By Dane Albright

What traits define a key employee? Key employees may be highly paid, responsible for management decisions, engender a special rapport with customers and creditors or produce a significant impact on sales. A business may have an insurable interest in key employees based on their level of influence on the business’ success.

What happens within a business when a key employee dies? A key person’s death can disrupt sales, production and potentially create credit issues. The business loses a valuable, experienced employee and must go through the time and expense of hiring and training a replacement.

How can a business plan for this unexpected loss? It can create a side fund, borrow money or use current cash flow to meet immediate needs, but these methods have considerable drawbacks. If a key person is insurable, the preferred method would be life insurance.

What does an employer do to get life insurance on a key employee? The business obtains written consent from the key employee to purchase a life insurance policy on the employee’s life with the business as owner, beneficiary and premium payer. Premiums are a non-deductible business expense, but when properly done, the business receives the death benefit income tax free.

How much insurance should the business purchase? There are multiple ways to determine the proper amount of coverage for key-person life insurance. The simplest is the Multiple of Compensation method. Typically insurance carriers will allow a multiple of five to 15 times compensation as a reasonable amount of coverage. The older the key employee, the smaller the multiple. Two other methods are the Cost to Replace method and the Contribution to Earnings method. Both of these are more complex and should be calculated with the help of your financial adviser.

How does the business benefit while the employee is living? The main value of a key-person life insurance policy is the death benefit income when a key person dies. However, the policy is considered an asset on the company’s books and can be used as collateral for other credit needs. If the policy has cash value, it also can be accessed for current needs. Another option is that cash value in the policy can fund a deferred compensation agreement with the key employee, providing supplemental income for that person at retirement.

Key-person life insurance is a valuable tool to ensure that a business has liquid assets on hand to meet any obligations created by an untimely death. Please consult your financial adviser for your specific situation.

If you are a business owner and want more information on the benefits of key-employee protection, please contact your local, independent life insurance agent to find coverage that works for you.

Blog republished from The Cincinnati Insurance Companies.