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For a small business, the owner or other key individual often serves as the engine behind the company. In addition to providing leadership, these people often help to secure the financing necessary to keep an organization moving forward. That's why key person insurance can be a vital planning tool.
What Is the Purpose of Key Person Insurance?
Essentially, it's a life insurance policy that is typically taken out on a business owner or other key individual. However, unlike personal life insurance policies, the business typically pays the premiums and is the beneficiary of the policy. The goal of this coverage is to help keep a business operational after an individual passes away and, if that's not possible, to help pay outstanding debts. Some policies also include a rider that provides benefits if the key person becomes disabled.
Why Would a Business Owner Need Key Person Insurance?
For closely held businesses, the death of a business owner or other key individual can suddenly leave a company without the expertise or capital it needs to perform day-to-day operations. Unless they have enough cash to buy the deceased person's shares, the remaining partners or heirs could be forced to sell the business to an outside party that may or may not act in the best interests of the employees and other stakeholders.
The death benefit from key person insurance helps to provide a vital source of cash that these parties can use to find and hire a suitable replacement. Even in cases where the business's long-term viability looks doubtful, the money can help the business wind down operations by paying off outstanding debts, providing severance pay for employees and addressing any other financial obligations.
If the business is highly dependent on a certain person or people, some banks may even require the organization to have such a policy in place before providing a loan. As such, key person insurance may prove valuable even in cases where the individual outlives the term of a policy.
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How Much Coverage Do You Need?
Typically, the goal of key person insurance is to provide a death benefit that's sufficient to help the business stay afloat after a key individual dies or becomes disabled. The management team might use one of the following methods to measure the employee's financial worth to the organization:
- Current Salary: With this approach, the business may multiply the employee's compensation by a certain factor that reflects the difficulty of replacing that individual. While this method can be helpful in some cases, it may not be the best choice in cases where the key person is an owner who intentionally accepts a below-market salary.
- Contribution to Profits: Another strategy is to calculate the key employee's contribution to annual profits — taking into account relationships they have built with suppliers, customers or lenders.
- Cost of Replacement: Another method businesses may use to determine the size of a key person policy is tallying all of the costs involved in finding, hiring and training a qualified candidate to replace the insured individual. In addition to factoring in the direct expenses incurred, the business may want to consider the "opportunity costs" involved — that is, the sales or business relationships lost by the key person's death or disability.
The Bottom Line
If you're considering key person insurance for your business, consider speaking with a financial representative. They can help you determine the amount of coverage your business needs.