Key Person Insurance: What Is It and Do I Need It?
We protect what we value most with insurance. Car insurance and home insurance ensure that we can financially survive a major property loss. Life insurance pays money to beneficiaries after a death, acting as a financial lifeline to the deceased’s loved ones. Business insurance is a hedge against uncertain losses and unpredictable risks that companies face.
Key person insurance, also called key man insurance, can be thought of as a hybrid between business insurance and life insurance. Companies can take out this type of insurance on the lives of certain employees to cover the risk of losing “key” workers. The company pays the insurance premium, and if the covered employee dies, the business collects the death benefit. Key person insurance can also be structured as a disability policy if the employee becomes disabled.
Investors and lenders may require a key person policy to provide for business continuity. Key person insurance can be used in partnership buyouts as well.
Who Qualifies as a Key Person in My Business?
According to the Insurance Information Institute (III), key employees are those who have knowledge and skills that significantly contribute to your business income. Although this might sound a little vague, you probably have a good idea of who is indispensable to your business. The following are examples of key persons:
- The owner
- An individual with highly specialized abilities, knowledge, or industry connections
- An employee who single-handedly brings in a large amount of sales or revenue to the company
- An employee whose reputation is of vital importance to the business’s financial viability
A key person could be a salesperson that generates a large share of new business, a chef or a craftsman whose skill is a huge selling point, or an officer with connections in the business world that are the lifeblood of the company. A key person is often in upper management, but they do not have to be. They tend to be highly compensated, which reflects their value to the business.
You know who the key persons are in your company. They are those workers who, if they departed tomorrow, would have an adverse financial impact on the business and leave you scrambling to replace them.
How Does Key Person Insurance Work?
Here is a quick synopsis of how key person insurance works:
- The covered employee must agree to the company taking out a key person policy on them
- The business/employer is the owner of the key person insurance policy
- The business/employer pays the policy premium and is the policy’s beneficiary
The III says that, in some cases, the insurance company may additionally require a statement from the company’s board of directors about the policy’s purpose.
If you have ever bought regular insurance before, you are probably familiar with the two main options: term life and whole life. The III adds that businesses typically use term life insurance when they are only concerned with losses caused by the death of a key employee, but that whole life policies, which accumulate cash value, are sometimes appropriate. A less common form of key person insurance—key person disability insurance—provides a similar financial safety net, but pays out when the covered employee suffers a disability that prevents the employee from working.
Key Person Insurance Amounts and Costs
To know how much key person insurance to purchase for an employee, figure out how much they are worth to your business. The III notes that some insurers have formulas to make this determination, but they may not accurately reflect an employee’s value.
Nationwide Insurance notes that, when determining the coverage amount for a key employee, it can be helpful to consider their current salary and multiply this number by a factor of 5 or 7. Policy Genius recommends taking into account the employee’s gross compensation (an amount that covers not only salary, but also bonuses, equity or stock, business expenses, and transportation services) and multiplying this by a factor of 5 to 10. Other points to consider are the cost to replace (e.g., finding, hiring, and training a replacement) the insured person and the revenue or profit the person brings in.
Costs for key person life insurance roughly mirror costs for regular life insurance. A $100,000 policy might start at about $100 per month. The following factors affect the cost of key person insurance:
- The amount of coverage
- The type of policy (term life is generally cheaper than whole life insurance)
- The insured’s age, gender, health, and lifestyle
- Total compensation of the insured
- Occupation and industry of the insured
- Size of the company (bigger companies usually need more coverage, resulting in higher premiums)
- Industry (some industries have higher risks of premature death or disability)
- Whether policy riders are purchased (waiver of premium, living benefit, and business exchange riders are examples of riders available with key person policies)
When a crucial employee dies or becomes disabled, the business that took out the key person policy receives a tax-free payout from the insurer. This money can be used for a number of things, such as
- temporarily covering operating expenses until a replacement is found;
- recruiting and training the new hire;
- absorbing lost revenue (such as sales lost and projects canceled due to the key person’s absence);
- covering outstanding loans;
- paying off debt, making investor distributions, and paying severance if the business is forced to shut down; and
- making benefit payments to survivors.
If the key person is an owner of the business, a key person insurance payout can also cover a buyout of the deceased’s ownership share in the business if they suffer an untimely death. A buy-sell agreement should also be in place if using key person insurance for this purpose.
The Final Word on Key Person Insurance
The III cites insurance industry data showing that the success of about 70 percent of companies is highly dependent on one or two people—yet just 22 percent of businesses have purchased key person insurance.
Insurance gaps can leave you holding the financial bag when uncovered losses arise. You probably already have many types of insurance covering your business, but without key person insurance, you could face a significant setback if an irreplaceable employee becomes disabled or passes away. If your business has certain employees who you could not imagine functioning without, key person insurance may be well worth the cost. It may also be required if you plan to take out a loan or are seeking investors in your business.
To discuss the risks your business faces and how to address them, you should meet with a knowledgeable business attorney. We can help you think through whether your business should consider purchasing key person life insurance or disability insurance—including who you should insure, how to obtain a policy, and how much insurance to take out. To discuss this and other measures you can take to protect your business, please reach out to our office and schedule an appointment.