The Key to Security

Is key person insurance right for your small business?

Collette McKenna Parker

April 3, 2008

Years ago, Bill Bowden sold some life insurance to a Hollywood movie production company. The movie being produced was a sequel  – so the returning actors were essential – and the policy he sold was for the life of the movie star. If the star somehow died unexpectedly before filming wrapped up, the movie company would lose tens of millions of dollars. The star was a key employee of that company, and the company protected itself with key person insurance.

Believe it or not, the major motion picture industry has something in common with Atlanta's small businesses – total dependence on key employees. It's especially true in small businesses – each person represents a vital part of the company, and the smaller the company the more valuable the players. So how can you protect your company when that delicate balance is upset and you lose one of your key employees?

No one anticipates an event like death, and in a small company it can feel like the loss of a family member. But what happens next? Key person insurance can prevent the business from immediate failure by supplying lost revenue, and providing enough money to find and train the correct replacement.

"The costs associated with replacement of a key person – lost productivity and recruiting and training new employees – are quite high," says M. Bryan Freeman, president of Habersham Funding. "I've heard 50 percent of an employee's salary and up to 100 percent in some cases. This translates to big money when you are talking about a key person who is likely a high earner."

Key person insurance, also known as corporate owned life insurance (COLI), works like life insurance, except the company pays the premiums and is the beneficiary. The products are similar to the life insurance you buy to protect your family. Term life insurance is less expensive per year, but once the term is up, you're no longer covered and you don't get any of the money back. According to Bill Bowden, a consultant for Buck Consultants, these policies are extremely affordable. For example, he says, for a 45-year-old healthy male, a 10-year, $1 million term key person policy might cost between $800 and $1,000 per year.

Companies can also take out "return of premium" policies on key employees, where you get the money back at the end of the term; or a "guaranteed premium universal life policy," where as long as you pay the premium, your coverage is guaranteed for life, even if the employee lives to be 100. Both of these are more expensive and can run around $8,000 per year.

Bowden says there are two ways to look at buying key person insurance: first, the enterprise risk, and second, a project risk.

Enterprise risk

Key person insurance is a shrewd idea if the entire company would be in jeopardy if one person passed away. Consider a company where the owner is great at sales, but is dependent on one particular engineer, who is really the key to the delivery of results. "There's a risk to the entire enterprise if that person dies or is disabled. It's a long term risk, and therefore rather than a 10-year term policy, I'd try to have a plan for that person throughout their employment life," Bowden says.

Project risk

Sometimes a company will buy a policy for a key employee only for the life of a project. For example, if an architectural firm is hired to build the new tallest skyscraper in Dubai, the firm may take out key person insurance on the project manager for the three years it will take him to complete the building. "In this case, if the project value is $10 million, you can estimate the cost to the disruption of the project. Construction projects are penalized if completed late and usually provided a bonus if they're early. If you lost that key employee or he is disabled, your financial results would be at risk," Bowden explains.

So how do you know who should be insured? It's usually obvious, Bowden says. In very small companies, it's usually the owner. In slightly larger companies, it could be the top sales person. "Employers usually take out a key person policy on the life of an employee whose work, knowledge or overall contribution is uniquely valuable," Freeman says.

You can also purchase professional overhead insurance, or long term disability insurance. Professional overhead is for business owners like doctors and accountants. If the business owner is disabled, they can continue to pay expenses for staff, rent and general overhead, up to a monthly limit, like $15,000 or so, for the term of the policy. "While I don't think many companies buy it, if the company can afford it, it's worth considering," Bowden says.

Disability insurance would insure a company up to a certain limit in the event that the owner or rainmaker becomes disabled.

And don't worry, if you get sick of your policies, often you can sell them for more than the cash value of them in a life settlement. Companies like Habersham Funding buys life insurance policies from people and businesses who no longer need them. "We don't care what the cash value of the policy is," Freeman says. "Often we pay four-to-ten times the cash value. We look at the fair market value." Freeman recently purchased a key man policy with a cash value of $20,000 for more than half a million, turning the insurance into an investment.

And while most companies do not buy insurance for this return, key person policies are an investment in both the treasured employees and the security of the business.