Key Man Insurance - Protecting Your Business Profits and Livelihood

Key Man Insurance: Protecting Your Business, Profits, and Livelihood

Key Man Insurance is a life preserver for your business.  It can prevent the devastating impact of losing a key person in your business, your revenue, and you personally.

It can mean the difference between your small business collapsing or rising like a phoenix from the ashes. At one of your most vulnerable moments, key person insurance can be the infusion of capital needed to protect your business.

But as you’re busy in the day-to-day of your business, this element of business continuity planning often gets forgotten.  It often gets stuck in the mental file of nice to have, but I’ll get to it later.  And that can be a fatal mistake.

Instead, we’ll have a conversation about how to make sure small businesses can keep moving forward, no matter what happens.  And we’ll help you prevent the loss of a key person from threatening your company, your profits, and your livelihood. 

Where Key Man Insurance Fits into the Cash Flow System

Protecting your small business from financial threats is just one part of a bigger journey to building time and money freedom. 

That’s why we have created the 3-step Business Owner’s Cash Flow System. This is your roadmap to take you from just surviving, to a life of significance, purpose and financial freedom.

Livelihood Safeguard

The first step is keeping more of the money you make by fixing money leaks.  Then, you’ll protect your money with insurance, legal protection, and Privatized Banking.  Finally, you’ll put your money to work, increasing your income with cash-flowing assets.

Key Man Insurance is part of Stage 2.  It helps you protect the wealth you’ve created so that no event has the power to sweep it away.  It’s part of your livelihood safeguard, ensuring that your company continues producing your income. 

Your Key Employees Are Your Most Valuable Company Assets

Where does the value of your company come from?  If you started naming your company assets off the top of your head, you’d probably list your real estate first. Then, perhaps your cash, inventory, equipment, accounts receivable, clients, goodwill, and your reputation.

But topping that list is your people.  People make all the things happen.  And you know that great people are worth their weight in gold.  Your business would be nothing without the people who add their knowledge, skill, and expertise to create what everyone knows as your company.

What Makes a Key Person, in Fact, “Key?”

For one POS company that provided machines and merchant services, one salesperson brought in 75% of the business’s revenue.  The salesperson is the ultimate example of a key person – someone you would rather not have to imagine your business without. 

Losing that person would mean lost sales, a floundering business, and significantly less personal income to you.  It might cause you to struggle to pay your overhead and other employee’s salaries. And because of their unique abilities and talents, the cost of replacing them would be tremendously high.

Perhaps they have the Midas touch in sales or marketing, bringing in the majority of your new accounts. It could be the VP of operations or key decision-makers who are largely responsible for the efficiency and processes your company is known for.  Or maybe it’s your #1 technician, with the wealth of knowledge, skill sets, and expertise that has built your company’s reputation.  Without them, you may be unable to deliver on your company’s promises and products.

A key person is indispensable to the company because of their talents or even their reputation. Their judgment is invaluable to the company.  They usually hold decision-making power, have a high-level salary, and are often central to the company’s vision and direction.

Impact of Losing a Key Person

If your key person passed away unexpectedly, you would have a gaping hole.  Aside from the emotional toll that would hit your company, it could cause management or operations to come to a screeching halt.

As a result, your company would inadvertently lose sales as you struggled to regain your footing.

At some point, you would need to fill the position with someone else.  But finding just the right replacement person, with the right skill set could cost a lot of time and money.  Recruiting, hiring, and then training would add another layer of financial cost and complexity.  And, inadvertently, costly mistakes could be made during the learning curve as they get up to speed to perform at the level of your initial key person.

The disruption of operations could impair your business credit and your ability to pay off company debts.

And your stakeholders’ confidence may be shaken, from customers to staff, suppliers, creditors, and even investors.

Measuring the Value of a Key Person

To create a key person life insurance plan to cover the costs of losing a key person, you first have to ballpark their value. It’s hard to say exactly what’s at stake if you lost your key person. 

Key Man Insurance - Protecting Your Business Profits and Livelihood

The POS company we mentioned earlier felt that the company would probably lose six months to one year’s worth of revenue if they faced that monumental challenge.

You could estimate the cost of replacing your key person or use a multiplier of their annual salary. 

However, most importantly, you want to get a good idea of the actual cost to your company in terms of lost earnings and additional expenses.  Then, it’s time to create your action plan to make sure your company can come up with those funds.

Options to Transfer the Risk of Losing a Key Person

One option would be to put money aside to accumulate regularly to cover the cost of replacing your key people.  This is called a sinking fund or building up reserves.  It would prevent you from having to come up with a huge sum all at once. However, since such an event is unpredictable at best, you may not have sufficient time for the funds to accumulate to reach your target and may still end up with a shortfall.  Additionally, you may not want to use up or deplete your reserves.

Another option would be to cover costs out of your cash flow.  The main downside of this option is that you don’t know the ultimate impact to your cash flow, so relying on it may prove to be risky.

You could expect to take business loans to cover overhead and key man replacement costs.  But at a time your business is least financially viable, you could have the most difficulty getting access to borrowed money. And if you did manage to secure a business loan, you’d end up paying more than the cost of losing your key person when you factor in the interest cost.

Why Key Man Insurance Is the Best Option to Cover the Cost of Losing Critical Employees

Key Person Insurance supersedes the sinking fund, reserves, cash flow, or bank financing options of indemnifying your small business against the loss of a key person. 

Here’s how:

Firstly, Key Man Life Insurance is the only sinking fund that’s guaranteed to be self-completing. That means that no matter when the loss event occurs, you know the death benefit paid out will be the capital infusion needed to cover the losses. 

Additionally, instead of having to come up with the money all at once, you will have made incremental premium payments over time, lessening the burden.

If you combine this risk mitigation strategy with Infinite Banking, you’ll have a store of capital that you can use for any emergency or opportunity, even those unrelated to the key person.  You’re not only storing your dollars in a place that’s better for you than the bank, but you’re also getting one dollar to do multiple jobs for you. Your same premium dollars are indemnifying your business (and you) against the loss of your key person, providing reserves. 

And, if that’s not enough, you could also shift your strategy down the road to create a deferred compensation package for that same employee, giving them an even greater incentive to stay employed with you.

Most importantly, since you know the finances you need will be there for you, you gain peace of mind. With an abundance perspective, you can innovate and create value more liberally, because you’ll be forward-thinking, knowing that your company won’t suffer if you lost your key person.

How Key Man Life Insurance Policies Work

Putting key person life insurance in place is fairly straightforward.  Because the company has an insurable interest in the life of its employees, they can buy life insurance on them.  (Insurable interest means that the owner of the policy would experience financial loss if that person were to pass away.)

You, the proprietor, would first identify the key employees and set the value.  Then you’d purchase key man life insurance coverage on your key employees. 

Your business then pays the premiums and also becomes the owner and beneficiary of the policy. 

Your key employees would be the insured but would have no rights to the key person insurance policies.  However, if in the future, you no longer need one of the key person policies, you could transfer it to the employee or have them purchase it. 

How a Key Man Insurance Policy Is Taxed

When your key person passes away, the death benefit proceeds will infuse your business with capital (income tax-free in most cases) to cover costs and help you remain afloat. 

And because the death benefit would be income tax-free to your business, the premiums you pay wouldn’t be tax-deductible. 

Types of Key Man Insurance

You have multiple options when buying a life insurance policy for your Key Man Insurance.

If you used a term life insurance policy, you’d have low-cost premiums, but you would only have coverage for the duration of the policy.  The term life insurance coverage would only serve one use; that is, to cover business costs if you lose your key person.

If you used a permanent life insurance policy, you’d not only have an insurance payout for any time you may lose your key person; you’d also build up cash value. 

In our opinion, the best type of policy you could use would be whole life insurance.  This tool would be a high cash value, dividend-paying policy with a mutual company that would give your business access to high early cash value and long-term growth. This policy can be used to leverage the Infinite Banking concept, earning tax-advantaged compound growth, while giving you access to your capital through life insurance loans, allowing you to put your money to work in two places at the same time.

Extras to Supercharge Your Key Man Insurance

To put the most distance between you and insolvency, get a key person policy that performs best in the widest range of circumstances. 

What if your key employee becomes disabled, rendering them unable to work?  Your business could still suffer financial loss, at a time when the risk of the key employee dying is heightened.  

We recommend adding disability insurance (Waiver of Premium Rider) for total disability on your key man life insurance policy.  This option makes the insurance company the premium payor if your key employee becomes completely disabled. This keeps the life insurance policy and your peace of mind intact.

And what if your key employee left your company to work for someone else, and you filled their position?  You would want to make sure the key man life insurance is transferrable.  Adding the Business Exchange Rider allows you to move the key person insurance policy from one key person to another without starting a new life insurance policy and resetting your cash values. 

Additionally, you could initiate a Key Man policy that later converts to an Executive Bonus Plan or is used in conjunction with a Buy-Sell Agreement

Your Next Step to Key Man Insurance

Do you have key employees whose value makes you exuberantly grateful, but also worried about the possibility of losing them? Then it’s time to do something about it. 

You might feel that the timing is too uncertain. Or cash flow might be too tight or unpredictable right now. However, key man insurance is vital to your business’s longevity. 

If you’re ready to determine whether you need key man insurance, we can help.

Book a call with our advisor team. We’ll help you navigate protecting your business, your income, and you personally from the cost of losing a key employee.  You’ll also find out the one next thing you need to do to accelerate time and money freedom.

Rachel Marshall

Rachel Marshall is the Co-Founder and Chief Financial Educator of The Money Advantage and President of Marshall's Insurance and Financial Services. She is known for making money simple, fun, and doable. Rachel has built a team of licensed professionals (investment advisors, insurance agents, attorneys, tax strategists) to help her clients create time and money freedom with cash flow strategies, Privatized Banking, and alternative investments. Rachel is the co-host of The Money Advantage podcast, the popular business and personal finance show. She teaches how to keep more of the money you make, protect it, and turn it into cash-flowing assets.
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