Keyman Life Insurance: Adding Coverage After The Fact

Keyman life insurance is a type of insurance policy that a company purchases on the life of an owner, a top executive, or another individual considered critical to the business. The company is the beneficiary of the policy and pays the premiums. This type of insurance is designed to provide a financial cushion to the company in the event of the sudden loss of a certain individual, allowing the company to recruit a replacement or cover short-term revenue deficits. The process of obtaining keyman insurance involves identifying key employees, understanding the importance of such insurance, calculating the right amount of coverage, choosing the right type of insurance, and considering the tax implications.

How to identify a key person

A key person is an individual whose premature death could potentially jeopardise the ongoing success of a business. This could be the business owner, a partner, or an indispensable employee.

To identify a key person in your business, assess their contribution to the company's bottom line and determine whether your business would suffer dramatically without them. Here are some roles that may be considered key people:

• High-performing salespeople
• Product designers
• Supply chain specialists
• Software developers and engineers
• Top salesperson
• Lead engineer

These individuals possess specialised skills, talents, and expertise that are essential to the organisation's continued success. They make a significant contribution to a company's profits and earnings.

It's important to note that the absence of a key person doesn't necessarily mean their death. Key person insurance can also cover situations where the key person becomes incapacitated or disabled and is no longer able to work.

Understanding the importance of key man insurance

Key man insurance is a crucial form of business insurance that financially safeguards a company in the event of the death or incapacitation of a key individual within the organisation. The policy is purchased by the business on the life of an owner, top executive, or another critical employee. The company pays the premiums and is the beneficiary of the policy, receiving a payout that helps cover the costs associated with finding and training a replacement, as well as maintaining business operations during the transition period.

Key man insurance is important for business continuity and risk management. It shields businesses from the financial repercussions of losing a key person, who is defined as someone whose absence would cause major financial harm to the company. This could include the owner, founder, top salesperson, IT specialist, or anyone with specialised skills, talents, and expertise that are essential to the organisation's success.

• Cover Lost Profits: The insurance can compensate for the sharp decline in profits that may occur when a key person dies or becomes incapacitated, providing a financial buffer during the transition.
• Offsetting Lost Income: The proceeds from the policy can help replace lost income due to the absence of a key person, who often has unique skills, connections, or insights that drive significant revenue.
• Pay Off Business Debt: The payout can help settle outstanding business debts, maintaining the company's solvency and creditworthiness.
• Purchase Shares of Deceased Partner: In partnerships, key man insurance can fund the buyout of the deceased partner's shares, ensuring a smooth ownership transition.
• Cost of Replacing the Key Person: The insurance can cover the costs of recruiting, relocating, and providing attractive compensation packages for a replacement executive or specialist.
• Cover Business Expenses: In addition to recruitment, the policy can help cover training costs and other expenses associated with bringing a new hire up to speed.
• Facilitate the Wind-Down Process: In cases where the business cannot continue without the key person, the insurance can help with winding down operations, settling debts, and fulfilling employee contracts.
• Maintain Business Operations: The payout allows the company to maintain day-to-day operations, pay salaries, and buy time to strategise the way forward or find a suitable buyer.

Key man insurance is particularly relevant for small businesses, which often depend heavily on just one or two individuals. It is a valuable tool that helps protect the company from financial losses due to the sudden absence of a pivotal player. By having key man insurance in place, businesses can ensure they have the necessary financial resources to mitigate the loss of a key person and continue operations without interruption.

Calculating the right amount of key man coverage

• Size of the business: The size of your business will impact the amount of coverage needed. Typically, small businesses with fewer employees may require higher coverage amounts to protect against the loss of a key individual.
• Key person's impact: Assess the key person's contribution to the company's financial success. Consider their role, skills, and expertise, and how difficult it would be to replace them. The more critical their role and the harder they are to replace, the higher the coverage amount should be.
• Salary and benefits: The key person's salary, bonuses, and benefits should be factored into the calculation. The coverage amount should be sufficient to cover the costs of recruiting and training a replacement, as well as any other associated expenses.
• Revenue and profits: Consider the key person's contribution to the company's revenue and profits. If they are responsible for a significant portion of the company's sales or profits, the coverage amount should reflect that.
• Time to find a replacement: Estimate the time it would take to find and train a replacement for the key person. The coverage amount should account for the potential revenue loss or added costs during this period.
• Industry and company structure: The industry your business operates in and its structure (shareholders, partnerships, etc.) can impact the coverage amount. For example, businesses in high-risk industries may require higher coverage amounts.
• Other factors: Other factors such as the key person's age, health, gender, and smoking status can also influence the cost of coverage.

To calculate the right amount of key man coverage, you can use the following methods:

• Salary multiplier approach: This method involves multiplying the key person's annual salary by a factor of 8 to 10. This is a simple and quick way to estimate the coverage amount, but it may not represent the full value of the key person's contribution.
• Total compensation package: Consider the key person's total compensation package, including salary, bonuses, and benefits. Add up all the components to get a comprehensive coverage amount.
• Recruiting and training costs: Think about the costs associated with hiring and training a replacement for the key person, including recruitment fees, training costs, and other overheads.
• Market rates: Reflect on the market rates for hiring someone with similar skills and experience. Calculate the market salary or compensation package, plus recruitment and advertising fees.

It is important to note that these calculations are just a guide, and the specific needs of your business may require adjustments. Consulting with a financial advisor or a life insurance specialist can help you fully capture all considerations and risks. Additionally, using a key man insurance calculator can assist in determining the right coverage amount for your business.

Types of key person insurance

Key person insurance is a life insurance policy that a company purchases for an owner, a top executive, or another individual considered critical to the business. The company pays the premiums and is the beneficiary of the policy. This type of insurance is also known as "key man insurance" or "key woman insurance". It is needed if the loss of a person would be devastating to the company's future.

Key person insurance is available in two types: term life insurance and permanent life insurance.

Term Life Insurance

Term life insurance provides coverage for a specified period, such as 10, 20, or 30 years. If the insured key person dies within this term, the business will receive a death benefit payout. Term life insurance is generally less expensive upfront compared to permanent life insurance, with level premiums throughout the term. These policies do not accumulate any cash value and are straightforward, offering only a death benefit. They are suitable for businesses that require coverage for a specific duration, such as until a project is completed or a loan is paid off.

Permanent Life Insurance

Permanent life insurance provides coverage for the lifetime of the insured, as long as the premiums are paid. This type of insurance is typically more expensive than term life insurance but offers level premiums for life. Permanent life insurance policies can accumulate cash value over time, which can be borrowed against, withdrawn, or surrendered. Some types, like universal life insurance, offer flexibility in premium payments and death benefits. This type of insurance is suitable for businesses that anticipate a long-term need for key person coverage, and the accumulated cash asset can be used as a financial resource.

The choice between term and permanent life insurance depends on the specific needs of the business, including the duration of coverage needed, budget considerations, and financial strategy.

The cost of a key man insurance policy

The characteristics of the key person being insured will also influence the cost of the policy. The age, gender, and health of the key person will be taken into account, with younger and healthier individuals typically receiving more affordable rates. The key person's occupation and industry may also impact the cost, as some jobs and industries are considered riskier than others.

The size and structure of the company purchasing the policy will also be a factor. Larger companies with more revenue stand to lose more in the event of the key person's death or illness, and thus will pay higher premiums. However, this also leads to higher payouts from the insurer to cover lost revenue and replacement costs. The industry the company operates in may also affect the cost of the policy, as certain industries have a higher risk of premature death or disability.

When determining the cost of a key man insurance policy, it is important to consider the financial risk associated with the loss of the key person and the perceived value of their contributions to the company. Quotes from multiple insurance providers should be obtained to find the most suitable coverage at the best price.

Frequently asked questions