The small business you started with your college roommate isn’t so small any longer. With a couple million in revenue and about a dozen employees, it’s humming along nicely. An independent appraiser values your respective 50% shares at more than $5 million each.
Then tragedy strikes: Your business partner dies without a will or succession plan. Her share in the business transfers to her jerk husband, who starts talking a big game about how he’s going to “improve” the well-oiled enterprise. The company’s sales slide, revenue dries up, and you start thinking about doing something else with your life.
If you’d taken out a key person life insurance policy on your business partner, none of this would have happened. After her death, you’d have received a death benefit big enough to buy out her share and prevent her meddling husband from muscling in on the business. If only you’d known about key person insurance before, you could have prevented this.
What Is Key Person Life Insurance?
Key person life insurance is a policy that covers a critical employee or partner in your business. It’s also known as key person insurance or key man insurance.
Key person life insurance works a lot like a typical life insurance policy. The biggest difference is that the business owns the policy and is the policy beneficiary, meaning it’s entitled to the death benefit payout if the insured person dies while the policy is in effect.
In most other life insurance scenarios, the policy owner and insured are the same person, and the beneficiary is a close relative, like a spouse or child.
What Is a Key Person?
A key person is anyone considered essential to a company’s continued success. In many cases, the key person is indispensable. Their absence threatens the company’s very existence.
The tragic hypothetical we began with — preventing a surviving spouse from interfering in a small business — is just one potential use for key person life insurance. Among other things, you can also use this type of life insurance to compensate for the loss of a vital employee’s expertise or talent.
A key person can be:
- An employee with unique, critical skills, such as the head of the research and development department
- An employee whose personal contacts are crucial to the company’s profitability and growth, such as the head of sales
- An executive responsible for daily company operations
- A partner whose capital supports the company’s operations or whose business interest must be prevented from falling into the wrong hands
How Key Person Insurance Works
Key person insurance works like any other life insurance policy. However, because your company is the policy owner, it’s your responsibility to apply, not the insured employee’s.
Your company can’t take out key person insurance on someone without their knowledge. The key person must consent to being insured and cooperate during the insurance application and underwriting process. That said, your business can require key person insurance as a condition of employment.
If the death benefit is substantial — over $1 million or so — the employee may need a medical exam to confirm they’re healthy enough for coverage.
Once the policy is in effect, you pay premiums to keep it in force. If the insured person dies while it’s in force, your company collects the death benefit and can use it as it sees fit. Under normal circumstances, this death benefit is tax-free. It doesn’t count as business income, and you’re not required to pay income tax on it.
What Key Person Insurance Covers
Kerson insurance exists to offset costs incurred when a covered employee dies. Those costs include:
- Finding and training the person’s replacement
- Replacing revenue the person was directly responsible for
- Covering additional costs incurred due to the person’s death, such as overtime wages or temporary employees
- Offsetting indirect losses resulting from the person’s death, such as clients leaving the company
- Purchasing the person’s interest in the company, which may include buying out their heirs
- Paying debts that come due as a result of the person’s death, such as a bank loan conditioned on their continued employment
Sometimes, the death of a critical employee or partner spells doom for the company. If the business can’t stay relevant after they’re gone, key person insurance can offset the costs of winding up the business:
- Employee severance
- Payments on outstanding loans and credit lines
- Lawyers’ fees
- Making final distributions to investors
Types of Key Person Insurance
Key person insurance can take several different forms. Usually, it’s a type of life insurance, hence the term “key person life insurance.” But you can take out disability insurance policies on key employees and partners too.
Term Life Insurance for Key Employees
Term life insurance is the most affordable type of key person coverage. It remains in effect for a fixed, finite term, usually between 10 and 30 years. Premiums remain level for the entire term.
You can choose the term length and may have the option to extend the policy after it expires. However, the new premium will be much higher, so it may not be worthwhile. If the insured person outlives the policy term, the policy expires worthless and your company doesn’t get the death benefit.
Whole Life Insurance for Key Employees
Whole life key person insurance is the most expensive kind. It’s a type of permanent life insurance. That means it remains in effect as long as you continue to pay the premiums, so it’s most appropriate for business owners and long-term employees.
Whole life insurance builds cash value at a predictable rate over time. That’s a potential source of liquidity — and flexibility — for your business. You can tap the cash value by taking loans against it or making partial withdrawals, though either can reduce the death benefit if you don’t repay them. You can also use the cash value to pay policy premiums.
Variable Universal Life Insurance for Key Employees
Variable universal life insurance is another type of permanent life insurance. It offers more flexibility than whole life, particularly around how the cash value component is invested. Variable universal life premiums are also usually lower than whole life premiums.
You can allocate part or all of your policy’s cash value to market-traded securities like stocks, increasing your upside during good years for the market while increasing your risk of loss if the market falls.
You may also be able to adjust the amount of coverage, though adjusting upward may raise your premiums. So variable universal life is a good choice for businesses that prefer flexibility over predictability.
Disability Insurance for Key Employees
Key person disability insurance is a long-term disability policy that pays ongoing benefits if the covered person becomes unable to do their job due to a covered disability. It’s a good option for businesses that want to protect the revenue a key employee generates, even after they hire and train their replacement.
Do You Need a Key Person Life Insurance Policy?
If the death of an employee or business partner would cause serious harm to your business, you probably need a key person life insurance policy.
Start with employees and partners whose loss threatens the company’s long-term profitability, if not its very existence. They’re the most important people to insure.
For employees you consider less critical but still very important, consider how much it would cost to replace them and how long it would take to get their replacement up to speed. Because your business is likely to be less profitable during that time, you need to account for the total cost, of which salary could be a small portion.
At some point, it’s no longer worth the trouble and expense to take out life insurance policies on employees, even if they’re integral to your company’s success. Replacing an employee is always expensive, but that doesn’t mean you have to insure everyone who works for you for the expected cost to hire and train their replacement.
Key Person Life Insurance FAQs
Key person life insurance isn’t on many business owners’ radars. If this is your first deep dive into the subject, you probably still have questions.
How Much Does Key Person Insurance Cost?
Key person insurance’s cost depends on numerous factors. The most important include:
- The type of policy — term life insurance is much cheaper than permanent life insurance, especially whole life insurance
- The term length if it’s a term life policy
- The insured person’s age
- The insured person’s gender
- The insured person’s current health status, personal health history, and family health history
- The size of the death benefit or coverage amount, which depends on the loss you expect to incur if the insured person dies
- The insured person’s occupation and lifestyle — if they have a dangerous job or hobbies, it costs more to insure them
It always pays to shop around, especially for larger policies. Because you can’t deduct key person premiums on your business taxes, every dollar you pay toward the policy reduces your profit.
Where Can I Get Key Person Insurance?
Key person insurance is more niche than life insurance for individuals, so few insurance companies sell it. If you have an insurance agent who helps you with other types of business insurance, ask them to help you.
If you don’t want to work with an insurance agent, look to established insurance companies like State Farm, Allstate, and Nationwide. They have well-developed business insurance departments and underwrite countless key person policies.
How Much Key Person Insurance Coverage Do I Need?
How much key person insurance you need depends on several core considerations about the individual you’re covering:
- Replacement Cost. How much will it cost to replace the employee? If their job is highly specialized or they’re an executive-level employee, it’s going to be difficult — and costly — to find a suitable replacement.
- Earnings Contribution. How much does the employee contribute to your company’s earnings? Such a metric isn’t measurable for all employees, but you should have a good sense of how much people in sales and business-development roles add to the bottom line.
- Buyout Cost. This consideration applies to people with equity in the company — fellow owners and partners. Valuing closely held companies is always tricky, but consider investing in a third-party appraisal to get a ballpark figure of the company’s total value. Then, multiply that figure by the insured person’s ownership percentage.
- Business Risk. This usually applies to owners and top executives whose death would cause a liquidity or credit crunch. For example, if the company’s main business lender demands immediate repayment of all outstanding loans, you need a life insurance policy big enough to cover it.
Is Key Person Insurance Tax-Deductible?
Unlike most business expenses, key person insurance premiums are not tax-deductible or tax-advantaged in any way. Your premium payments reduce your company’s profits dollar for dollar.
On the bright side, key person insurance death benefits are usually tax-free. The biggest exception is if you don’t report a policy’s existence to the IRS while it’s in force. In that case, the IRS may consider the death benefit taxable business income.
To avoid that, report all key person insurance policies to the IRS using Form 8925. You should also report any other employer-owned insurance policies using this form, even if you don’t consider them key person policies.
From standard business liability and property insurance coverage to more specialized policies like cybercrime insurance and inland marine coverage, growing businesses need a broad spectrum of protection.
But as any business owner knows, human capital is among a business’s most important assets. If your business would struggle to recover from the death of a key employee or partner, you’d do well to look into key person life insurance. Should tragedy strike, you’ll be glad you did.
For more information, see our article on the best small-business insurance companies.