- What is Key Person Insurance and Why Do I Need It?
- Key Person Insurance Explained
- Why Is Key Person Insurance Important for Your Business?
- Who Needs Key Person Insurance?
- How Much Key Person Insurance Does My Company Need?
- Getting the Right Key Person Insurance Policy
- Working With the Right Insurance Provider
- Key Factors in Pricing Premiums
- Conclusion and Summmary
1. What is Key Person Insurance and Why Do I Need It?
The unexpected loss of a business leader can derail even the strongest company. But key person insurance provides protection to keep your operations running smoothly if a vital team member can no longer contribute.
This coverage is essential for privately-held firms that rely on a few key managers to drive performance. Yet many organizations underestimate their needs and struggle to implement the right policies.
If you are a business owner, stakeholder or investor, we at ShockProof.me are your expert partners to help you in the crucial task of properly structuring your key person coverage. This guide will walk through the key considerations to secure the right coverage for safeguarding your business. We'll look at:
- Defining key person insurance and how it works
- Assessing your company's unique risks and coverage needs
- Designing customized policies tailored to your situation
- Choosing the right carrier and coverage features
- Estimating costs based on risk factors
With an experienced advisor's help, you can implement smart key person insurance to protect against leadership losses destabilizing your business. Such coverage is essential for small and mid-sized companies lacking management redundancy.
Rather than leaving things to chance, let ShockProof.Me help develop your risk management strategy. Our team makes securing the right policies smooth and simple.
2. Key Person Insurance Explained
Definition and Purpose
Key person insurance provides a payout to a business if a vital employee dies or is unable to work due to illness or injury. It helps offset financial losses related to that person's absence for an extended period. Companies insure C-suite executives, technical experts, rainmaker salespeople, and other indispensable team members whose prolonged loss would significantly impact operations and profits.
Key person insurance gives policyholders tax-free proceeds to draw upon in the event of losing someone integral to the business. This can help counteract numerous problems that arise, such as plummeting sales, delays in operations, and reputational damage. The funds act as a financial safety net to minimize disruption and ensure continuity of business performance.
How Does It Work?
The company takes out a life insurance or critical illness & disability insurance policy on the key employee. In the unfortunate event that the policy conditions are triggered, such as death or inability to work, the insurer then pays out a pre-determined lump sum directly to the business.
This insurance payout can provide vital liquidity and be utilized in several ways:
- Replacing lost income and decreased profits during the transition period
- Funding the recruitment, hiring and training costs for a replacement
- Compensating temporary staff or consultants to fill the expertise gap
- Maintaining credit terms and relationships with lenders and suppliers
- Preserving or restoring the company's valuation, which may suffer due to uncertainty
The lump-sum payout gives businesses access to ready capital exactly when it is needed most - during a leadership crisis. The funds provide stability and ensure business continuity, helping bridge the gap until long-term arrangements are made after the key person's departure.
What Events Trigger a Payout?
Key person policies generally come in two main forms:
Life Insurance pays out upon the insured's death. This covers against the permanent loss of someone who was central to operations - whether an owner, executive, technical expert or sales rainmaker. It provides a lump sum to begin the difficult process of permanent succession planning.
Critical Illness & Disability insurance pays out if the insured person becomes unable to work due to unexpected illness or injury. Often this pays out if the key employee cannot carry out their normal occupational duties for a period of time. Policies specify whether they cover partial disability, total disability, or both depending on the individual's role and responsibilities.
While unpleasant to consider, it is prudent for businesses to evaluate their vulnerabilities and implement coverage for either permanent or temporary loss of vital staff who would be difficult or impossible to replace quickly.
3. Why Is Key Person Insurance Important for Your Business?
Losing a key team member without warning or planning can have wide-reaching impacts on small and mid-sized businesses. Here are some of the major reasons this type of coverage matters:
Protect Against Financial Loss
Replacing someone's salary and profit contribution takes significant time. Lost income in the interim while being short staffed in a leadership position can severely endanger the business. Key person insurance provides readily available funds to cover those losses and maintain stability.
Fund Recruitment and Replacement
Finding a qualified successor and getting them fully up to speed typically takes months. The capital available from a key person insurance payout can cover expensive search costs, headhunter fees, signing bonuses, and premium salary offers to attract someone of equal caliber and expertise.
Maintain Business Operations
Banks, vendors, customers and partners will likely grow concerned about doing business with the company during a poorly managed leadership transition. Access to payout funds can prevent disruptions by demonstrating operational stability and continuity to these important stakeholders.
Preserve Company Value
The unexpected loss of a top level employee before a succession plan is in place often erodes business valuation due to the uncertainty it creates. Key person insurance payouts help offset potential valuation drops that could result from decreased earnings performance during transition periods.
Provide Reassurance to Stakeholders
Implementing proper key person coverage demonstrates good risk management to shareholders, lenders and prospective buyers or investors. It signals that operations are insured against disruption if top leadership talent were lost. This is especially important for privately held companies with concentrated management.
4. Who Needs Key Person Insurance?
While all businesses benefit from continuity planning, certain types are at heightened risk if they lose a top contributor without adequate coverage or succession planning in place:
Small Businesses
Owners are often directly involved in day-to-day operations or even personally generate much of the revenue. If suddenly incapacitated by death or disability, the financial impacts can be company-ending without insurance to provide bridge financing.
Companies Reliant on Management
Firms highly dependent on a few executives' unique skills, relationships and institutional knowledge have outsized exposure if one leaves unexpectedly. Key person coverage allows continuity funding to pay for replacement management talent.
Partnerships
Partnerships losing a founder or managing partner can face complex challenges transitioning ownership stakes and decision-making authority. Insurance payouts give breathing room to restructure leadership and operating procedures with reduced time pressure.
Recently Merged Firms
Following a merger or acquisition, departures of executives overseeing integration of systems and processes can jeopardize the consolidation's success. Key person policies on certain individuals provides capital to hire temporary specialists to fill any knowledge gaps.
Businesses Planning Leadership Changes
Founders planning retirement, ownership transition, or a sale of the business in the next 3-5 years should strongly consider insuring themselves during the multi-year exit process. This protects company value from their loss derailing succession plans already in motion.
5. How Much Key Person Insurance Does My Company Need?
Securing adequate coverage is crucial, and requires conservatively estimating potential financial impacts if a key person were unable to work for an extended period. Consider:
5.1. Assessing the Impact if a Key Person Could No Longer Work
Estimate Value Lost
Thoroughly calculate the key person's total economic value and current contribution to the company through factors like salary, bonuses, profit distribution, commissioned sales generation, and overall impact on performance and operations. Also factor in harder to quantify value likely lost through decreased productivity and efficiency during a long transition period.
Factor-in Time to Get Back on Track
Industry experience shows most companies realistically take a minimum of 6 months, and more often closer to 12 months to return to normal profit levels after unexpectedly losing a key team member. The payout needs to sufficiently cover revenue shortfalls and additional costs for this entire period.
5.2. Determining Appropriate Coverage for Each Key Person
Tailor coverage amounts to each individual's economic contributions and the estimated time and expenses related to replacing them:
Salary and Benefits
Covering 1-2 years of compensation protects against lost productivity while funding temporary staffing and recruiting efforts for a permanent replacement.
Profit Contribution/Loss
Estimate total revenue and profit decreases likely to result from the person's absence. Factor in their economic impact based on role, responsibilities, experience and relationships.
Cost to Find Replacement
Include projected search fees, headhunter costs, hiring bonuses, relocation packages and other costs necessary to attract a successor of equal caliber and expertise.
Customising Coverage by Leadership Role
Requirements differ based on the insured's organizational role and breadth of business responsibilities:
Owners/Partners
Majority shareholders or sole owners warrant high coverage limits given their disproportionate economic and operational impact if lost. Partners may require less if others can effectively fill the gap.
Top Executives
Insuring C-suite positions like CEO, CFO, COO provides interim leadership funds if a vacancy arises and reassures employees, customers and investors about stability.
Technical Experts and Rainmakers
Technically irreplaceable wizards and salespeople generating large revenues warrant coverage thar reflects their outsized economic contributions. Their niche skills and client relationships can depart with them.
6. Getting the Right Key Person Insurance Policy
Work closely with an experienced advisor to structure optimal policies and streamline this complex process. Here are key considerations:
Choosing Coverage Features
The right product design will maximize protection while optimising cost, depending on role:
Length of Benefit Period
For disability policies, choose shorter benefit periods to limit prolonged payouts unless total disability is likely. Longer benefit periods provide more protection but cost more.
Critical Illness & Disability Coverage
Assess the need for partial vs. total disability policies depending on the key person's responsibilities and feasibility of them working reduced hours in a disability event.
Life Insurance or Buy-Sell Agreement
For founder shareholders and investors, a buy-sell agreement can be funded by life insurance, forcing the company to buy back the owner's shares upon death. See our section on Shareholder Rights Protection.
7. Working With the Right Insurance Provider
The carrier's expertise with key person coverage also matters:
Adviser Guidance
At ShockProof.me we are both expert advisers and independent brokers. We provide guidance on more specialized products and structuring from multiple highly-rated insurers.
Flexible Underwriting
Partner with an insurer willing to consider creative underwriting approaches to avoid coverage gaps for non-standard cases.
Ongoing Policy Management
Pick a provider that helps monitor changing client needs and proactively amend policies as required over time as companies evolve.
8. Key Factors in Pricing Premiums
Multiple variables determine policy pricing, including:
Age and Health
Younger, healthier insureds often qualify for lower premium rates whereas higher risk groups pay more.
Insured Salary
Deciding how much income to replace will depend on the key person's role and risk of disruption.
Critical Illess & Disability Benefit Amount
Higher total coverage amounts can require significantly higher premiums.
Policy Term
Longer benefit terms increase the cost of insurance, but give assurance of coverage for the full term. Shorter terms may be cheaper now, but any future renewal will be at a higher cost, or may be impossible if the health circumstances of the key person have changed.
9. Conclusion and Summmary
Key person insurance enables smart companies to invest now in protecting against unexpected loss of leadership talent. Partnering with expert advisors simplifies the process of securing and optimally structuring this vital coverage.
- Key person insurance is essential for privately-owned companies that rely on vital team members to drive performance.
- Key person insurance provides financial protection if a crucial employee dies or is unable to work due to illness or injury.
- It helps offset financial losses, maintain business operations, and preserve company value during leadership crises.
- ShockProof.me helps businesses properly structure their key person coverage and offers expert guidance.
Don't leave your company's future to chance. Contact us today to discuss your needs.