How many hats do you wear? General manager, chief of sales, part-time gunsmith, substitute gun counter clerk, payroll manager — for many of you, that’s just before lunch.  

What would happen to your business if something happened to you?

Or maybe you’re lucky enough to have a couple of indispensable people on your payroll: the ’smith who understands the machinery better than the people who made it; the salesperson who always knows the perfect way to close a sale and who knows every potential customer in your community.

How do you preserve what you’ve worked so hard to build? How do you keep the whole works from collapsing if you, or a miracle worker on your payroll, die suddenly? As with other potential disasters, the first line of defense is insurance — in this case, key person insurance.

According to the Insurance Information Institute, a “key person” in a business is someone whose special knowledge and skills contribute significantly to the income of the business. Key person insurance (or key employee insurance) is designed to compensate your business when a key person, whether that person is an owner, partner or employee, dies. It is, in essence, a form of life insurance for your business.

How It Works

For most of us, a life insurance policy is meant to provide funds to pay off the mortgage, send children to college and maybe give the surviving spouse a financial cushion for a few months or a year or two. For your business, a key person insurance policy can pay for:

• Searching for and hiring a replacement, whether that means a general manager, a crack technician or a top-notch salesperson.
• Temporary expenses incurred while you (or the people you leave behind) figure out what happens next: an office manager and scheduler to keep things working, or a part-time accountant to deal with invoicing and payroll.
• Compensating the business for lost goodwill, sales contacts or income when it suddenly finds itself without the insured’s name recognition.
• Buying back shares in the business from a shareholder’s family member who has inherited a piece of the business but not the interest or business acumen.

All of that translates into cash that a key person policy can provide. A life is still being insured, but the business owns the insurance, pays the premiums and is typically the beneficiary.

Key Things to Know

Most commonly, key person insurance is life insurance in the usual forms — term or permanent — with the usual considerations: Term insurance is usually cheaper, doesn’t build cash value and can’t be borrowed against; permanent (or whole life, or universal life, or variable life) insurance builds cash value and can be used as security for a loan, but has higher premiums.

Key person insurance can also be disability income insurance, which pays if the insured becomes disabled and is unable to perform his or her job. Work with your insurance broker to carefully balance the cost of the insurance premiums with the covered conditions — if the policy pays when the insured is unable to perform usual and customary duties for the position (rather than being unable to perform any job), the premiums will likely be higher, but your peace of mind will be greater.

You, for example, might be able to sit in a chair and make phone calls, but if you need to be on job sites and talking to customers and crews in order to be effective, you’ll want a policy that pays if you can’t be active. A disability income insurance policy will pay a percentage of the disabled person’s earned income; if that person is a partner or a sole proprietor, the policy can pay office expenses (rent, utilities, salaries, depreciation).

Independent Advice

By the way, about that insurance broker: Make sure the broker works with more than one company (and thus can shop your policy around). You’re more likely to get a better deal. It’s also helpful to ask for the ratings on the policies you’re offered (that is, the assessment from one of the rating agencies – Fitch, Moody’s, A.M. Best or Standard & Poor’s) as well as asking the agent exactly what the ratings mean.

The ratings aren’t uniform either in application or appearance — a “superior” from Moody’s is Aaa, while a “superior” from A.M. Best is A++, and the agencies may differ in their evaluations.

If your business has a board of directors, you may need a resolution from your board to purchase key person insurance for a principal or employee. As with any matters involving board resolutions, consult a lawyer familiar with your corporate structure and business plan.

Ask the broker how your business interruption policy dovetails with key person insurance. The fire that destroys your office and records might also injure or kill someone, but you want to be able to get up and running as soon as possible. Find out what the short-term cash prospects would be under those kinds of circumstances and which policy will help you the most in specific situations.

Tax Cautions

Before you pick up the phone to call your insurance broker, though, plan a session with your accountant for an overview of your business affairs to guide your conversation with the broker. You’re looking for answers to questions such as:

• How much is the business bringing in now?  
• How do things look in the next six months, next year, next five years?
• Do you expect close competition (making a good salesperson vital), or are you in a safe market with reliable customers? (Congratulations!)
• What are the salaries of the people you depend on most heavily? Are they expecting healthy raises in the next couple of years? If you had to hire someone from a competitor, would you have to pay more than you’re paying your employee?

You probably have a good sense of the answers to these questions, but having the most accurate numbers on a piece of paper in front of you will be necessary.

These conversations can help you think about how to value not just the business as a whole, but your contribution to the business: your time, your talent, the goodwill that’s built into your presence, as well as the contributions from important employees. You’re looking for the answer to “How much money does the business lose if something happens to this person?”

Conversations with an insurance broker can result in additional expenses, and no one likes to reduce their bottom line. No question here, though, that a small bite of expense now can save major expense (and real business loss) later. Consider the premiums an insomnia cure. Needless to say, we hope that no readers (or business heirs) ever need the proceeds of those policies.

As always, seek advice from your own accountant, banker or insurance broker, particularly where tax consequences are concerned.