key person insurance

What is Key Person Insurance? Also known as “Key Man” Insurance, or Company Owned Life Insurance (COLI), it is a type of life insurance that provides coverage for vital individuals of a business.

Who is Considered a Key Employee?

The employees designated as “key” are solely determined by the business. Business owners, presidents, vice presidents, other executives, or even employees can be considered key, depending on their value to a company. Anyone who is crucial to the ongoing success of the business may be considered a key person.

This type of life insurance is used to protect the business if the insured individual suddenly dies. For instance, if an insured individual (like the business owner) suddenly dies, the company is able to receive a death benefit to stay afloat while a replacement is found, which can sometimes take years. It also allows other business partners to buy the company from the deceased’s estate. This protection allows for a business to not fear ownership portions of the company to be bequeathed to any heirs that do not have an interest in the corporation’s future success.

Benefits of Key Person Insurance

Just like taking out a life insurance policy on a family’s wage earner to provide protection in the event of tragedy, Key Person Insurance provides protection to a business. If a key-person employee or business partner suddenly dies or gets injured, the business can still function without considerable loss.

If a Key Person Insurance policy is structured using term life insurance, the insured must use the policy within the specified term. If the policy is structured using convertible term insurance, it may be converted to a whole life or permanent life insurance policy at a later day. Key Person Insurance structured with whole life or permanent life insurance products have even more benefits for the insured.

Key Person Whole Life Insurance

Key Person Insurance policies, in the form of permanent or whole life insurance policies, can earn cash value in the form of interest and dividends. This cash value can be used by the policyholder, usually the business, for expenses related to the company. The cash value of a Key Person Insurance policy can be used two ways: First, it can be withdrawn with tax advantages and used directly to cover business costs. Second, the business may take out tax-advantaged policy loans on the cash value they borrow. Policy loans have the added benefit of continuing to earn interest on the full cash value of the policy, making each dollar go essentially twice as far.

Policy loans from Key Person Insurance policies can be especially beneficial to business owners. Unlike traditional bank financing, there is no approval process for a loan and don’t require assets to be put up as collateral for a loan. The asset is the insurance policy itself; any unpaid portion of the loan will be deducted from the death benefit of the policy. It provides businesses a discrete and liquid way to act quickly on investment opportunities and cover unexpected costs when needed.

Death or injury aren’t the only uses of Key Person Insurance structured with whole life insurance. The policy can be transferred to the employee as a retirement bonus or used as a split-dollar arrangement to offer additional tax benefits to the insured.

A split-dollar arrangement is a type of Key Person Insurance where the businesses funds a large life insurance plan on an employee. The business loans the employee money for the insurance policy premiums, and the employee is responsible for claiming the amount of interest from the loan as earned income on an income tax return. When the employee dies, the business recoups its premium payments from a portion of the death benefit. The remainder is distributed to the employee’s beneficiary. Before this happens, the employee is eligible to use the cash value of his/her policy as a living benefit.

Who Owns and Pays for Key Person Insurance?

The business who takes out the Key Person Insurance policy is the owner and beneficiary of the policy. Because the business owns the policy, they are responsible for any premiums. However, just like many properly structured Whole Life Policies, the business can choose when and how to pay the premium, and depending on how the business incorporates the policy’s dividend earnings into their infrastructure, the dividend can be used to pay the premium.

What is the Right Amount of “Key Man” Coverage?

A business must first decide how many key employees they would like to get insured, to then determine the overall cost of the insurance. If you were to have a corporation take out a key man policy on one employee, but there were 50 key person players, it would be an inefficient amount of coverage.

Typically, key man coverage is determined by looking at the overall worth the insured brings to the business. This is usually done by multiplying the insured’s earned income by five. Some businesses will insure their key people up to 10 times their earned income if necessary.

Key Person Insurance for Independent Business Owners

If you are a business owner looking to purchase Key Person Insurance because you are the key person, you would instead need to purchase a personal life insurance policy. The only time the purchase of Key Person Insurance for yourself is merited is if there is a third party beneficiary.

Key Person Insurance for Big Business

Bigger business owners interested in purchasing insurance or who currently have insurance policies in place for their company may be eligible for Key Person Insurance using premium financing. For big enough businesses, banks will lend funds to pay Key Person Insurance premiums on very, very favorable terms. The business is only responsible for paying the interest on the insurance premium loan. Essentially, a big business could obtain permanent life insurance coverage at a term life insurance price.

Premium-financed insurance isn’t for everyone. Banks that participate in these programs require participants to meet certain requirements. Provided a business meets these requirements, premium-financed insurance to one of the best financial decisions a big business owner could make regarding foundational levels of protection.

If you are a public or private company, key man insurance using whole life insurance products is a great way to protect the corporation from financial loss if a vital individual passes away. The death benefit received can sustain the company during transition, but also protect the company from ownership naturally bequeathing to heirs or other individuals that may not have an interest in the organization.

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