In business, and in life, among the most important ways to manage risk is through insurance. For certain types of companies - particularly start-ups and small businesses - one major threat is the sudden loss of an owner or irreplaceable employee. To safeguard against the risk, insurers offer key person insurance.
Under a key person policy, a business buys life insurance covering the owner or employee, pays the premiums, and names itself the beneficiary. Should the key person die while the policy is in effect, the business receives the payout. As you formulate and adjust your succession plan, one of these policies can serve as a critical safeguard.
Costs and coverage
Key person insurance can take a variety of forms. Term policies last for a specified number of years, typically five to twenty. Whole life (or permanent) policies, which are generally more expensive, provide coverage as long as the premiums are paid, and they gradually build up cash surrender value. This value appears on a business's balance sheet and may be drawn on, if the business needs working capital.
The cost of key person insurance also depends on the covered individual's health, age, and medical history, as well as the desired death benefit. When budgeting for premiums, bear in mind that premiums generally aren't tax deductible. On the flip side, death benefits typically aren't included in the business's taxable income when received.
In terms of coverage limits, insurers may quote a rule of thumb of eight to ten times the key person's annual salary. However, every business will have different cash flow needs when a key person unexpectedly dies. A more accurate estimate typically comes from evaluating the lost income (or value), as well as the costs of finding and training a suitable replacement. This evaluation can be very complex as many factors should be considered, including the impact on ongoing operations, future growth, and financing the business.
An important decision
If you've already chosen a successor, you can buy a policy that covers both of you. And if you haven't it may be even more critical to buy coverage on your life to protect the solvency of your business. If you need help deciding whether key person life insurance is right for you, give our business advisory team a call!