What is Key Person Insurance and How Does it Work?

As a business owner, you've worked hard to ensure your company's current and future success. But just as you wouldn't build a home without insuring it, you wouldn't want to miss out on important insurance coverage for every aspect of your business—from physical assets to future cash flows.

If you own a closely held business, key person insurance can help you overcome the initial cash flow challenges that may come after the death of a key person—like the owner or a top salesperson.

What is key person insurance?

Key person insurance is a life insurance policy that's owned and paid for by an employer on the life of a key employee. This type of policy can be either term or permanent. Policy funds are payable to the business upon the death of a key employee to help with lost revenue, as well as the costs to find, hire and train a replacement person.

Why do I need it?

The death of a key employee or owner can put a serious financial strain on your business. You should consider key person insurance if you have an employee who's so important to your operations that the unexpected loss of this person would result in:

• Disruption in operations or production
• Loss of sales
• Loss of contracts due to the personal value or relationship the key employee brings
• High costs to find, hire and train a replacement for the key employee's role
• Loss of information or historical business operations because they exist only in the key employee's recollection
• Increased borrowing costs or loan calls from concerned lenders
• Funds needed to pay a death benefit or buy out an ownership interest from the key employee or owner's family or estate
• Loss of ranking in the marketplace or industry in which your business exists due to the loss of a key person

How can key person insurance help?

Key person insurance can't bring back your lost employee, but it can safeguard your business by providing needed funds until you rehire for the role or formulate a new plan to replace the key person's value. It can act as a bridge to provide much-needed capital due to lost revenue or lost relationships with suppliers or customers until you can hire a replacement.

What other benefits does it provide?

One advantage of key person insurance is that policy proceeds are exempt from federal income tax. If a permanent policy is used, the policy can provide tax-deferred growth of the policy's cash value and access to it if there's a financial need. If the situation changes over time, the policy can be converted to a form of nonqualified deferred compensation as a way to retain a key employee.

How does key person insurance work?

Let's say Bill and his brother, John, equally own Right Bikes, a bicycle sales, parts and repair business. They have 10 stores and have been in business for 15 years. Right Bikes has an estimated value of $8 million.

Travis, a Right Bikes employee, is a former motocross racer with extensive professional relationships throughout the racing world. Travis has been able to secure repair contracts with half of the racers currently participating in major racing championships. He's also helped Right Bikes serve as the sponsor of key events, the vendor of choice for several bike manufacturers and the exclusive spot to purchase certain top brands. Travis is a highly paid—and key—employee to Right Bikes.

In a discussion with their wealth professional, Bill and John realize that Right Bikes could suffer extensive financial loss if Travis were to pass away unexpectedly. He created significant goodwill and contracts that could potentially end with his death.

The brothers decide to purchase a key person insurance policy on Travis, payable to Right Bikes. If Travis were to pass away prematurely, Right Bikes would have income tax-free cash flow to pay for:

• The cost to hire a replacement for Travis
• The cost to train his replacement
• The loss of goodwill, as well as possible loss of revenue and contracts during the time Travis is gone and before his replacement can be found

The bottom line

When you own and operate a closely held business, it's critical to ensure that every aspect of it is appropriately insulated from risk. Take the time to identify associates within your company whose unexpected loss could hinder future earnings, and approach the topic of key person insurance with these individuals in a thoughtful way.

If you'd like to learn whether key person insurance is right for your business, contact your First Citizens Wealth Management partner. They can review your business and help determine who should be covered and by what type of insurance, as well as how much death benefit is needed.