Many businesses have executives or personnel that are irreplaceable or at least very difficult to replace. This is especially true for small businesses and startups.
These individuals are referred to as key people. The partners who own a business are key people. The top salesperson who generates a bulk of your company’s revenue would also be considered a key person. The lead programmer of your company’s multimillion-dollar proprietary software is a key person, or the renowned chef at your upscale restaurant.
These are professionals whose absence would have a severe financial impact on your business. Their knowledge, creativity, skills, and/or reputation are critical to the viability of your company.
If you have key people in your firm, there are three types of insurance your company should have to protect itself against the potential loss of these professionals:
Read on to learn more.
According to the Social Security Administration, you have a 25 percent chance of suffering a disability that limits your ability to work at some point in your career. These odds apply to your key people.
We tend to think of disability insurance as a way to help people protect their own income. But what would happen to your business income if you lost a key person to a disability for a year, five years, or permanently?
- If it’s your best salesperson, would those clients take their business elsewhere?
- If it’s your product creator, will your business be able to replace his or her skills?
- If it’s one of the owners, will lenders, investors, suppliers, or clients get nervous and abandon you?
You can minimize these concerns with key person disability insurance.
This type of policy can help your business offset the financial burden of a key contributor being disabled.
Key person disability insurance is owned by the business entity. The business pays the premiums and is the policy’s beneficiary.
If the insured key employee becomes disabled due to an illness or injury, the business will receive a benefits payment. These payments can be used to offset lost sales, recruit a replacement, keep the company afloat until the insured recovers, and/or allay concerns from stakeholders about your company’s financial viability.
To determine how much coverage to purchase on a key person, you will have to estimate the full financial cost of losing their services to a disability.
In addition to the amount of coverage, the cost of premiums for key person insurance depends on the age, health, lifestyle choices, and role of the key employee.
Benefits may be payable monthly or as a lump sum. When payments are paid monthly, the benefit period is typically between 6 to 24 months.
The key person’s injury or illness will have to meet the insurance company’s definition of disability for your business to collect benefits. The key person must be unable to perform the substantial and material duties of their job. They cannot work in any other job with comparable duties and/or earnings for the business.
The policy may also contain exclusions and limitations on what causes a disability to a key person. For example, disabilities caused by attempted suicides or critical acts are typically not covered. Limitations may be placed on key people who have pre-existing conditions or risky lifestyle choices like skydiving.
According to the National Association of Insurance Commissioners, 71 percent of firms surveyed said they were very dependent on one or two key people for their success. However, only 22 percent of respondents had key person life insurance in place.
Life insurance is designed to protect people who depend on you financially in the event that you pass away. Usually that means family members. But with key person life insurance, you can protect your business if one of your key people dies unexpectedly.
As with key person disability, your company typically owns the key person life policy. The company also pays the premium and is the beneficiary.
In some circumstances, your business and a key employee may split the premium payments. This means you also split the policy benefits.
In either scenario, the employee must agree to the company’s purchase of key person insurance on their life.
Your company can use the death benefit for any number of purposes. These include finding a replacement, paying off debts, paying investors, or closing the business down in an orderly manner.
The cost of a key person life policy is determined by the same factors as a key person disability policy. Deciding how much coverage is needed may depend on a number of factors.
You should talk to your insurance carrier or agent about formulas used to determine the key person’s worth to your business. You can also calculate the employee’s valuation by analyzing their responsibilities and the expected cost of replacing them.
Business continuation insurance is a third type of insurance to protect businesses from the loss of a key person.
It’s similar to key person disability and life insurance. In fact, business continuation covers both the death and disability of a key executive, owner, or partner.
Business continuation is commonly used for companies with multiple owners or partners. If a partner dies or becomes disabled, business continuation insurance helps facilitate a succession plan for the company.
In this scenario, the policy would be set up so that the remaining owners could purchase the shares owned by the affected partner using the policy benefit. This is usually done in conjunction with a buy-sell agreement. This type of agreement ensures that an owner’s share of the company passes to the other owners and not to other heirs in the event of their death.
A business continuation policy can also name the actual business as the beneficiary. This enables the business entity to buy its own equity from the deceased or disabled owner.
Business continuation insurance can also be used to cover the potential disruption of business resulting from the death or disability of a key person who is a non-owner. A buy-sell agreement would typically not be used in this scenario.
Here are a few more details to help you determine your need for key person insurance:
- Being covered by these policies does not prevent key people from owning their own individual life and disability insurance policies.
- You can use key person insurance as an employee benefit because it can often be transferred to the individual.
- Though key person insurance premiums are not tax-deductible, the policy proceeds are usually provided to the company free of income tax.
- Another option to help keep certain businesses afloat during the disability of an owner is business overhead expense insurance. This type of insurance helps cover your monthly business expenses if an injury or illness impacts your ability to work. The amount the policy pays in benefits will be based on your company’s monthly overhead expenses each month, up to a cap.
Jack Wolstenholm is the head of content at Breeze.
The information and content provided herein is for educational purposes only, and should not be considered legal, tax, investment, or financial advice, recommendation, or endorsement. Breeze does not guarantee the accuracy, completeness, reliability or usefulness of any testimonials, opinions, advice, product or service offers, or other information provided here by third parties. Individuals are encouraged to seek advice from their own tax or legal counsel.