- Key person insurance (KPI) can protect your company from unexpected loss — but what exactly is it?
- In the event of a key employee’s untimely departure, how can a KPI cover costly business disruptions?
- And how can you determine how much coverage you get with a KPI?
What is it and why is it used?
Most people are familiar with the term “rainmaker,” defined as a person who brings in clients, revenue, business or even intangible prestige to an organization. These individuals are extremely skilled at their craft, possess unique qualities that make them productive and typically generate significant results within their organizations. The unexpected loss of a key contributor, especially at the wrong time, can create a snowball effect and put the entire business at risk.
KPI can serve as an effective hedge against the unexpected loss of an owner, an executive or a major contributor and significantly increase a company’s ability to survive the unexpected event. KPI is not only applicable to owners, executives and founders, but can also include top producers, decision-makers, nonprofit executive directors, scientists, athletes, entertainers and cybersecurity experts — anyone whose untimely departure would cause a significant business disruption.
It’s important to note that the IRS classifies KPI premiums as a nondeductible expense to the business, and the employee needs to consent to the coverage.
How do you structure KPI?
There are several ways to structure the design of KPI, with some options being more sophisticated than others. In the most common (and straightforward) design, the business is owner and beneficiary of a term life insurance policy on a key individual and pays the annual premium.
If the insured individual passes away, the life insurance proceeds are paid income tax–free to the company and can be used in a number of ways. Common examples include hiring an executive search firm to find a suitable replacement, buying out business interests of deceased shareholders, fortifying the balance sheet, paying off debt, distributing money to investors, supplementing operational cash flow needs or, in some cases, winding down the business.
KPI doesn’t need to be complicated or overly expensive. With proper planning, owners, employees, investors, customers and creditors can have peace of mind knowing that the business is protected and that there’s a plan in place. Many businesses that choose to proactively address this type of planning are rewarded by their bank and investors, be it through more favorable lending terms or an increased valuation.
Many lenders require KPI as part of their criteria to provide an added layer of financial protection, especially when personal guarantees are involved. Most lenders classify the death of a guarantor as a technical default in the fine print of the loan documents. This default may need to be cured in as little as 30 days (though 90 is more common). Surviving owners will be called in to meet with their bank to renegotiate the terms, provide additional liquidity as collateral or potentially replace any deceased guarantors. These conversations tend to have better outcomes for businesses that come to the table with “new” liquidity on their balance sheet (i.e., the proceeds from a KPI claim). It’s becoming more and more common for businesses to place a KPI policy on an owner, as well as an additional policy equal to the amount of their personal guarantees.
There’s no perfect formula for determining the appropriate amount of key person coverage. The cost will largely depend on the age and health of the insured, as well as the type of insurance used. Some common methods include:
- A multiple of compensation
- Percentage of revenue or profits
- Earnings contribution method
- Replacement cost
- Total debt personally guaranteed
For-profit companies and nonprofit organizations should consider the use of KPI. While many factors go into making the decision as to who, what amount and what type, KPI is relatively simple to design and implement, potentially saving companies and jobs if something unfortunate happens.
 https://www.irs.gov/publications/p535#en_US_2020_publink1000208856; see “Nondeductible Premiums.”
Investment Advisory services are provided by First Republic Investment Management, Inc. Trust and Fiduciary services are offered through First Republic Trust Company, a division of First Republic Bank; and First Republic Trust Company of Delaware LLC and First Republic Trust Company of Wyoming LLC, both wholly owned subsidiaries of First Republic Bank. Brokerage services are offered through First Republic Securities Company, LLC, Member FINRA/SIPC. Insurance services are provided through First Republic Securities Company, DBA Grand Eagle Insurance Services, LLC, CA Insurance License # 0I13184, and First Republic Investment Management, DBA Eagle Private Insurance Services, CA Insurance License # 0K93728.
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