What are the disadvantages of key person insurance?
While key person insurance offers several advantages for businesses, it also comes with certain disadvantages and considerations. Here are some of the potential drawbacks:
Cost: Key person insurance premiums can be relatively expensive, particularly for businesses with older or higher-risk key personnel. The cost of the premiums may strain a company’s budget, especially for startups and small businesses.
Tax Treatment: In many jurisdictions, premium payments for key person insurance are not tax-deductible business expenses. Additionally, the insurance proceeds may be subject to taxation as ordinary income when received by the business. You can read more on the taxation of keyman insurance here.
Complexity: Key person insurance policies can be complex and may require a thorough understanding of insurance terminology and coverage options. Navigating the various policy types and determining the appropriate coverage amount can be challenging.
Limited Applicability: Key person insurance is primarily designed to protect against the loss of key employees. It may not be suitable for businesses with a small team or where no single individual has a critical role.
Dependence on the Key Person: Relying solely on key person insurance to mitigate the risks associated with the loss of a key employee can create a false sense of security. It’s essential to have a comprehensive business continuity plan in place that addresses succession planning and other strategies for managing such risks.
Premium Adjustments: Premiums for key person insurance may change over time based on the age and health of the insured individual and the financial health of the insurance provider. These adjustments can impact the policy’s long-term affordability.
Payout Delays: In some cases, the insurance company may take time to process and approve a claim. This delay in receiving the payout can be a disadvantage if the business needs immediate financial support.
Policy Lapses: If the business fails to pay the premiums on time, the key person insurance policy can lapse, resulting in a loss of coverage. Maintaining consistent premium payments is crucial to keeping the policy in force.
Policy Exclusions: Key person insurance policies may have certain exclusions or limitations that can affect the coverage. It’s essential to thoroughly understand the policy terms and conditions to avoid surprises in the event of a claim.
Alternative Strategies: Some businesses may find alternative strategies, such as creating a financial reserve or implementing cross-training and succession planning, more cost-effective and practical for managing the risks associated with the loss of a key employee.
In summary, while key person insurance can provide valuable financial protection, it’s essential for businesses to carefully weigh the advantages and disadvantages and consider their specific needs, budget, and alternatives before deciding to purchase such a policy. Consulting with insurance professionals and financial advisors can help businesses make informed decisions about their risk management strategies.