Key person insurance is an important type of business insurance that protects companies against financial losses that can occur due to the death or disability of a vital employee. This insurance policy provides funds and coverage to offset revenue losses, recruitment costs, and debt repayments if such an employee is unexpectedly unable to work.
What Is Key Person Insurance?
Key person insurance, also known as keyman insurance, is a life insurance policy that a business takes out on a key employee whose knowledge, work, or overall contribution is considered uniquely valuable to the company. The proceeds from the policy are used to protect the business from losses if that employee dies or becomes otherwise unable to work.
The main purpose of key person insurance is to compensate the company for the costs, loss of profits, and other disruptions that would arise if they lose their “key person”. This type of coverage is essential for financially protecting businesses that rely heavily on individuals whose talent or leadership is not easily replaced.
Unlike personal life insurance that goes to beneficiaries, the payout from key person insurance is paid directly to the business itself. This money can then be used to recruit and train a replacement, repay outstanding debts, maintain daily operations, and keep the business financially stable during the transition period.
Some key benefits provided by key person insurance policies include:
- Coverage for death benefits – Pays a lump sum if the key employee dies.
- Living benefits – Provides funds if the employee is diagnosed with a terminal illness or becomes disabled and unable to work.
- Business continuation – Money to keep the business running until a replacement is found and trained.
- Recruitment funds – Provides resources to find and train a new person to fill the key role.
- Debt repayment – Funds to handle financial and contractual obligations in the absence of the key employee.
While key person insurance is similar to life insurance, there are some important distinctions:
- The policy owner is the business, not an individual.
- The payout goes to the business, not any beneficiaries.
- It covers revenue losses tied directly to an employee’s absence.
- The premiums are usually not tax-deductible for businesses.
How Does Key Person Insurance Work?
Ownership and Beneficiaries
With key person insurance, the business is both the policy owner and beneficiary. The policy is taken out specifically to protect the company against financial issues, so the payout goes directly to the business itself.
The employee being insured must consent to be covered and will be required to provide medical history and undergo a health evaluation. However, they cannot own or control the policy.
Determining the Coverage Amount
Factors like the employee’s salary, role, experience, ownership stake, and the specific costs of replacing them guide the insurance amount. It should cover projected losses and continuation expenses during a transition period.
Common measures used to quantify an appropriate amount are:
- 1-5 times the key employee’s annual salary or total compensation
- 10-20% of the company’s annual revenues
- Projected expenses for temporary staff, recruitment, training
- The key person’s economic value to the company
Premiums and Tax Implications
As the policy owner, the business is responsible for paying the insurance premiums. These regular payments keep the coverage active. Premium costs depend on the size of the death benefit, the insured’s age and health, and other variables.
Premiums are usually not tax-deductible for the business. For employees, the premium amounts are treated as taxable income. Some exceptions exist, so professional tax advice is recommended.
When Should a Business Consider Key Person Insurance?
Not all employees require key person insurance, even if losing them would hurt productivity. Careful consideration should determine if this specialized coverage aligns with the company’s specific risks and needs.
Identifying Key Employees
Individuals that warrant key person insurance are often:
- Major revenue generators (sales leaders, rainmakers)
- Irreplaceable technical experts or project leaders
- Decision makers with vital institutional knowledge
- Top executives and founders that drive growth
- Essential creative talents or product developers
Assessing the Financial Impact of Their Loss
Quantifying an employee’s economic value can justify a substantial investment in key person insurance. Impacts may include:
- Lost sales and accounts
- Delayed projects and milestones
- Recruitment, relocation, and training costs
- Reduced productivity and efficiency
- Negative effects on credit, valuation, stock price
Evaluating the Risks and Needs of the Business
Key factors that indicate a need for key person insurance:
- A concentrated revenue stream tied to one or two employees
- A start-up heavily dependent on its founders
- A small business with irreplaceable expert knowledge
- A pending liquidity event like selling the company
- Business deals contingent on a key employee
- Credit agreements requiring insurance for certain people
Key person insurance can be an invaluable tool for managing risk related to the unexpected loss of invaluable employees. Assessing the likelihood of such an event and quantifying its business impacts will allow organizations to determine if this type of coverage is a prudent investment. With proper planning, key person insurance can financially protect companies and enable them to survive and move forward even after losing their most important contributors.
