Insurance Choices Now Can Save Your Business Later
By Hilary Ingoldsby Whitesides
December 29, 2011
You probably know that when it comes to your business, you can never be too safe. Fire insurance, alarm systems, workers compensation and even life insurance are some of the most important ways to protect your company. But there is another step that might be the most important step you ever take toward protecting your business’ future: having key man insurance.
As the name suggests, key man insurance covers the company in case of an unexpected death or disability of a key employee that would seriously hurt the company’s cash flow.
“The concept is that a business will look at its employees and determine who is a key person in the organization, who if something were to happen to them it would have a negative financial impact on the company,” says Ric Tanner, senior vice president of Moreton Financial Solutions. In short, key man insurance functions like life insurance with the company as the benefactor.
Key man insurance is predominantly divided into two categories: term and permanent life. Term insurance, as Tanner explains, is much like renting an apartment. If you continue paying rent, you have use of the apartment. With term key man insurance, as long as you pay the premium, the coverage continues. However, when the time limit is up, the policy loses its monetary value—just as you would have no equity in the apartment when you moved out. Though premiums commonly increase with age, many businesses choose this type of coverage because it is less expensive or because the business’ executives know the covered employee will only be with the company for a determined amount of time.
Permanent life, however, provides coverage that never lapses and lasts until the covered employee dies, guarantying the company will receive an eventual payout from the policy. Because a permanent life policy has more economic value over the long run, the policies are also more expensive. But, some companies choose this type of coverage to ensure reimbursement after paying into the policy for so many years, even if the employee has already retired.
“From a long-term perspective it’s a great technique to cover risk while the insured employee is working there, but once they’ve left the business the company will still get an influx of cash to reimburse for the cost of the insurance,” Tanner says.
As with life and health insurance, some pre-existing conditions may disqualify employees from key man coverage. When applying for key man disability coverage, businesses may be required to provide proof that the loss of the employee would be financially detrimental to the business. According to Tanner, key man disability is usually defined as a permanent disability that prevents the employee from ever returning to work—not a short term condition.
Besides replacing the cash flow that may be lost from losing a key employee, key man insurance benefits are substantial. Returns from the policy can help recruit a new employee to replace the deceased and provide an income incentive for them, Tanner says. However, perhaps most important of all is the common role of key man insurance in a joint ownership where company stock is involved.
“Companies will cover key persons or big share holders so they are provided a way to buy that person’s share of the company if it’s been worked out that the heirs won’t become partners,” Tanner says.
Other companies choose to transfer the policy to the personal life insurance of the covered employee when he or she retires.
Whatever the case, Tanner says most big businesses and many small businesses should have key man insurance.
“It’s critical for many businesses to have an agreement that identifies what will happen if one of the partners becomes disabled or passes away,” Tanner says. “How are we going to deal with this? Will the spouse be the partner? Will we buy their stocks? If so, how are we going to fund this?”
Key man insurance, in case of death or disability, may answer those questions and lessen the financial blow to the company. “Every company has key employees and the majority of businesses have [key man insurance], especially if they have a buy-sell agreement with partners,” Tanner says.