What is Keyman Insurance? How Does it Work?

Keyman insurance (also known as key person insurance) is a specialized use of life insurance. Businesses use it to cover the risk of losing a key employee. Keyman insurance is not a specific life insurance product. A key-person can be considered those whose role in the business is vital to its continued success. A business may utilize any type of life insurance policy to protect a key employee.   

A company applies for and owns a keyman life policy life. The company pays the premium and is the beneficiary of the policy. The company owns all rights in the policy, including any cash values in the plan. If the key employee were to die while the policy is in force, the company would collect the death benefit. These funds are treated as an addition to surplus, and income is tax-free. The company can use funds for any purpose such as hiring and training a replacement employee, replacing lost profits, protecting the companies’ credit position, funding a stock redemption, or making survivor benefit payments.   

Opportunities to sell life insurance are plentiful for financial advisors who work with owners of closely-held businesses. Succession planning, business continuation, supplemental retirement planning, employee retention strategies, and owner estate planning. Indemnifying a business against the loss of a key employee may lead to additional sales opportunities.    

The basic principles of life insurance planning for key employees include key employee identification, valuation formulas, taxation, ownership strategies, loss indemnification, and employee retention.   

Who typically owns keyman insurance?   

The business typically owns the key employee insurance coverage. Although, there are situations where it might be preferable for the business owner to purchase the insurance. One example may be when forming a new corporation. With the high startup costs of a new business, borrowed money may supplement capital. When a business fails because of the death of a key employee, creditors are paid first, leaving little money left for the shareholders. Since personal assets are usually immune from the creditor claims, the owner should hold title to the life insurance. If the company is a single-member LLC or a sole proprietorship, the owner and insured would also be the business owner.   

How does a business determine what employees may need keyman insurance coverage?   

The single greatest asset a company has is its employees; however, not all employees are considered keyman employees. The key employee contributes substantially to the company’s success due to specialized knowledge or training and may be hard to replace. This is regardless of the kinds of duties he or she performs. A key-person can be the business owner, or a non-owner, who has very specialized abilities. These abilities are critical to the financial health of the company and are costly to replace. It might be a skilled craftsman whose unique skills and reputation among customers bring in much of the business. It may be an officer who maintains the confidence of financial institutions guaranteeing a steady flow of credit. It might be a top fashion designer or a star salesperson who brings in a large share of the new business generated every year. You find key employees in various positions. Many are in the upper management, but not always. They are almost always highly compensated. In short, key employees come in all kinds of shapes and forms.   

How much life insurance can a business get on a key employee?  

To insure a key employee, you will have to quantify the monetary loss to the company. There are many ways to determine this value. Most computations revolve around replacement cost determination, the estimate of lost profits or credit, or a simple income multiple. The four most common approaches are:    

  1. Multiples of income.   
  2. Contribution to profits.   
  3. Business discount.   
  4. Business life value.   

Employee valuation is an art and not an exact science. It pays to provide the company the values from one or more of these formulas.  

How does keyman insurance impact taxes for a business?  

The most asked question about keyman insurance is if the premiums for a key employee are a tax-deductible expense? Per U.S. Code § 7702, the answer is, unfortunately, no. Please read our article answering the question, is keyman insurance tax deductible?  

When should a company purchase keyman insurance?    

Companies will want to know if there are other ways to indemnify the risk of a key employee’s death. Here is an opportunity to put key person insurance planning in perspective for potential clients! A system of periodic savings deposits and investments are well-meaning ways of seeing that the needed cash is there. This practice is too often inadequate. Often, savings plans are started too late to build enough funds for the emergency. Or they can be interrupted because of business slumps and a lack of ready cash for the savings. Investments, even if conservatively structured, are not guaranteed to produce the required values. Small privately held businesses, especially those taxed as pass-through entities, rarely keep enough cash to fund the risk. What is left? Life insurance, of course!   

What are the reasons life insurance should be the preferred choice?   

  • The convenience of installment payments.   
  • A guaranteed amount of money, on a specific date, from the day it is first purchased.   
  • Companies are particularly vulnerable when a claim is made on the lives of two or more key individuals at the same time. The result with no plan is a large outlay of cash upfront and on an installment basis. When compared to the moderate cost of life insurance, key employee insurance is the better choice.  
  • The potential for a steady buildup of cash values and a semi-compulsory form of contribution.   
  • Leveraging a large benefit with a small number of dollars.   

What types of life insurance should a company buy on a key person?   

While term life is the right solution in many key person insurance plans, most plans include permanent life insurance. A permanent plan accumulates cash value, and the premiums remain constant during the life of the policy. The cash value may pay for the costs of replacing a lost employee or to recoup its premium into the plan. Alternatively, it may serve as a future employee benefit to incentivize employee retention of a key person. Since all these plans are company-owned, the cash value may be used for any valid business purpose.   

Policy riders are increasingly important. Waiver of premium and living benefit riders with critical, chronic, and terminal illness benefits are useful. We recommend you automatically include them in all your initial proposals. Companies can protect themselves financially if an employee dies prematurely, suffers a critical illness, becomes disabled, or is unable to care for themselves due to severe cognitive impairment or inability to perform two of the six activities of daily living. These benefits are for both permanent and term life plans. A lesser-used rider is the guaranteed insurability rider. It automatically increases the amount of life insurance at regular intervals with no additional underwriting required. This is particularly valuable for younger employees whose value to the company escalates over the years.   

When should a company review key person insurance planning?  

There are two types of companies. Those that have planned for the loss of a key employee and those that have not. For those that have, see if the policy is adequately funded (this is rare!) and contains living benefits. Also, look for non-compliance with the Notice and Consent Requirements of the Pension Protection Act of 2006. If the death benefit proceeds become taxable, it is almost always better financially to rewrite the existing policy and get back in compliance with the law. Honestly, there is no real option to fix this problem other than to rewrite the insurance!   

If the company is profitable, it is easy to get them to agree to put a strategy in place indemnifying the risk of losing a key employee. Every solution you present should include an explanation of monetary loss indemnification and the need to retain and reward the key employee.   

A Simple Case Study on Keyman Insurance.   

Mary owns and operates a small boutique furniture store that sells handmade Queen Anne casework reproductions. Mary is a woodcarver by training and used to contract out the dovetailed drawers for the highboys. The highboys represent 50% of her business. She hired Matt as an apprentice three years ago. He has now reached a point where he can hand make the dovetailed pieces in-house. Mary recognizes Matt as a key employee. She is concerned that if she lost his services, her business would suffer financially. First, she is worried about losing such a quality craftsman to a commercial cabinet shop on the other side of the city closer to where Matt lives. Second, if Matt suffered a disabling injury, illness, or death, her business would suffer tremendously. The quality of the work would suffer and hurt the reputation of her shop. This would make it more difficult to charge the premium prices she needs to turn the profit required to keep her shop open.   

After discussing concerns with her insurance professional, they decided the best solution was a combination strategy using both term life insurance and permanent insurance. To best indemnify her business from the loss of Matt due to death or health-related event, Mary took out a 20-year term policy. She also added a living benefit rider if Matt became disabled or missed extensive time due to critical illness. Mary also invested in Matt by purchasing a permanent life plan paying $5,000 per year in premium for a $200K index UL plan. The goal is to fund a company-owned life plan on Matt and pay it over ten years. The policy was designed primarily to grow tax-deferred cash. In the future, the policy would be bonused to Matt to be used as a source of supplemental retirement income or provide a paid-up life plan with living benefits. In the meantime, the policy would be considered a key employee life policy. Mary could use the cash value for any purpose if necessary. When the policy is distributed to Matt as an employee benefit, Mary can take a tax-deductible write-off based on the policy value. It is considered cash compensation to Matt. Matt would be responsible for the taxes owed upon receipt of the benefit. Mary expects the policy will have sufficient cash value that the taxes owed can be paid by taking a distribution from the policy at the time the transfer is made.   

The takeaway here is that while loss indemnification is primary, an employer may want to use key employee insurance for a future secondary need. In this case, Mary needed an enticement to keep Matt with her company. The policy can act as a benefit for employee retention. Also, the company has a tax beneficial way to provide leveraged benefits to select personnel in the future.   

Where can I find the experts on key person life insurance?   

EMG Insurance Brokerage can help with keyman insurance planning for your client. You can find out more about life insurance and key person insurance planning by calling EMG Insurance Brokerage. We know it is essential for advisors to access quality products, expert advice, and cost-effective solutions.   

We keep up to date on markets, trends and continually update our carrier offerings. Connect with us for guidance on how to grow your business today; we are here for you.   

 

Clay Lund
clund@insurancedesigners.com
Insurance Planning Specialist
EMG Insurance Brokerage

Direct 713.507.1016