The Purpose of Key Employee Life Insurance

The purpose of key employee insurance is to help protect a business from economic losses that can occur when a key employee dies.

Losses from a Key Employee's Death

A business can typically suffer in four ways if a key employee dies:

The death may cause a loss of management skill and experience. This can be particularly devastating for companies without management depth.
There may be a disruption in sales or business production. When a key employee's talents are vital to these areas, the business is certain to suffer. And if clients recognize the key employee as vital to the business operations, they may delay orders or refrain from doing business until they find out how the organization will respond to this loss.
The business may experience credit difficulties. A drop in business income may make it more difficult to make credit payments. In addition, creditors may hesitate to extend loans or favorable credit terms to a business that has lost a key employee, particularly if that employee's talents or resources were factors that encouraged the creditor to extend loans or special terms in the past.
Losses also surface from expenses associated with hiring and training a replacement for the key employee. Even if the company can promote from within, business losses may continue to accrue until the replacement becomes thoroughly familiar with the job.

Advantages of Key Employee Life Insurance

It is clear that there are serious financial consequences when a key employee dies. Here are the advantages businesses enjoy when key employee life insurance is in place:

The employer receives needed funds which can be used to help meet financial obligations and train a replacement if the key employee dies.
Death proceeds are exempt from the regular income tax, but may be subject to the corporate alternative minimum tax.
While the policy is in force and the employee is alive, the cash value of a permanent policy is available for use in a variety of ways.*

*Withdrawals and loans will affect policy values and death benefits and may have tax consequences.

How Key Employee Insurance Works

Key employee life insurance is one of the simplest of the business life insurance programs to implement. The business applies for the policy on the life of a key employee. If the business is a corporation, the board of directors must adopt a resolution authorizing the purchase of the policy. The resolution should mention that the policy is being purchased to protect the corporation from loss it could suffer if the key employee died.

The employer applies for, owns and is the beneficiary of insurance on the key employee's life.
If the employee dies, policy proceeds are paid to the employer to use as it wishes.

The business pays all of the premiums and is the policyowner and beneficiary. All incidents of ownership should belong to the business. If the insured has any of these incidents of ownership, the policy proceeds will be included in his or her estate for federal estate tax purposes.

Key Person Valuation

There are two basic ways to determine the amount of key-person insurance:

contribution to earnings
cost to replace experience

Contribution to Earnings Method

The employer estimates the loss of annual earnings that would be caused by the employee's death and then multiplies that annual loss by a certain number of years (limited by insurance company underwriting guidelines). This figure is then multiplied by the present value factor for $1 per year, where the period is measured by the remaining working years, and a reasonable rate of interest is used to discount future earnings. Click here for an example.

Cost to Replace Experience Method

The economic value of the key person is determined by subtracting from the key person's compensation the salary that would be required to pay someone else to perform the employee's routine duties. This difference is then multiplied by the number of years it will take to recruit, train, and bring a replacement up to the employee's level of experience.

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