What Is Key Person Insurance?
Key person insurance is a life insurance policy that a company purchases on the life of an owner, a top executive, or another individual considered critical to the business. The company is the beneficiary of the policy and pays the premiums. This type of life insurance is also known as "key man (or "keyman") insurance," "key woman insurance," and "business life insurance."
- Key person insurance is a life insurance policy a company buys on the life of a top executive or another critical individual.
- Such insurance is needed if that person's death would be devastating to the future of the company.
- For small businesses, the key person might be the owner or founder.
- The company pays the insurance premiums and is the policy's beneficiary, should the person die.
Understanding Key Person Insurance
Key person insurance offers a financial cushion if the sudden loss of a certain individual would profoundly negatively affect the company's operations. The death benefit essentially buys the company time to find a new person or to implement other strategies to save (or shut down) the business.
In a small business, the key person is usually the owner, the founders, or perhaps a key employee or two. The main qualifying point is whether the person's absence would cause major financial harm to the company. If this is the case, key person insurance is definitely worth considering.
In addition to life insurance, key person insurance is also available as disability coverage in case the individual is incapacitated and no longer able to work.
The Process of Key Person Insurance
For key person insurance, a company purchases a life insurance policy on certain employee(s), pays the premiums, and is the beneficiary of the policy. In the event of the person's death, the company receives the policy's death benefit.
That money can be used to cover the costs of recruiting, hiring, and training a replacement for the deceased person. If the company doesn't believe it can continue operations, it can use the money to pay off debts, distribute money to investors, provide severance benefits to employees, and close the business down in an orderly manner. Key person insurance gives the company some options other than immediate bankruptcy.
To determine whether a business needs this kind of coverage, company leaders must consider who is irreplaceable in the short term. In many small businesses, it's the owner who does most things, such as keeping the books, managing employees, handling key customers, etc. Without this person, the business can come to a stop.
Categories of Loss Covered by Key Person Insurance
Key person insurance can cover a company against a range of risks. For example, it may provide:
- Insurance to protect profits—for example, offsetting lost income from lost sales or losses resulting from the delay or cancellation of any business project involving a key person.
- Insurance designed to protect shareholders or partnership interests. Typically, this enables the surviving shareholders or partners to purchase the financial interests of the deceased person.
- Insurance for anyone involved in guaranteeing business loans or banking facilities. The value of insurance coverage is arranged to equal the value of the guarantee.
Cost of Key Person Insurance
How much insurance a company needs will depend on the size and nature of the business and the key person's role. It's worth asking for quotes on $100,000, $250,000, $500,000, $750,000, and $1 million policies and comparing the costs of each.
The cost will also depend on whether the company buys a term life policy or a permanent life policy. Term life is almost always significantly cheaper.
In addition, the cost of the coverage will vary on a variety of factors, such as the health of the key person, their gender, their age, the type of policy, the amount of coverage, the type of company, its structure, and the industry it is part of.
What Are the Benefits of Key Person Insurance?
Key person insurance financially protects a company against the death or incapacitation of its key person. The money from the insurance helps a company replace the key person and the costs associated with doing so. It can also be used to pay off debts, pay back investors, or cover any other financial costs the company may incur when losing its key person.
How Much Key Person Insurance Do You Need?
The amount of key person insurance needed for a business will vary depending on the business and the type of role the key person plays. Purchasing key person insurance that is eight to 10 times the key person's salary is often recommended or the monetary value of the key person. The latter option can be difficult to value, but methods include the amount of revenues/profits associated with the key person or the costs required to replace the key person, which includes recruitment, training, and the loss of revenue in the time it takes to replace the individual.
Who Pays for Key Person Insurance?
The company that purchases the key person insurance is the entity that pays the premiums for the insurance. The key person does not pay the insurance.
The Bottom Line
Key person insurance allows a company to continue to operate in the event of the loss of an individual critical to the success of the business. The death benefit to the company can cover a variety of costs to ensure the business can survive the sudden loss of its key person. Choosing the right key person insurance, the amount of the policy, and other details is particularly important for small businesses and new startups.