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Posted on APR 19, 2017

Key person life insurance: An important risk management tool

The financial success of mid‐size businesses, which typically have relatively few employees, can depend on the unique talents and expertise of a single person or a few key people. “These ‘key employees’ are often the most difficult to attract, replace and/or retain,” says Ed Agnew, VP Sales Executive, Johnson Insurance. “If a key employee is lost to a competitor or unexpectedly passes away, the company may have trouble recruiting someone of the same caliber to replace that person.”

Who is a key employee?

Generally, anyone who directly contributes to your company's bottom line or is fundamental to its operations is considered a key person. In some businesses, it's a salesperson who has developed strong and long‐standing relationships with important customers. It may be an employee who leads product development, or a C‐suite executive, such as a CEO, COO, CIO or CFO. Or, it may be an owner of the company.

If a key person unexpectedly passes away, the business's profitability—or even survival—may be called into question. Depending on the role the key employee played in the business, his or her loss may result in:

  • Management disruption
  • Increased expense of recruiting, hiring and training
  • Loss of sales and revenue
  • Impairment of the business's competitive position
  • Loss of confidence among creditors (which can make it more difficult or expensive to obtain needed credit), suppliers and/or employees

“In some cases, a key employee may be someone who plays multiple different roles within the company,” Agnew says. “The likelihood of finding one person with the skills to fill all those roles is slim, so the company may need to consider making multiple hires to compensate.”

Manage the risk

Key person life insurance can be a useful tool to manage the risk of losing a key employee. “The premiums for key person life insurance are inexpensive compared to the policy benefits,” Agnew comments. “Depending on the age and health of the employee, a lot of leverage can be gained.”

If a key employee passes away, the death benefit is payable to the company tax‐free, as long as certain government regulations have been met, such as filing an annual tax form and having the employee sign a consent form. “There are no strings attached to the proceeds, so the company can use it for whatever business purpose is most important at the time,” Agnew says. “Death benefits are paid in a timely manner, exactly when they are needed most.”

Another advantage: Cash values accumulate tax‐deferred. They can often be accessed on a tax‐advantaged basis through policy withdrawals (up to the basis) and policy loans.

A flexible tool

Key person life insurance is usually owned by the business, and the business is also the beneficiary of the policy. But it's also a versatile tool that can be set up in different ways for a variety of purposes. For example, sometimes it's used to:

  • Retain key employees. “The business buys a policy that will accumulate cash value and makes an arrangement with the employee that if they stay with the company long enough to accomplish certain goals, at some point in time—like when they retire—the cash will go to that employee as a bonus,” Agnew explains.
  • Fund a buy‐sell agreement. If multiple partners own a business, the death benefit provides the funds necessary for the remaining partner or partners to buy the deceased partner's shares. The deceased partner's heirs receive cash and the other partner or partners receive shares in the company.
  • Reward key employees. “To reward a key person, some companies put an insurance policy in place that the employee owns,” Agnew says. “The company agrees to pay the premium as a bonus to the employee. If the employee stays until his or her death, the person's beneficiaries receive not only the death benefit, but also the policy's cash value.”

Learn more

When the success of your business hinges on the talent and expertise of a single person or a few key people, the need to mitigate your risk and exposure is critical. To learn more about how key person life insurance can help protect your business, contact your Johnson Insurance advisor.