What is Key Man Insurance?
Key man insurance is an insurance policy that a business purchases to cover the loss of income or expenses that can result when a key member of a business is no longer able to lead the business. It may include both life insurance and disability insurance on the key person (or just one of those), and the key person may be the business owner or another key employee.
Key man insurance addresses three primary situations:
- A key person brings in a large percentage of profits or revenues for the business.
- A key person brings special knowledge or talent to the business (e.g. an employee that develops a patentable product for the business).
- The key person’s expertise and knowledge mean that replacing him or her in the event of death or disability and training the replacement would be very costly.
If you purchase key man insurance, your business will receive a payout if the key person identified in the policy dies or becomes disabled. This can help your business continue to thrive in the face of a difficult transition. Sometimes, SBA lenders or banks may also require a business to take out a key man insurance policy before it can obtain a business loan.
What Key Man Insurance is Not
Traditionally, a key man insurance policy is owned by, funded by, and payable to the business entity. This makes it different from other types of business life insurance and business disability insurance, such as life and disability insurance used to fund a buy sell agreement.
In buy-sell insurance arrangements, often (for long-term tax considerations), the business is not the owner, beneficiary, and premium payer for the policy, as is the case with key man insurance. For example, it’s common for business owners in a buy sell arrangement to own life insurance policies on each other and to be the beneficiaries on those policies.
Do You Need Key Man Insurance?
It can take years to build up the expertise and knowledge needed to successfully run and grow a business. You can lose that expertise and knowledge in a heartbeat, quite literally, if a business owner or another key person passes away or becomes critically disabled.
According to a survey by the National Association of Insurance Commissioners, 71% of small businesses are highly dependent on one or two key people for their success, but only 22% have key man life insurance. Research has shown that the survival rate of small businesses drops after an owner or other key person dies. Even for businesses that do survive this transition, productivity and employment rates drop significantly.
While you might think that only large corporations can benefit from key man coverage, that’s not necessarily the case. The smaller the business, the more dependent it usually is on 1 or 2 key people for its success. Even sole proprietorships with employees can benefit from key person coverage if, for example, one of those employees is a second in command or otherwise makes valuable contributions to the business (If you’re a sole proprietor with no employees, then you can get a personal life insurance policy).
Contributed by Donald Sprague, Toropoint Managing Director
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