How Key Person Life Insurance Can Keep Your Business Afloat

Key Takeaways:

• The death of a key employee or team member can hurt—even potentially sink—your business.
• Key person life insurance is underused by entrepreneurs.
• Key person insurance can cover the cost of finding a replacement for the vital team member.

As a business owner, do you feel like there are certain people on your team you can’t live without—people who are so important to the success of your enterprise that their absence would be felt across the company, and who would be extremely difficult to replace?

We find that most highly successful entrepreneurs have such key people in place. Unfortunately, we also find that most of those business owners don’t have any safeguards in place in the event those people suddenly are no longer with the company. Without safeguards, the loss of these key people (including, of course, you as the owner) can be devastating to a company’s financial health and ability to stay on top—or even keep the lights on!

The good news: If you have key people in your company, you can ensure your fortunes stay strong even after they’re gone by using key person insurance.

Protection against the worst outcomes

There are times when, due to death, key people in a company are lost. Key person life insurance provides funds to a business to address the financial losses that can occur when a key person dies. Revenue losses can be offset, and money can be tapped to help ensure the business remains viable and doesn’t fail—for example, to find a replacement for or train someone to take the job of the key person who died.

This is almost always the most cost-effective approach. Additionally, key person life insurance pretty much guarantees the money required will be available when needed.

Here’s how it works. The company buys a life insurance policy on its owner and/or key personnel (see Exhibit 4). A separate policy is often purchased for each key person. If a key person were to die while the policy is in force, the proceeds from the life insurance would go to the company to enable it to keep running and possibly recruit or train someone to replace the key person.

Tax implications: For the most part, the payout from the life insurance policy is tax-free to the company. However, the premiums the company pays for key person life insurance policies are not tax-deductible.

Many entrepreneurs lack key person life insurance

While key person life insurance can be extremely useful for many business owners, only about three out of five surveyed had key person life insurance policies on themselves or other critically important personnel (see Exhibit 5).

What’s more, nearly three-quarters of the entrepreneurs who lack key person life insurance say their businesses would suffer if they were to die unexpectedly (see Exhibit 6). In effect, these firms have no financial backup plans in the event they lose a key person.

But even among those business owners with key person insurance, there is often a big problem. Most of them have not reviewed or revisited their key person insurance within the past three years (see Exhibit 7). That means the insurance could be outdated and insufficient—and no longer adequate to address the current needs of the company and its owners.

How to value your key personnel

Even when you know you’ve got key people in your firm who are essential to its health, it’s not always obvious how to best “value” them for the purpose of taking out key person insurance on them. Obviously, you want to insure them for the right amount without greatly over- or under-insuring them.

In general, there are three basic ways to calculate how much life insurance to take out on a key person:

1. Multiples of compensation. This way is based on the all-in compensation a key person earns. That might mean including income, bonuses, the cost of benefits and any other form of compensation (such as equity grants). Then you add the multiplier, which tends to range from two times to ten times (but can be even more). This approach is relatively easy to implement because it is a straightforward algorithm.

Example: If a key person was making $300,000 a year all-in and the multiple was 5x, then the death benefit of the life insurance policy would be $1.5 million.

1. Cost of replacement. With this approach, the amount of life insurance on a key person is a function of what it will cost to find and compensate someone else who is similarly qualified to take the job. Finding a replacement includes the cost of recruiting. This method is seen as most viable when there is a large supply of capable applicants and when the cost of recruiting a new key person for the role is not seen as arduous. It is anticipated that a new, high-caliber applicant will be identified and recruited fairly quickly.
2. Contribution to profits. Here, the estimated ability of the key person to add to the bottom line is combined with the amount of time it will take to find a replacement and get him or her up to speed. It is a good way to also help address the losses the company may face without a talented person in the position.

Sometimes in using this approach it is easy to calculate a key person’s financial contribution (as in the case of salespeople, for example). You can determine the average profit of a salesperson over a period of years. However, this approach can become much more subjective when, say, a company founder is involved.

Next steps

If you’re an entrepreneur who relies on specific people to help ensure your continued success, key person insurance is almost certainly worth looking into. If you already have such insurance in place, but the policy has been gathering dust in a drawer for years, it’s probably time to revisit your coverage to ensure it still is structured to give you the financial safety net you need—before you learn the hard way that it’s not.

Take action: If you think you could potentially benefit from key person insurance, contact your legal or financial professional to explore the topic further.

VFO Inner Circle Special Report

By Russ Alan Prince and John J. Bowen Jr.

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