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“No one is indispensable,” goes the saying. But as many small business owners know, there may be one or more people whose knowledge, work, and overall contribution is in fact vital to the company. Many small businesses aren’t prepared for the consequences if the business owner or another highly valued employee becomes disabled or dies, dramatically reducing a company’s productivity and revenue stream.
Even if your business can replace a key person, it can take time and money to do so—things a small or startup business often doesn’t have.
That’s why key person insurance could be an important coverage for your small business, and may be worth discussing with your insurance professional. In fact, venture capitalists, banks, and other lenders often insist that key person coverage be a part of an organization’s business plan, especially for any startup businesses they fund.
If the key person named in a policy becomes disabled or dies, the benefits typically go to the business to compensate for lost profits or extra expenses caused by the loss of that person. In some instances, the policy’s proceeds go directly to venture capitalists or banks if they are the beneficiaries under the insurance policies. These policies allow the investors and creditors in a fledgling business to protect their investment.
Key person insurance can also pay expenses related to finding and training a successor, including an employment agency’s fees and the potential expenses needed to relocate the new person—and possibly finance a higher salary for him or her. These policies can also fund obligations to the key person’s family, such as deferred compensation or continued salary.
Key person policies can also buy out a deceased employee’s shares according to a buy-sell agreement between business partners. This is sometimes called a “business will,” and it may govern the situation if a co-owner dies or is otherwise forced to (or chooses to) leave the business.
The cost of covering a key person varies based on the same factors that apply to anyone seeking a new life and/or disability insurance policy, such as the amount of income the insurance policy would replace; the employee’s age, height, weight, and medical history; and whether he or she smokes or has dangerous hobbies, such as skydiving or car racing.
Key persons and life insurance
When a business purchases a life insurance policy for key person purposes, the business typically owns the policy, pays the premiums, and is the beneficiary. The employee, having agreed to be listed as a key person, must agree to the company’s purchase of this insurance. Moreover, the life insurer may require a resolution from the company’s board of directors stating the purpose of the policy’s key person provision.
When determining the appropriate amount of coverage, consider such relevant factors as the value of the person to the company; the projects or clients that would be lost by his or her departure; sales generated by the person; replacement and training costs; reduced profits during a transition period; and any loans that might come due as a result of the key person’s death.
Key persons and disability insurance
Key person provisions, when incorporated into disability insurance policies, are there to compensate the business for the temporary or permanent loss of a key person due to an injury or illness. A disability policy includes a definition of disability that must be satisfied before the beneficiary under the insurance policy receives any benefits.
Benefit payments are generally made to the beneficiary—whether it is a company or an individual—on either a weekly or monthly basis for a specified period of time.
Should a key person become permanently disabled, the economic loss to a business may be the same as if the person had died. However, the risk of a key employee experiencing partial disability is much greater than the risk that the person will die. A 35-year-old has a 50 percent chance of being disabled and unable to work for three months or longer before he or she turns 65, according to the National Association of Insurance Commissioners (NAIC).
Key person insurance is rarely discussed within small business circles, but it can play an indispensable role in maintaining business continuity or facilitating the sale of a business if such disastrous circumstances arise.
Loretta L. Worters is vice president of the Insurance Information Institute, whose mission is to improve public understanding of insurance—what it does and how it works. Ms. Worters is an author and woman’s advocate frequently quoted in leading publications including the Wall Street Journal, the New York Times, USA Today, Business Week, Forbes, and U.S. News & World Report. She also appears regularly on television networks including ABC, CNBC, CNN and Fox. Follow her on twitter at @LWorters.
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