Key Man (Person) life insurance is a policy written on the owner of a small or large business. Affordable rates on high face amounts of coverage are available from many top-rated companies. Typically, a buy-sell policy is written on someone who is considered irreplaceable, and is closely involved in running the day-to-day operations. A financial hardship would result if that person died or left the company.
Most companies or small businesses have at least one employee who is crucial to the success of the business. That person can be the best salesperson, the owner, a partner or someone who controls the day-to-day operations. But the loss or death of that person could cause the company irreparable damage and possibly force bankruptcy.
A Key Person Term Life Insurance policy is actually life insurance on the business. The company is the beneficiary of the policy and naturally pays the policy premiums. The tax-free proceeds provided from the death of the “key person” allow the business to spend much-needed time to find a new person, or, if necessary, make the appropriate adjustments to ensure the company remains profitable.
It also helps assure continuity of the business for employees, the local community, and customers. The company (or corporation) can also use the life insurance proceeds to distribute money to investors, pay off debt, or possibly avoid bankruptcy. If it is a family-owned entity, the money can provide much-needed time to find the most suitable buyer, or make the transition for other family members to take over the business.
Recruiting a replacement CEO or CFO (if planned) takes time. Hiring an outside search firm will help with the process, but it still may take weeks or months to find the perfect replacement. During this time, it is critical to protect one of the biggest assets - your creditworthiness for commercial borrowing, which may suddenly become a short-term need.
NOTE: Typically, a small face amount of life insurance won't provide the security that is needed. However, larger amounts generally cost less (per thousand dollars) than amounts under $100,000. Also, blending a combination of term and permanent coverage will lower premiums and perhaps offer more flexibility.
These types of plans are not tax-deductible since the taxpayer receives a benefit from the policy. IRC 26 US Code 264 clearly stipulates that both direct and indirect situations do not avoid the tax liability. Also, proceeds paid to the business are fully taxable unless specific requirement sections of 101 (j) are satisfied before the policy is in force.
How Rates Are Determined
Premiums for coverage are based on many factors, including age, current physical condition (including existing medications), past medical history and the amount of coverage desired. Often, the existence of these conditions may increase the premium, but seldom prohibit the applicant from qualifying for some type of coverage.
But before the insurance policy is purchased, a value must be established for the key person and his his/her services to the business. Factors to be considered include the cost of replacing, hiring and training the replacement, the lost sales generated by the key employee and future lost revenue that would have been generated.
Another critical factor is how long it will take to find a replacement. If the industry is very specialized, and a lengthy national research campaign is needed to find the perfect successor, a higher face amount may be needed. Conversely, if the pool of candidates is large, and it only takes a few months to find the perfect replacement, a smaller policy may be quite suitable.
Permanent Or Term
Many businesses purchase key-person coverage as a permanent life insurance policy. Term insurance, however, is much less expensive and can generally provide ample coverage. A term life policy can provide a large amount of coverage with the rate guaranteed for as many as 30 years. You can renew coverage, although if your health has changed, often the "guaranteed" renewal premium is prohibitively expensive.
Determining the most cost-effective length of term coverage is extremely important. For example, if the key person is 40 years old, and their expected retirement date is at or about age 60-65, a 30-year plan will not be appropriate, and will be more expensive than a 20 or 25-year guarantee. And of course, if the covered individual retires early or leaves the company, the term contract can be canceled without a penalty.
A blend of temporary and long-term coverage will perhaps provide the protection you need while keeping premiums at a manageable level. There are specific policies that accomplish this under one contract. However, when non-guaranteed dividends are used in the projections, the increased risk may not be a financially sound concept for your specific situation.
However, since this type of policy is quite flexible, it can be cancelled at any time without a penalty. Before purchasing a Key-Person term life insurance policy, several different types of coverage should be considered, along with comparing quotes from many different “A” rated life companies (Ratings furnished by A.M. Best Co.)
Can A Claim Be Denied?
It's extremely unusual, but in rare instances, a claim can be denied. Naturally, any act of fraud will void the policy provisions. Also, if there is a specific named exclusion in the policy, if a claim is submitted for that specific reason, typically, a payout will be withheld.
Challenging contestability can cause death proceeds to be delayed or possibly turned down. During the first two years that a policy is active, the carrier can utilize this "contestability period." An investigation of the accuracy of the application and medical information provided can be used. If there were any fraudulent statements, significant omissions, or important misrepresentations, the contract could be rescinded.
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