Like other assets of the company there are employees who are more important to your operation than other, either because of their skills or from the investment they have made in the start up of the company. These are your key employees.
In general, a key employee can be anyone who:
1. Is responsible for management decisions
2. Is highly paid
3. Has a significant impact on sales, or
4. Has a special rapport with customers and creditors
In a small business, this is usually the owner, or perhaps another employee or two. These are the people who are crucial to a business, the ones whose absence would sink the company. What would happen if one day you came into work and one of these persons had died, could your business survive this loss. That is why you need key man insurance on those people!
Key man life insurance is an affordable way to prevent your business from sinking after a critical employee passes away.
Losses from a Key Employee's Death
The key employee or business owner death can affect the business in the following areas:
- Deterioration of Morale and Structure
- Lost Confidence from Clients
- Disagreement Between Surviving Heirs, if Owner
- Potential Sale of Business to Outside Party
- Fulfillment of Spousal Compensation
- Lost Business Opportunities
- Financial Cost of Replacing Key Employee (time and money)
Here is how Key man Insurance works
A company purchases a life insurance policy on the key employees, pays the premiums and is the beneficiary of the policies. When the insured person dies, the company receives the insurance payout.
The reason this coverage is important is because the death of a key person in a small company often causes the immediate death of that company. The purpose of key man insurance is to help the company survive the blow of losing the person who makes the business work. The company can use the insurance proceeds for expenses until it can find a replacement for the employee, or, if necessary, pay off debts, buy out the deceased's shares in the company (buy-sell agreement), distribute money to investors, pay severance to employees and close the business down if necessary in an orderly manner.
In a tragic situation, key man insurance gives the company some latitude and options other than immediate bankruptcy.
If the company is just you and doesn't have any employees or other people who depend on it, then key man insurance is not as necessary. You will notice that I did not mention your family, please do not confuse key man insurance with personal life insurance. If you have a spouse and children who depend on your income, then you should have personal life insurance.
The big question is ﾓHow do you determine if you needs this insurance?ﾔ Well the first thing you must do is look at your business and determine whether there are any employees who you would have difficulty replacing in the short term.
In many small businesses it is the owner who holds the company together, he may keep the books, manage the employees, handle the key customers and so on. If that person is gone, the business pretty much stops. However, the owner of a business should not immediately be considered the right or only candidate for a key man life insurance policy.
Rank is less important than who the critical employees in your business are. Your business could not function day to day without you, but it also may not be able to survive without your revenue-generating sales team or without the precious relationships a business development employee has with your vendors.
How much key man insurance do you need?
That depends on your business, but in general you should get as much as you can afford. Shop around and get rates from several different companies; most life insurance companies sell key man insurance policies.
Determining the value of a key employee is not easy. Three different methods have been developed to help business owners estimate the worth of an employee to the company:
Multiple Compensation Method
This is a simple method of calculating key man worth. It assumes that an employeeﾒs value is accurately reflected in his or her total compensation.
Contribution to Profits Method
This method estimates the impact an employee has on the companyﾒs net profit. The company calculates the expected profit, and considers excess profit to be the result of key employees. An estimate is made of the percentage of profit attributable to each key employee, and is then multiplied by the excess. This number is then multiplied by the number of years it will take to hire and train a replacement.
Cost of Replacement Method
This method calculates the direct costs required to interview, hire, and train a replacement. It also includes an estimate of opportunity costs due to the loss of the key employee.
While most companies use ﾓTerm Lifeﾔ Insuranceﾔ to fund a key man policy you do have the choice of either using a ﾓTerm Lifeﾔ or ﾓWhole Lifeﾔ Insurance policy, the difference is really the cost and your companies financial position. You should get quotes on varying amounts such as two, five or ten times the key employeeﾒs salary and compare the costs of each.
Then think of how much money your business would need to survive until it could replace the key person, come up to speed and get the business back on its feet. Be sure to buy a policy that fits into your budget and addresses your short-term cash needs in case of tragedy.
It is not fun to think about, but key man life insurance is an affordable way to ensure the future of the business these critical employees you are insuring have worked so hard to make successful.
Glenn S. Ferguson, FLMI, HIA, founded Comprehensive Insurance Agents & Brokers & Comprehensive Consulting to assists both large, multi-national corporations, as well as smaller family owned businesses with their insurance decision-making. Glenn has been helping individuals and businesses in the Bahamas with their insurance needs for the last 18 years. He is a Fellow, Life Management Institute (FLMI); Associate of The Health Insurance Association of America (HIA) and a licensed insurance broker.
