Key Person Insurance

What Is Key Person Insurance?

Key person insurance is purchased by a business to insure the life of one of the company’s most vital employees. It’s intended to help the company recover from the loss of a key contributor whose untimely death or disability would negatively impact the company’s value or operational capabilities.

Employees that are typically covered by this type of insurance include high-level executives and other decision-makers, employees who are highly visible, top salespeople, and employees with unique knowledge or skill sets.

As with any life insurance policy, key person policies have three primary roles:

Owner: This is the person or company that purchases the key person insurance policy and typically pays the premium. The owner has the right to transfer, sell, or change the terms of the policy.

Insured: This is the person upon whose death or disability the policy would pay the benefit. Therefore, premiums are directly tied to the health and lifestyle of the insured.

Beneficiary: This is the person or entity that would receive the death benefits should the insured pass away during or be incapacitated during the period of coverage.

Key person life insurance differs from other life insurance policies in that the business is both the owner and the beneficiary of the policy. The key person essentially has no active participation in the policy. However, the business is legally required to notify the insured employee of its intent to purchase the coverage, provide them with details of the policy, and obtain their consent.

Who Is Key Person Insurance For?

If the overall financial success of your company is intrinsically tied to one or two people within the organization, then you should purchase key person insurance to protect those vital persons. The key person doesn’t necessarily need to be the owner or the CEO of your company.

For example, if you have a salesperson who is an absolute superstar and outsells all of your other salespeople consistently and by a wide margin, they could be considered a key person in your business as well, because your company would suffer a tremendous loss of revenue if that person were to die or become disabled and unable to work.

If you’re still not sure whether your business needs this insurance coverage, ask yourself the following questions:

• Does a significant portion of your revenue and income depend on the unique skillset of one particular individual?
• Do you have company debts that you wouldn’t be able to pay off without a key individual?
• Is your company’s reputation tied to one key person’s name and reputation?
• Is your company seeking a loan or investment?

If you have answered “yes” to any of these questions, your company should purchase a key person life insurance policy.

Why Do You Need It?

The repercussions of losing an important business contributor can be devastating. University of Central Arkansas researchers cite the loss of a key person among the top causes of small business bankruptcies.

Key person insurance will ensure that your company is financially protected from the fallout of a key person’s death, so you can recover and move forward. Your company will be better able to cover hiring or training a replacement. You can also make up for loss of profits or any debt that you may incur while the company is recovering.

Key person insurance is necessary even if your business plans to shut its doors after the loss of a key person; the money can be used to cover the closing costs, pay off investors, and provide severance packages for employees.

Life vs. Disability Insurance

There are two basic types of key person insurance: life insurance and disability insurance.

Key person life insurance is applied either as a term policy or a permanent policy. A term policy applies for a specific period of time, which may vary from as short as one year to as long as 20 years. Coverage ends when the term expires or the insured person dies, whichever event occurs first. Term policies are considerably cheaper than permanent policies.

Sometimes, a key person doesn’t actually pass away but does become incapacitated and unable to perform his or her duties. In this case, key person disability insurance will compensate a company for the costs associated with the partial or total absence of the key individual. This coverage applies regardless of whether the person is temporarily or permanently unable to contribute.

How Much Key Man Life Insurance Coverage Do You Need?

There’s no one size fits all solution for how much key man insurance you should buy. You should consider how valuable the key person is for your company and how much your company will lose if you lose them. The payout should be large enough to cover the worst-case scenario.

Additionally, consider how hard and costly it would be to replace the key person – certain positions and certain industries will have more talent on offer. The policy should offer a sufficient cushion to move past the loss of a key man.

Tax Considerations for Key Person Insurance

Any company purchasing key person insurance for its essential employees should know that premium payments are not classified as business expenses and, therefore, are not tax-deductible. If the company is the policy owner and beneficiary, which is typically the case with key person insurance policies, the IRS doesn’t allow the premium costs to be deducted.

The payouts, on the other hand, are not subject to income taxes. However, this is contingent on the employee being notified and consenting in writing that the employer intends to take a business life insurance policy out on them and that the business will be the beneficiary. Also, the employee must consent to the employer having the option of keeping the policy in force even after they cease being employees.

If these conditions are not met before issuing the key person policy, the insurance payout will not be tax-exempt.

What Happens if the Key Person Leaves the Company?

Key man policies were more popular a few years back, as the insured employees were more likely to stay with the company for longer. However, the business climate has changed significantly since then.

More and more executives and top employees are looking to advance their careers by taking on new roles and challenges at different companies. This has made key man policies slightly more risky for businesses, as there’s less of a guarantee that a key person will remain with the company long-term.

In the event that a key person leaves a company during the coverage term, the business can cancel the policy with no negative business risk.

Ownership of the policy can be transferred to another key employee after the insurance is no longer needed for business protection. The employee simply assumes the premium for the remainder of the policy term and changes the beneficiary for their personal needs.

Hypothetical Examples of Key Person Insurance at Work

Example 1: Protecting for Loss of Revenue

Peter owns a successful and rapidly growing small business. His top salesperson is James and he relies on him for the intellectual capital behind their proprietary technology company. Peter understood that James was a key person in his business so he took out life and trauma insurance on him. When James tragically died in a car crash, the business was deprived of his vital expertise and its ability to continue operating was in jeopardy. Luckily, Peter was able to use the payout from the key person policy to weather the loss and hire and train a new person to replace James, enabling him to continue operating the business.

Example 2: Protecting Business Debts

Colin’s business needs to buy expensive equipment in order to expand its operations. He takes out a business loan to purchase suitable equipment, backing the loan with a personal guarantee, a mortgage over the equipment, and his home. Colin takes out key person insurance on himself, realizing that if he were to get seriously ill or passed away, the company would have no means of repaying the loan. Two years after taking out the insurance, he suffers a serious illness that prevents him from working. The insurance pays out the loan, leaving the business and Colin debt-free.

What Does Key Person Insurance Cover?

A Key Person insurance policy can provide financial coverage for a period of time after a key person dies unexpectedly. The policy can be used either to provide a temporary substitute for your company or to hire and train a permanent replacement. It can also be used to make up for any loss of profits or debts resulting from a key person’s death.

Additionally, this type of life insurance can be used as a guarantee for business loans. The key person insurance policy can be put toward shareholdings or partnership interests.

What’s Not Covered?

It’s important to understand the exclusions in your key person policy. The most common key person insurance exclusions are fraud, misrepresentation, and suicide. A claim can be denied in case of a proven instance of intentional dishonesty.

During the first two years of every life insurance policy, there is a contractual clause known as the contestability period. If a claim is made during those two years, the insurance company will conduct an investigation to determine if there were fraudulent statements or deliberate omissions made during the application process. Also, key person insurance will not cover suicide during the two-year contestability period.

What Does Key Person Life Insurance Cost?

The cost of key person life insurance primarily depends on the following factors:

Type of Policy and Amount of Coverage: Limited-term life insurance policies are less expensive than permanent insurance as they offer coverage for a fixed period of time and don’t accumulate a cash value.

Policy Death/Disability Benefit: The greater the amount of coverage that’s in place the higher premiums will be.

Key Person’s Age, Gender, and Health: In general, the older the key person is and the more pre-existing health conditions they have the higher the premium will be.

Company Structure and Size: Premiums are higher for more valuable companies and also rise with the value of the key person’s contributions.

Industry: Premiums will be higher for riskier industries because of the increased risk of premature death or disability.

It’s important to understand that the cost of insuring an older or less healthy employee can be very high and in certain cases impossible.

Additionally, the cost of key person insurance usually becomes more manageable, but also more important, as companies move beyond the development phase and start to scale. Pressure to purchase key person policies often comes from investors who want to know that their investments are protected before coming on board.