of the insured. A portion of the premiums is deposited into a cash-value account. The cash value increases over time and is an asset and may be used as collateral for a loan.
Permanent life insurance may pay dividends, which the business will receive. Because this type of policy accumulates value, it may be sold in a payout if the business determines coverage is no longer necessary.
Because of the cost difference, key man insurance is usually term insurance. Whichever form of insurance you purchase, the company needs to periodically conduct an insurance review. The review determines whether the company needs to increase or decrease the amount of coverage on each key employee.
4. Key Man Life Insurance Tax Treatment
Key man insurance is paid using after-tax dollars and is not tax-deductible. The only exception may be if the employee’s taxable income increases because of the insurance. To determine tax liability or benefit it is best to speak with your company accountant.
The death benefit of a key man insurance policy is generally paid without income tax liability upon the person’s death. The exception to this is with C corporations.
If you are a C corporation the death benefit will need to be included in your alternative minimum tax (AMT) calculation. You will need to show information about the key man coverage in your corporate tax return every year. This includes the number of insured employees, the amount of each person’s coverage, and if the employee gave permission for the policy’s purchase.
5. Tax Treatment for Employees
There will be no tax implications for the employee who is insured if the company is the sole owner and beneficiary. If you transfer the key man insurance policy ownership to the employee, they may have a tax liability. At the point of transfer, the insurance may be considered compensation by the IRS.
6. How Much Key Man Insurance Coverage Is Necessary?
The amount of coverage you need on each key person in your company will be dependent upon the impact that person’s loss would have on the company. To reach this determination, you need to consider the revenue and profit you can attribute to that employee. This includes the cost structure of the company, any “soft” value the employee has to the company, and the cost to replace the key person.
The most common methods for calculating a person’s coverage are:
Multiple compensation—multiply the employee’s compensation by the number of years the company estimates it will take to recover from their death
Percentage of revenue or profits—multiply revenue or profit the employee generates by the number of years it may take to replace them
Cost to replace—a total of the costs to replace the key employee include locating, hiring, and training the replacement, plus the loss of income during this process
The face value of policies usually has a limit based on the insured person’s income, if they have ownership in the business, and the corporate structure of the business.
7. Key Man Life Insurance
The difference between key man term insurance and standard life insurance is the reason for the coverage. A standard life insurance policy provides personal coverage. If the insured dies, their family receives cash benefits.
A key man insurance policy is for business purposes. It provides coverage for key personnel who are crucial to company operations. In the event the insured person dies, the business will receive an infusion of cash critical to their survival.
The funds compensate for the loss of revenue the business incurs following their key employee’s death. The company may also use the funds to pay off company debt and pay the costs of new employee training.
A key benefit is the company’s ability to pay the employee’s family for the deceased person’s interest in the business. This allows the business to maintain control over its key employees while providing financial security to the deceased person’s family.
When purchasing a policy you may want to review the various succession planning options available to businesses. This may include whether to purchase you also need to consider additional options such as buy-sell agreement insurance.
8. Key Man Disability Insurance
This is a policy that provides funding to a business if one of its key employees becomes unable to work due to a disability. A standard disability insurance policy provides the employee with loss of their wages and payment for medical expenses.
A key man disability policy will cover the business for their loss of revenue, the cost to hire a new employee, and more. The cost for this insurance will be dependent upon the age of the employee, their overall health, and their role within the business.
Consideration includes activities the person participates in when not working. This can include activities such as flying their own airplane, mountain climbing, motorcycle racing, or other high-risk activities that increase premiums.
9. Limitations of Key Man Insurance
Keyman insurance provides financial security for a company only in the event a key employee dies. It does not cover the loss of a key person who decides to leave your company due to retirement or to take a job with another company.
You are not able to purchase this type of insurance for employees who are not crucial to your business operations and ability to generate revenue. You cannot purchase key man insurance for independent contractors or other non-employees your business uses in its day-to-day operations.
10. Key Man Insurance Policy Cost
Your insurance agent will pull out their key man insurance calculator and go to work to provide the most cost-effective policy available. Your key man insurance policy premiums will be based on a variety of factors:
- Term insurance is lower in price than permanent life insurance
- Term insurance has a set period of coverage and does not accumulate any cash value
- Permanent life insurance policies are higher in price, but provide additional benefits
- The higher the death benefit, the higher the cost of the policy
- Employee’s overall health, including their age, medical history, and family health history
- Employee’s lifestyle, including hobbies, occupation, and driving record
Employees that are older or have health issues will be more costly to insure. You may want to look at all the business options Hummel Group offers. This includes commercial insurance, employee health plans, financial services, and business succession planning.
Financial Security for Your Business
Business owners tend to consider their loss if an executive becomes the subject of a lawsuit and purchase coverage for that type of liability. They tend to overlook the risk if one of the key players suddenly dies, leaving the company struggling to survive. Key man insurance is just one of many insurance options your business needs to consider.
When creating or reviewing your operating procedures and budget contact Hummel Group. We provide a wide range of business services to meet the needs of your business. You may call us toll-free at 800-860-1060 or use our online form to get a quote.