Key man insurance cost calculations

Key Man Insurance Cost vs. Benefits

How much does key man insurance cost and is it worth it for your growing company? If you’ve been considering life insurance policies for your top executives or key employees, here’s what you need to know about cost vs. benefits.

Key Man Insurance Cost

The cost of a key man insurance policy depends on a number of factors:

  • The health, gender and age of the person a company is insuring
  • The face amount of the policy (aka the amount of the policy’s death benefit)
  • The size of the company—bigger companies are typically worth more and require more key man insurance coverage
  • The type of insurance purchased: term life insurance, permanent life insurance, or disability insurance

Term Life Insurance

Term key man insurance costs significantly less than permanent life insurance, but also comes with significantly less in the way of benefits. In fact, the only benefit a term policy offers is a death benefit paid out to the company should the insured pass away within the specified term, usually 10, 20, or 30 years. 

If the insured outlives the term specified in the key man insurance policy, the company may choose to renew the policy. Often, renewing term insurance costs more than the original policy premiums, due to the insured’s increase in age and/or changes in health.

When purchasing term insurance for key man coverage, companies often choose terms based on the insured’s projected retirement date. This locks in the lowest possible policy premium now and helps the company avoid increased costs associated with renewing key man policies down the road. The policy terminates around the date an executive or key employee retires, at which point there is no need to further protect the individual’s contribution to the company. 

In addition to deciding how long to insure key employees, companies must decide how much insurance is needed. Key man insurance costs widely fluctuate depending on how much insurance is purchased. The two most common ways to determine how much insurance is sufficient are:

  1. Contributions: How much value does a key employee bring to the company and how much would it cost to replace his/her contributions (including hiring, training, relocation costs, building a new book of business, managing client relationships, etc.)? Is the key employee a specialist that would require extensive resources to replace?
  2. Compensation: How much does the company pay a key employee (including salary, bonuses, commissions, etc.) and is it sufficient to cover the cost of hiring someone to replace him/her? Would multiple hires be required? 

Insurance companies will place a limit on key man policy amounts, typically based on how much an employee is worth (how much they are compensated), often 10x an employee’s salary. For example, if a key employee makes $100,000/year, a key man insurance policy on that employee may not be underwritten with a face value exceeding $1 million. 

For businesses just starting out, it’s common for key shareholders to forego a salary in the first few years, or take a very small salary until the business gets its footing. In this case, it’s more difficult to prove a person’s worth. A good rule of thumb is to compare policies and opt for the most coverage the company can afford and the insurer will underwrite. 

Permanent Life Insurance

Permanent key man insurance costs significantly more than term life insurance, but can also offer the most mileage for dollars spent in policy premiums. When policy premiums are paid on permanent insurance, a portion goes to pay for the death benefit of the policy and a portion goes toward the policy’s “cash value”—a built-in savings component that earns interest and potential dividends. The cash value of a permanent key man policy can be utilized by the company in a number of ways:

Liquidity

Permanent key man insurance offers access to cash flow for business capital, expenses, property, equipment, acquisitions, etc. without relying on banks or Small Business Association (SBA) lenders. 

In fact, most banks and SBA lenders will require a company to have key man insurance on key stakeholders in order to qualify for a loan. While term key man insurance will meet this requirement, permanent key man insurance allows a company to bypass the bank altogether by taking out a policy loan on an insurance policy instead. 

The perks of policy loans can include lower interest rates and the company determines the payback terms of the loan, plus the insurance company may still pay interest and potential dividends on the full cash value, regardless of the amount borrowed.  

Example: 

ABC Corporation needs a $50,000 loan for new machinery to meet rising demand. It takes out a policy loan from one of its key man insurance policies, which has $200,000 in accumulated cash value. The insurance company charges 7% interest on the loan, but they pay a guaranteed 5% rate of return on the cash value of the policy. 

It costs ABC Corporation a total of $53,500 for the new machinery (loan + interest), but in the same fiscal year the key man policy’s cash value grows to $210,000 (cash value + guaranteed rate of return). ABC Corporation had a net gain of $6,500 and recaptured the interest paid.

Tax Benefits

Permanent key man insurance policies receive tax-advantaged treatment that can help grow and protect a company’s wealth. While the policy premium itself isn’t tax deductible (neither are term policy premiums), permanent life insurance earns tax-deferred interest and potential dividends that can be utilized tax-free by the company.

Policy loans are tax-free and allow a company to access earned interest and dividends tax-free. 

Incentives

Permanent life insurance lasts for the duration of the insured’s life. When a key employee retires, the company can opt to transfer the insurance policy to the former employee or retain the policy but reassign the beneficiary as the former employee’s family/estate. 

If the company chooses to transfer the policy to the former employee, the key man insurance cost becomes the responsibility of the former employee, but they also receive all the accumulated cash value to use as they wish. The former employee then reassigns the beneficiary as their own family, estate, or charity of their choosing.

If the company opts to retain the policy, the company is still responsible for the key man insurance cost but also still has access to the cash value to use as business capital. Once the former employee passes away, the death benefit goes to the former employee’s beneficiaries and the policy is closed.

Either of these options function to provide an incentive to key employees and can even be structured to replace a 401(k). In some cases, the incentive can be structured to go into effect before retirement, like as a bonus for years of service or achievement. 

Disability Insurance

Sometimes key man insurance is purchased in the form of disability insurance, where the insurance policy pays out if a key employee becomes disabled and can no longer work. Depending on the policy, it may pay out if a key employee is temporarily unable to work or permanently unable to work. How the policy is structured will determine key man insurance cost for disability coverage.

Benefits of Key Man Insurance

Regardless of the type of key man policy you choose, it can provide financial continuity in the event a key person passes away or becomes unable to work. Here are the most common ways it is used:

  • Provides funds for replacement hires and training
  • Helps resolve outstanding debts and avoid bankruptcy
  • Helps meet obligations to investors and lenders
  • Provides severance pay in the event the company must close
  • Offsets lost income, especially if key person was in a sales position
  • Provides business partners/shareholders with buy-sell options

Who Pays for Key Man Insurance?

In the case of term or disability key man policies, the cost of insurance is the responsibility of the company. 

The company also pays for key man policies structured with permanent life insurance. It’s not uncommon for a properly structured permanent life insurance policy to earn enough interest and dividends that it pays for itself. This is also known as a self-paying or paid-up policy.

As previously mentioned, if a permanent insurance policy is later transferred to a key employee, the employee is responsible for the key man insurance cost if the policy isn’t self-paying or paid up. 

Should a company decide they want to utilize the cash value of a permanent key man policy while the insured is working for the company, but not wish to retain the policy or use it as an incentive after a key employee retires, they may opt to withdraw the remaining cash value and terminate the policy. Any gains will be taxed accordingly.

Key Man Insurance Riders

Insurance riders are supplemental insurance that provide flexibility to policies. Adding a rider may increase your key man insurance costs, but also gives a company more options as to how it utilizes its policies.

Business Exchange Rider

A business exchange rider allows a company to transfer a key man policy from one employee to another. Should a key employee resign, quit or get fired while a key man policy is still in force, the company may reassign the insured from the former employee to a new employee without additional underwriting.

The key man insurance cost will change to reflect the health status, gender and age of the newly insured employee. In the case of a permanent life insurance policy, the cash value will be preserved.

Return of Premium Rider

This type of supplemental insurance is for term key man policies. If the insured outlives the designated term of the insurance policy, some or all of the premiums may be returned to the company. 

Disability Rider

Key man insurance policies can be structured as disability insurance policies, but you may also have the option to add a disability rider to a life insurance policy. With a disability rider in place, a company may be able to access a portion of a policy’s death benefit in the event the insured becomes disabled. Essentially, it’s an advance on the death benefit of the policy and offers flexibility to cover more unexpected events.

Advanced Key Man Insurance Considerations

Higher net worth companies and family-owned businesses may have additional options for covering key man insurance costs: premium-financed insurance and the split-dollar arrangement.

Premium-Financed Insurance

If a company is large enough, banks will lend it money to pay insurance premiums on very favorable terms. The company will only be responsible for paying interest on the premium loan. This could equate to obtaining the benefits of permanent key man coverage at a term insurance price.

The experienced Wealth Strategists at Paradigm Life can help facilitate premium-financed insurance for well-qualified business owners. For more information, call 801-406-1064.

Split-Dollar Arrangement

Often used to retain and attract valuable employees, split-dollar arrangements utilize properly structured permanent life insurance to fund a large life insurance plan on the employee. The death benefit is split with the employee’s estate when he/she passes away. 

In a split-dollar arrangement, a company loans a key employee funds to purchase life insurance. The employee is responsible for claiming the amount of interest from the loan as earned income on his/her income taxes. When the employee passes away, the key man insurance cost is recouped by the company and the remainder of the benefit (earned interest and potential dividends) goes to the employee’s estate.

Conclusion

There’s more to consider when it comes to key man insurance cost than the price of the insurance policy premium. Not having sufficient insurance and a financial business succession plan are major contributors to bankruptcy, especially for small companies and family-owned businesses. Choosing the right policy for your company’s needs helps your business survive the unexpected and permanent key man policies can offer financial alternatives that help a company retain more of its profit.

For help finding the right key person policy for your budget, schedule a free consultation with a Paradigm Life Wealth Strategist today.