Key man insurance is life and disability insurance which covers a business owner or key employee. The business owns the policy, pays the premiums, and receives the payout if the key person dies or experiences a covered disability. This allows the business to continue and offsets expenses and loss of income that can occur in the key person’s absence.
According to surveys by the National Association of Insurance Commissioners, more than 60% of Americans have personal life insurance, but only 22% of American business owners have key man life insurance, leaving their business unprotected if a key person passes away. In this article, we’ll tell you everything you need to know to protect your small business with key man insurance, also known as key person insurance.
AXA ranked number one global insurance brand for the 8th consecutive year and is the sponsor of this article.1 Click the link below for a free quote on your key man life insurance policy.
What Key Man Insurance Is and What It’s Not
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 dies or becomes disabled. 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.
Michael DiPiazza, National Director of the Business Strategies Group at AXA, says 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, says DiPiazza, 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.
This article is about key man insurance that’s purchased to continue the business and offset expenses and loss of income if a key person dies or becomes disabled. It does not address insurance to fund buy sell agreements. For a discussion of buy sell agreements and insurance that can be used to fund them, click here.
Do You Need Key Man Insurance?
Thomas McGlynn, Assistant VP for Advanced Markets at AXA, says, “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).
How Much Does Key Man Insurance Cost?
The good news is that key man insurance is generally an affordable business investment, with premiums ranging from approximately $100 per year to a few thousand dollars per year depending on the number of key people insured and the amount of coverage (for term policies; permanent/whole life insurance is typically costlier).
The cost of key man coverage varies based on the following:
- Key person’s age, gender, and health – According to InsuranceQuotes.com, men will pay 38% more than women for life insurance. Smokers pay a 235% premium! In general, the older you are and the more pre-existing health issues you have when you purchase your policy, the higher your premium will be.
- Company structure and size – For example, it will cost less to insure a 2-person partnership compared to a corporation with several owners and employees. The higher the value of the business and the key person’s contributions to the business, the larger the amount of coverage needed and therefore the higher the premium will be.
- Industry – Premiums can be higher for riskier industries.
- Amount of coverage and type of policy – The more coverage you get, the higher your premiums will be. Term insurance is less expensive than permanent life insurance. If you add disability coverage, that will cost extra.
The charts below show AXA’s average rates for key man life insurance policies, based on quotes from www.keypersoninsurance.com. These rates are for term policies, which are most popular with small businesses. AXA provides key man policies in 10, 15, and 20 year terms, as well as year-to-year renewable terms.
Premiums for permanent life insurance are generally about 5 to 10 times more expensive than term life insurance.
Sample Key Man Insurance Costs – Example One
Example 1: The insured key person is a 40 year old non-smoking male in excellent health.
|Amt. of coverage||10 year term policy||15 year term policy||20 year term policy|
|$1 million policy||$390/year||$585/year||$705/year|
Sample Key Man Insurance Costs – Example Two
Example 2: The insured key person is a 45 year old non-smoking woman in excellent health. The premiums are higher because of the insured’s older age.
|Amt. of coverage||10 year term policy||15 year term policy||20 year term policy|
|$1 million policy||$545/year||$695/year||$915/year|
When you’re shopping around for key man insurance, there are three things to keep in mind:
- You can increase your coverage limit by a lot for a relatively small increase in premiums.
- Don’t always choose the cheapest policy.
- Be flexible – your coverage limits may need to change over time.
You may think that a $1 million key man policy is going to cost 10x time more than a $100K policy. However, premiums are not priced that way. Premiums on a $1 million policy will cost you only about 4x as much as the premium on a $100K policy.
Think about the future when deciding how much coverage and what term to get. For instance, if you get a 10-year policy, it may be cheap now. However, once it expires, you’ll have to renew, and premiums can go up significantly because the key person is a decade older and has potentially developed health issues.
Your coverage limits may change as your business evolves. A $100K policy may be enough today, but the value of a key person to your business may increase two or threefold over the next several years. Fortunately, most key man policies allow you to periodically update your coverage limits, so you don’t have to start from scratch and get a new policy each time.
Michael DiPiazza, National Director of the Business Strategies Group at AXA, says that “The best rule of thumb is to choose coverage for as long as you anticipate it will be needed for the least amount of cost.” He provided a few examples. If you have a key employee who is 55 years old, a 10-year key man policy might be sufficient because it’s likely that they will retire in the next decade. However, if you have a 47-year old key person, you may need a 20-year term to protect yourself until he or she retires. Locking in a 20-year term also means your premiums won’t increase down the line before the employee reaches retirement age.
The bottom line is that a small investment now in key man insurance can save your business thousands, even millions of dollars, when it’s in its most vulnerable state. To get a quote for your business, click here.
How Much Key Man Coverage Do You Need?
Now that you know how key man insurance works and how much it costs, you’re probably wondering just how much coverage you’ll need. AXA provides policies with coverage limits ranging from $100,000 to as much as 10x the key person’s compensation.
Just like buying personal life insurance can raise some unknowns, there’s no single way to figure out how much key man coverage you’ll need. But here are some approaches that insurance agents often recommend and that has worked well for small businesses:
- What is the key person’s compensation? Many key man policies are assessed as a 5x-10x multiple of the key person’s compensation (salary+bonus+other perks). For example, if the key person earns $100,000 per year, then you might consider getting, at a minimum, a $500,000 key man policy.
- How much would it cost to replace the key person? The biggest disruption from losing a key person may be the time and money it takes to find a replacement and train that individual. To help figure out how much coverage you need, you can calculate how much money it would take to hire and train a replacement for the key person. You should also factor in the decline to company revenue during the hiring/training period.
- How much has the key person contributed to my business? A key person may have contributed profits, intellectual property, or valuable customers to the business. One guideline for key man policies is to calculate the percentage of company profits that the key person contributed and then multiply that by the number of years it would take to replace the individual.
Example: if the business’ net profits were $1,000,000, and the key person brought in $250,000 in income, they contributed 25% of the company’s profits. If it would take 2 years to find and train a replacement for the key person, you may want to purchase a $250,000 X 2 = $500,000 key person insurance policy.
The best approach is to come up with an estimate of the amount of coverage you think you might need and then to confirm that with a trusted business advisor or insurance agent. Your insurance agent will go through your income statements and books with you to ensure you are purchasing adequate coverage.
Purchasing Term vs. Permanent Key Man Life Insurance
There are two types of life insurance that you can purchase for your key man policy:
- Term life insurance – This is the most common type of life insurance. The insurance company will pay a death benefit if the key person dies during the term of the policy. For example, if the business purchases a 20-year term life insurance policy, it will pay premiums for 20 years and will receive money if the key person dies during the 20-year period. Once the policy term is over, you must renew your coverage.
- Permanent/whole life insurance – Whole life insurance offers lifetime coverage and a cash value that builds up over time. No matter when the key person dies, the policy will provide coverage. While the key person is alive, the business can get cash by surrendering the policy or borrowing from the policy if needed.
Loretta Worters from the Insurance Information Institute says that most small businesses go with term life insurance because it’s more affordable. About 80% of AXA key man insurance policies are funded with term insurance. Since it’s more affordable, you can buy more coverage with term insurance. For example, a $200/year budget might allow you to buy a $100K 20-year term life insurance policy, but you’d need $1,000/year to purchase a $100K whole life policy.
While permanent life insurance is generally more expensive than term insurance, it does have a few benefits:
- Simplicity – The policy has no expiration date and doesn’t have to be renewed. If the key person named in the policy leaves the business, the policy can be bought with riders so that the insured’s name can be changed if the key person leaves the company or retires.
- Incentivizes a key employee – You can incentivize a key employee by allowing him or her to share in the policy’s cash value. McGlynn says some businesses use a deferred compensation arrangement. The key person foregoes some portion of his or her income while employed, and the business pays for the premiums. When the key person retires, the business can use the cash value built up in the policy to pay a monthly retirement benefit.
- Future financial flexibility – The company can borrow against the cash value in the policy if it’s in a cash crunch.
Some term life insurance policies are convertible to whole life insurance, so check with your insurance broker if you’ll be able to switch and when.
Adding on Key Person Disability Coverage
It’s important to get both key person life insurance and disability insurance. It’s easy to overlook disability insurance, but an individual is statistically more likely to become disabled than to have an untimely death.
The Council for Disability Awareness estimated that more than 1 in 4 people who were 20 years old in 2013 will become at least temporarily disabled before retirement. However, only about 15% of small businesses have key man disability coverage, based on a survey by the National Association of Insurance Commissioners.
While you can purchase disability and life insurance policies independently for more comprehensive disability coverage, the disability policy is usually a rider on the key man life insurance policy. Most insurers will pay a portion of the key person’s salary, usually 50-60%, if he or she becomes disabled.
Sometimes, there’s a waiting period before the benefits kick in, and there’s a benefits period during which the insurer will pay the benefits. The waiting period and benefits period will differ depending on whether you purchase short term disability insurance or long term disability insurance. To learn about the difference, click here.
Insurance companies have different definitions on what constitutes a “disability,” but it’s usually defined as the “inability to perform the material duties of the position.” For example, a leg injury that still allows the key person to work may not qualify, but something that confines them to a hospital for awhile probably will qualify.
Ask About Including a Business Exchange Rider
What if your key person decides to leave the business, and you hire a replacement? A business exchange rider allows the business to substitute a new key person for the key person identified in the insurance policy. There may be a change in premiums, coverage level, and the cash value of the policy (if it’s permanent life insurance). However, if you have this rider, the insurance company will not charge you money for a new application or for underwriting, allowing you to save some money.
If your key person leaves and you don’t hire a replacement, you can simply cancel the policy. There’s usually no charge to cancel a term policy; you just stop paying the premiums, and the coverage ceases. Permanent (cash value) coverage typically has a surrender charge that decreases over time which may diminish the amount of cash value you get back, depending on how long the policy is in force before you surrender it.
Tax Treatment of Key Man Insurance
Businesses Must Obtain Key Person’s Consent for Tax Free Death Benefit
If a business files a claim for key man insurance, the proceeds are generally not considered taxable income. This means the business will get the full face value of the policy. In other words, a $1 million policy means the business will get $1 million if a valid claim is filed.
The fact that key man insurance proceeds are tax free is a big benefit for businesses, says DiPiazza. However, to enjoy this benefit, the business must obtain the written consent of the key person whose life is insured. This is designed to protect employees from exploitation and also to allow employers to make ‘quid pro quo’ arrangements. For example, the business might agree to make some of the death benefit available to the key employee’s heirs.
Under the Pension Protection Act of 2006, businesses that own life insurance policies on employees of a business must do all of the following:
- Notify the employee in writing of the amount of coverage.
- Notify the employee that the business is the beneficiary under the policy.
- The employee must provide written consent to the coverage.
There’s no exception to these rules if the key person is the business owner. If the business owner is the key person, he or she should still sign a form providing consent for the policy.
Your insurer will usually provide you with an Employer Notice and Consent Form to obtain the necessary consent. To learn more about the Pension Protection Act and notice and consent requirements for businesses, click here.
We always recommend checking with your tax professional and lawyer to determine what will work best for your business. Note that these same notice and consent requirements do not apply for key man disability insurance.
Premiums Generally Not Deductible
A business typically cannot deduct premiums for key man life insurance on its tax return. The IRS rule is that “you generally cannot deduct the premiums on any life insurance policy, endowment contract, or annuity contract if you are directly or indirectly a beneficiary. The disallowance applies without regard to whom the policy covers.” Find out more info at IRS.gov.
Note, however, that if you choose to purchase disability coverage on a key person, you may be able to deduct those premiums.
The Bottom Line
Key man insurance can be critical for your small business if there’s a key person who is central to its continued success. Calculating the right amount of coverage for your business can be tricky though, so it’s best to talk to an experienced insurance agent.
AXA has many agents specializing in small business insurance. An experienced broker will be able to ask you the right questions and develop an estimate of how much coverage you need and how best to structure the coverage.
1 AXA S.A. has been ranked the No. 1 insurance brand in the world by Interbrand for eight consecutive years as of Oct. 5, 2016.
Applications for life insurance are subject to underwriting. No insurance coverage exists unless a policy is issued and the required premium to put it in force is paid.
Please be advised that this document is not intended as legal or tax advice. Accordingly, any tax information provided in this document is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer. The tax information was written to support the promotion or marketing of the transaction(s) or matter(s) addressed and you should seek advice based on your particular circumstances from an independent tax advisor.
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“AXA” is the brand name of AEFS and its family of companies, including AXA Equitable Life Insurance Company (AXA Equitable) (NY, NY), MONY Life Insurance Company of America (AZ stock company, admin. office: Jersey City, NJ) (MONY America), and AXA Distributors, LLC. All group insurance products are issued either by AXA Equitable or MONY America, which have sole responsibility for their insurance and claims-paying obligations. Some products are not available in all states.
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