Key Person Life Insurance: Protecting Your Business's Future

Key person life insurance is a type of life insurance policy that a company purchases on the life of a founder, owner, or critical employee. It is also known as key man or key woman insurance and is designed to pay a business upon the death of the insured, as opposed to that person's beneficiaries. The company owns the policy, pays the premiums, and is the beneficiary. This type of insurance is important for small businesses, as it can help them stay afloat during a transition period after the loss of a key employee. The death benefit can be used to recruit, hire, and train a replacement or to pay off debts and close the business down in an orderly manner.

Who is a key person?

A key person is an individual whose existence is critical to a company's operations and survivability. They are usually high-ranking employees whose death or incapacitation would have a devastating impact on the business. This could include company owners, partners, top executives, or indispensable employees with highly specialized knowledge, skills, or relationships.

The loss of a key person could jeopardize the business due to their unique contributions, such as their reputation, name, skillset, or client connections. Their absence could result in a significant financial burden for the company, making it difficult and costly to replace them.

Lenders or investors may require key person insurance as collateral for business loans or financing. This type of insurance ensures that the business has the financial means to recover from the loss of a key individual and can help stabilize the company while new strategies or leadership are put in place.

The specific individuals deemed "key persons" can vary depending on the structure and nature of the business. However, the defining factor is the potential impact their absence would have on the company's operations and financial stability.

Who pays for key person insurance?

Key person insurance is a type of life insurance policy that a company buys on the life of a top executive or another individual critical to the business. The company purchases the insurance and pays the premiums. The company is also the beneficiary of the policy and will receive the death benefit if the insured person passes away.

The company owns the policy and pays the premiums, so it is a form of company-owned life insurance, or COLI. The employee, however, must consent to being insured. The company can then use the money to cover the costs of recruiting, hiring, and training a replacement for the deceased person.

Key person insurance is needed if the insured person's death would be devastating to the future of the company. For small businesses, this person might be the owner, founder, or a key employee. The main qualifying point is whether the person's absence would cause major financial harm to the company.

The cost of key person insurance will depend on the size and nature of the business, the key person's role, their health, gender, age, and the type of policy, among other factors.

In summary, key person insurance is a valuable tool for businesses to protect themselves from the financial impact of losing a critical employee. The company pays for the insurance and receives the benefits, which can help stabilize the business and ensure its continued operation.

What is the purpose of key person insurance?

Key person insurance is a type of life insurance policy that a company purchases for an owner, a top executive, or another individual considered critical to the business. The company buys the policy, pays the premiums, and is the beneficiary. This type of insurance is also known as "key man insurance", "key woman insurance", or "business life insurance".

The purpose of key person insurance is to provide a financial cushion to the company in the event of the sudden loss of a key person. The death of such an individual would profoundly and negatively affect the company's operations and future. The death benefit buys the company time to find a replacement or implement other strategies to save or shut down the business.

In a small business, the key person is usually the owner, founder, or a key employee. The main qualifying point is whether the person's absence would cause major financial harm to the company. The loss of certain key employees can have a devastating impact on an organization. This could be due to their reputation, name, skillset, or clients they bring into the company.

Key person insurance can also be used to protect shareholders or partnership interests. It enables the surviving shareholders or partners to purchase the financial interests of the deceased person. It can also be used to pay off debts, distribute money to investors, provide severance benefits to employees, and close the business down in an orderly manner.

Additionally, key person insurance is available as disability coverage in case the individual is incapacitated and no longer able to work. The business can receive a disability benefit to help ensure business continuity.

When should a business consider a key person insurance policy?

A key person insurance policy is a type of life insurance policy that a company purchases for an owner, a top executive, or another individual critical to the business. The company pays the premiums and is the beneficiary of the policy. This type of insurance is necessary if the loss of the said person would be devastating to the company's future.

• Applying for a business loan: One of the most common reasons for a business to take out key person insurance is when applying for a business loan or other financing. Lenders or investors often require this type of insurance as collateral for the loan. In this case, the death benefit typically goes towards repaying the loan first, and any remaining money goes to the business.
• Business named after the owner or key person: If the business bears the name of the owner or another key person, their loss could jeopardize the company's reputation and viability. Key person insurance can provide financial stability during such a transition.
• Significant link to a person's reputation, skillset, or financial viability: If the company is strongly associated with a particular individual's reputation, skillset, or financial viability, their loss could negatively impact the business. Key person insurance can help stabilize the business and provide time to find a new direction.
• Impact on sales and finances: If the loss of a key person is likely to significantly affect the company's sales, finances, or overall financial health, key person insurance is advisable. This insurance can provide funds to ensure business continuity and give the company time to find a suitable replacement.
• Sole proprietorship or small business: For sole proprietors or small businesses, key person insurance can provide an insurance payout that allows heirs to close the company and pay off any business debts without incurring additional financial burdens.
• Partnerships and buy-sell agreements: In a business partnership, key person insurance can be crucial. It enables partners to buy out the other's shares in the event of an untimely death. This is typically done through a written buy-sell agreement, ensuring a smooth transition and protecting the business from potential disputes.
• Commercial lenders' requirements: Some commercial lenders may require key person life insurance for certain individuals as a condition for providing a loan to expand the business.
• Invaluable employees: If your business has employees who are invaluable and their loss would be financially detrimental, it is prudent to consider key person insurance. This is especially relevant if replacing them would be challenging and costly due to their unique skills, knowledge, or contributions to revenue.
• Business continuity and stability: Ultimately, key person insurance is about ensuring business continuity and stability. If the absence or loss of a particular individual is likely to cause major financial harm to the company, key person insurance is worth considering. It provides a financial cushion, giving the company time to make necessary adjustments, find replacements, or implement alternative strategies.

How much coverage is needed?

The amount of coverage needed for key person insurance depends on the business and the type of role the key person plays. A good rule of thumb is to buy coverage that is eight to ten times the person's salary. This can be calculated by adding the person's salary to their direct financial contribution to the company's bottom line, and then multiplying the result by at least five.

Another way to determine coverage needs is to identify the key person's monetary value to the business. This can be done by considering the following:

• The key person's contribution to the company's profits, including income that would be lost and the key person's impact on meeting business objectives.
• The cost of replacing the key person, including recruitment costs, training costs, and lost sales.

The coverage amount can also depend on whether the company buys a term life policy or a permanent life policy. Term life insurance is more affordable, but coverage is temporary and premiums will be significantly higher upon renewal due to the person's increased age. Permanent life insurance has higher premiums but can provide additional benefits, such as building cash value that the business can borrow against or withdraw from for future expenses.

Additionally, the cost of key person insurance will depend on various factors such as the key person's age, gender, health, the company's structure and size, and the industry it is in.

Frequently asked questions