Most small businesses have a key person or persons who are essential to the day-to-day management and long term success of the business. If this key person were suddenly unable to work due to death or a disability, the business may not survive. Key man insurance coverage (aka key person insurance) helps keep the business on track if a tragedy occurs.
What is Key Man Insurance, and Do I Really Need It?
Key man insurance is life or disability insurance on the key people in a business. If the covered individual(s) passes away or becomes disabled, the insurance company will pay a benefit to the business. Also refered to as Key Person Insurance, it is not covered under most standard small business insurance policies.
Key person insurance is important for three main reasons:
- If a key person dies or becomes disabled, the insurance proceeds help the business survive and pay its bills until it can hire and train a replacement.
- If you have a business partner(s), key person insurance gives you the means to buy out his or her portion of the business if they are unable to work due to death or disability.
- Lenders, including the U.S. Small Business Administration (SBA), may require borrowers to carry key person insurance to qualify for SBA financing.
If you’re a one person shop with no employees, then key man insurance may not be necessary because without you, your business ceases to exist. However, if you’re planning to apply for a business loan, then a lender may still require you to get key man insurance as security to make sure the loan will be paid even if you pass away or can’t run the business anymore.
Small businesses with multiple partners, employees, vendors, and customers have an even bigger need for key man insurance. The insurance helps the business maintain continuity if a key person dies or experiences an illness or injury.
How Does Key Man Insurance Coverage Work?
Despite the fancy name, key man insurance coverage is actually not that different from plain vanilla life and disability insurance. The business simply purchases a life and/or disability insurance policy that names the key employee or owner as the insured. The business pays the premiums and is the beneficiary of the policy.
If the named individual dies or becomes disabled, the insurance company will pay out a sum of money to the business. This gives the business enough money to weather the loss and manage the transition.
Life insurance on the key person
Derek Mazzarella, a registered insurance agent and financial advisor with Bulfinch Benefits Group, says that most small businesses start out by purchasing 10-year term life insurance on a key person and keep renewing it for as long as the key person is with the company.
Term life insurance policies pay out a death benefit if the covered individual dies during the term the policy is in effect. If you know the key employee or owner is going to be with the business until retirement, then the business may want to consider purchasing whole life insurance. Whole life insurance policies pay out a death benefit no matter when the covered person dies.
Whole life insurance policies have high premiums, but such policies also build up a cash reserve, says Sung T. Chang, an insurance agent with New York Life Insurance Company. When the key person retires, ownership of the policy can be transferred from the company to the key person, and the reserve can be used by the key person to supplement retirement income.
Disability insurance on the key person
If you buy only life insurance on a key person, your business is only half covered. Disability is statistically more likely than death, and disability of a key person can actually be harder on a business. “Disabilities of key employees,” Mazzarella says, “tend to be tougher on the business than death because there is uncertainty with when an employee will be able to return to work if at all.”
To cover all the contingencies, make sure you cover a key employee with both life and disability insurance. You may not necessarily need to purchase two separate policies; some life insurance policies come with riders that offer disability coverage. Ask your insurance broker for more details.
How Much Key Man Insurance Do I Need?
This varies depending on your reason(s) for purchasing the key man insurance.
If you’re getting key man insurance because a business lender requires it, you’ll need enough insurance to pay off the loan. If you’re getting insurance so that you and your business partner can buy out each other’s shares of the business, you’ll need enough insurance to cover the buyout. Lastly, if you’re purchasing key person insurance for continuity reasons, you’ll need enough coverage for the business to get back on its feet after the loss of a key person.
Most insurance companies, says Chang, set a multiple of 5-7 times the key person’s salary as the maximum limit on key man insurance.
Key Man Insurance Cost
Just like if you were to buy life insurance for yourself or a family member, the cost of key man insurance varies based on multiple factors:
- Age, gender, and health of the key person
- Salary of the key person and primary job duties
- The length of the insurance (term vs. whole)
For example, a 10 year term life insurance plan with Guardian Insurance that provides a death benefit of $250,000 for a healthy, relatively young key person would cost approximately $700-800 per year.
Where to Buy Key Man Insurance
When you’re ready to purchase key man insurance, says Richard Reich, President of Intramark Insurance, “contact a reputable life insurance broker who represents many of the highly rated companies.” Ask the broker to get you quotes from insurers that offer competitive rates on both life and disability insurance. A few good examples are MetLife, Prudential, Mutual of Omaha, Transamerica, Guardian Life, and Principal Financial Group.
By purchasing key man insurance, you will have the peace of mind that your business will be protected if a key owner or employee passes away or becomes ill. We recommend purchasing the policy sooner rather than later because you never know when it will be needed!