Every business includes a key person or persons that are essential to the function of the business. These key persons can be a sole proprietor, partner or shareholder. In the event that this person or persons die or become disabled it can be a devastating blow to the business or corporation. This loss has multiple effects on the business by not only losing a financial contributor to the business but also the talents of that individual.
Further, a new replacement will need to be hired and trained which also lays a double-whammy on any size business. These issues must be solved with the least amount of disruption to the functions of the company since creditors will need assurances that the business can continue without this key person. If they cannot be demonstrated, creditors may call in their loans.
In order to help with these adjustments and issues, businesses purchase key person insurance. Key person or Key employee insurance is a third party insurance policy where the employer is both the insured and the beneficiary of the contract and the life insured is that of the key employee or key person. Depending on the policy contract, a key person is typically insured for a multiple of their annual income (i.e. five times their salary) and in the event that this key person dies, the business will be funded the insured amount to be used towards hiring a replacement for the business. It is a temporary cash flow to assist the company in making its financial commitments and liabilities and raise the confidence of investors and creditors.
Like other forms of life insurance, key person insurance provides the company with a benefit that is exempt from taxes which allows for the entire amount of proceeds to be used in dealing with the financial and expert loss of the decreased. Some policies will also allow for a parachute clause where the key person’s life may be substituted for another if necessary. This can also provide some profitability while the company suffers the loss of a valuable attribute. The policy does not mandate that the business must use the money benefit towards the costs of a new replacement and therefore it can be used as the company sees fit.
Businesses that need key person insurance are typically those with;
• A small management team;
• No management team or training;
• A limited amount of cash reserves;
• Business loans that are personally guaranteed by the owner.