Why Key Person Insurance

We all know that when operating a business we don't take risks. Instead, we evaluate risk and then mitigate or eliminate it. There's enough alligators hiding in the weeds that we can't predict, that we don't move forward without removing as much known risk as possible.

There's a large known risk you're currently exposed to that you're not mitigating – loss of a key employee. And worse, this is a hard risk that can cause large financial losses.

Look at your revenue – are there employees that are directly responsible for some portion of that every year? If so, you're at substantial risk if they aren't around to bring that money into the company. Further, if they aren't there any longer there's likely to be substantial and sustained additional new expenses to source out a replacement and cover their costs as they get up to speed over a year or two. That risk can be six or seven figures a year. Now imagine if you wake up one day and your revenue just took a hit of that level, there's no fixing it, and you'll be a year, maybe two, just getting back to where you are now.

You need to eliminate that risk. The risk is low probability but high severity – they probably won't happen but if they do they can cause substantial issues with the operation of our business. This low probability-high severity risk is exactly what insurance is designed for.

Sources of the Risk

There are three possible ways you can lose that revenue and incur those expenses:

1. Death/premature passing
2. Disability
3. Leaving the company

These are not inconsequential risks. For example, the probability of dying between the ages of 40 and 50 is approximately 2%. The probability of disability over that time span is even higher.

The Math is Simple

Option A, no insurance, risk of substantial financial loss

With high probability the company will sustain its revenue.

Or with low – but not inconsequential – probability (2% chance of death + probability of disability + probability of exit) you'll have your current revenue MINUS all the revenue the key person is responsible for MINUS the cost of replacing them over a year or two. If this happens, it can be close to catastrophic.

Option B, with insurance, risk is eliminated

With 100% probability, the company's revenue is 100% minus the cost of the insurance. The cost of insurance is known, fully guaranteed, and a fraction of the cost of the chance of losing the revenue of a key person. The company is not financially impacted by these risks – we have eliminated the risk.

And that's why leaders of corporations get key person insurance in place – it eliminates a substantial (though often overlooked) known risk. It stabilizes the business and provides further assurances of the longevity and stability.

Insurance Solutions for the Three Risks

For each of the three risks there is a solution.

1. Death/premature passing – the solution is a key person life insurance policy owned by the corporation. If the key person passes, the policy pays the lost revenue and any expenses that result.
2. Disability – the solution is a key person disability policy. If the key person becomes disabled, the policy pays out enough to also pay lost revenue and any expenses.
3. Leaving the company – the solution to this is a Split Dollar policy which is provided as an additional financial benefit to the key person. If they continue with the company until retirement, they receive a very nice bonus of insurance plus a financial incentive. This can motivate key employees to stay onboard long term.

In the following articles we will provide details on how to choose both how the amount of coverage is calculated as well as how to choose the appropriate type of insurance.