Employee Key Life Insurance: What Your Business Needs To Know

Key person insurance is a life insurance policy that a company purchases for an owner, a top executive, or another individual considered critical to the business. It is also known as key man insurance, key woman insurance, or business life insurance. The company pays the premiums and is the policy's beneficiary, should the person die. This type of insurance is important for small businesses that rely heavily on one or two employees, as it can provide a financial cushion to sustain the business until the key employee is replaced. The death benefit can be used to cover recruiting costs, pay off debts, or distribute money to investors, among other things. Lenders may also require key person insurance as collateral for business loans.

Who is a key employee?

A key employee is a designation given to an employee who holds a position of significant importance within a company, and whose contributions are deemed critical to the organisation's success and survivability. While the specific definition of a key employee may vary across different companies and industries, there are several common characteristics that help identify these individuals.

Firstly, key employees often occupy executive-level positions within the company, such as division directors or vice presidents. They are usually involved in high-level policy-making and decision-making processes, which means their strategic input is invaluable to the company's operations.

Secondly, key employees can be individuals who are responsible for a significant portion of the company's sales or revenue. This could include business development roles, client relationship management, or specialised technical roles that are difficult and costly to replace.

Thirdly, in smaller businesses, key employees are often the founders or owners of the company. This is because they typically wear multiple hats, taking on a variety of responsibilities such as bookkeeping, employee management, and handling key customers. As such, their absence would bring the business to a standstill.

Additionally, key employees can also be defined by their level of ownership in the company and their compensation. For example, in the United States, a key employee is defined by the Internal Revenue Code as someone who meets at least one of the following criteria:

• An officer of the employer with an annual compensation greater than $130,000
• A 5-percent owner of the employer
• A 1-percent owner of the employer with an annual compensation greater than $150,000

How does key person insurance work?

Key person insurance is a type of life insurance policy designed to pay a business upon the death of the insured, as opposed to that person's beneficiaries. This type of insurance is also known as "key man" or "key woman" insurance, and "business life insurance". The company purchases the policy on the lives of owners, top executives, or other individuals considered critical to the business. The company is the beneficiary of the policy and pays the premiums.

The "key person" could be a company owner, partner, or indispensable employee with highly specialized knowledge, skills, or an extensive list of clients. The loss of such an employee can be devastating to a business, and key person insurance provides a financial cushion to help stabilize the business while it finds a new way forward. The policy provides funds that can help ensure business continuity if a key employee dies or becomes disabled, provided the policy has an additional disability rider.

The business owns the policy, but the employee must consent. When the insured dies or becomes disabled, the business receives the death or disability benefit. However, before a policy can be taken out on a key employee, life insurance companies require the written consent of the person being insured.

The money from the insurance can be used to cover the costs of recruiting, hiring, and training a replacement for 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.

Key person insurance is particularly important for small businesses and new startups, where the owner is often the key person, performing most of the essential tasks.

There is no exact formula for determining how much coverage is needed, but a good place to start is to consider how much it would cost to replace the individual. Companies will generally multiply the key person's salary by a factor of five to seven.

The type of policy, whether term or permanent, will also affect the cost. Term life insurance is significantly cheaper but expires after a set period, usually between 10 and 30 years. Permanent life insurance has higher premiums but builds cash value that the business can borrow against or withdraw from for future expenses.

What is the importance of key person insurance?

Key person insurance is a type of life insurance policy that a company purchases for an employee who is crucial to the business. This is usually the owner, founder, or a top executive, but it can also be someone with a highly specialised role or someone responsible for a large share of sales. The company pays the premiums and is the beneficiary of the policy.

The importance of key person insurance lies in its ability to protect a business from financial instability and collapse in the event of the death or incapacitation of a key employee. Here are some reasons why key person insurance is important:

• Financial Stability: Key person insurance provides a financial cushion to stabilise the business. The insurance payout can be used to cover operating expenses, supplement lost revenue, and pay off debts. This buys the company time to find a replacement, implement new strategies, or shut down the business in an orderly manner.
• Recruiting and Training: The costs of recruiting, hiring, and training a replacement employee can be covered by the insurance payout. This is especially important for highly specialised roles that may be challenging and expensive to fill.
• Business Continuity: Key person insurance ensures business continuity by providing funds to maintain operations during a difficult transition period. The money can be used to offset lost sales, project delays, or cancellations resulting from the loss of the key person.
• Protecting Shareholders and Partners: The insurance can help protect shareholders or partners by enabling the surviving stakeholders to purchase the financial interests of the deceased person. In a partnership, it can be used to buy out a deceased partner's shares from their family members.
• Loan Repayment: In cases where the policy is used as collateral for a business loan, the death benefit can be used to repay the loan. This protects the business from defaulting on its financial obligations.
• Peace of Mind: Key person insurance provides peace of mind that the business has the necessary financial resources to navigate the loss of a critical employee. This can reduce stress and uncertainty during an already challenging time.

Overall, key person insurance is important because it recognises that certain individuals are essential to a business and their loss could be devastating. By having this insurance, companies can safeguard their operations, protect their financial interests, and ensure they have the resources to adapt and recover.

How much key person insurance is needed?

There is no exact formula for determining how much key person insurance is needed to cover an employee. However, the general rule is to consider how much it would cost to replace the individual. This includes the percentage of the key person's contribution to the company's bottom line, as well as their current salary, which is often multiplied by a factor of five to seven.

The amount of key person insurance needed will depend on the nature and size of the business, the key person's role, and their contribution to the company's profits. It is recommended to purchase insurance that is eight to ten times the key person's salary or the monetary value of the key person.

It is also important to consider the type of policy, whether it is a term or permanent life insurance policy. Term life insurance is significantly cheaper and only pays out if the key person dies during the specified term, whereas permanent life insurance offers coverage that never expires.

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

Who owns the key person policy?

In the case of key person insurance, the business owns the policy and pays the premiums, making it a form of company-owned life insurance, or COLI. The company is also the beneficiary of the policy and will receive the death benefit should the insured person pass away.

While the insured person does not own the policy, their written consent is required before a company can take out a COLI policy on them.

The company purchases a life insurance policy on certain employees, 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.

The money from the policy can be used to cover the costs of recruiting, hiring, and training a replacement for the deceased person. If the company decides not to continue operations, the money can be used to pay off debts, distribute money to investors, provide severance benefits to employees, and close the business down in an orderly manner.

Frequently asked questions