Key Person Insurance

Have you ever thought about how a key employee's death might affect your company? When someone dies unexpectedly, his or her employer loses the benefit of that person's skill, experience, and important business contacts.

You can prevent unexpected tragedy from harming your company by purchasing key person insurance, which indemnifies a company against losing a valued team member's skill and experience. The benefits can be used to hire a replacement, restore lost profits, repay business loans, or otherwise compensate for the loss.

Most key person policies are owned by the company, the premiums are not deductible, and the death proceeds are income tax-free (however, for C corporations, there may be alternative minimum tax (AMT) consequences).

Of course, placing a dollar value on an employee's life is a difficult thing. You can determine the necessary amount of insurance in one of three ways:

  • The multiple approach estimates the insurance amount to be some multiple of the key person's total annual compensation, including bonuses and deferred compensation. The disadvantage of this approach is that the estimate may or may not relate to actual needs. However, the multiple approach is very popular despite its drawbacks; this may be due to the general difficulty of quantifying a key employee's value.
  • The more sophisticated business profits approach takes the amount of net annual profit that is directly attributable to the efforts of the key person and multiplies it by the number of years it will take for a replacement to become as productive as the insured. For example, if $250,000 of the company's net annual profit can be attributed to the key employee and it would take five years to hire and train a replacement, you would insure that employee for $1.25 million.
  • A third method determines the present value of the employee's profit contributions over a specified number of years and uses that as the face amount of the policy. For example, if the employee had an anticipated profit contribution of $250,000 per year for the next five years, subtracting a discount rate of 8 percent, the policy's face value would be about $1 million. This method assumes that the company will invest the insurance proceeds at some rate of return over a period of years.

Consult your insurer about their preferred approach. Regardless of which method you choose, key person insurance is a vital consideration that helps protect your business from the loss of its most valuable assets—its people.

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