More on Life Insurance
More on Life Insurance
Key person insurance is a life insurance policy taken out on an executive member of a business. The business is the beneficiary and pays the premiums.
Life insurance offers financial protection and peace of mind to the people who matter most to you. An individual policy provides a tax-free lump sum of money for your family or friends to replace lost income after your death.
But a business – whether it’s a start-up or longstanding company – needs financial protection too. If you’re a business owner, partner, or high ranking executive, key person life insurance (also called “key employee” or “key man” insurance) can help mitigate potentially devastating risks to your company, store, or firm.
Key person insurance is a business essential and lack of life insurance for your business’s top employees could be damaging, leading to tough losses or even bankruptcy. Below, we’ll explain the pros and cons of key person life insurance, including who needs it, how much it costs, and how it works.
Start-ups, small businesses, private and public companies, and large corporations can all benefit from owning key person life insurance
Businesses must undergo financial underwriting to qualify for key person life insurance
The best way to insure your business is to have a buy-sell agreement in addition to key person life insurance policies
Experts recommend purchasing 5 - 10x the employee’s gross compensation in life insurance
Key person insurance provides a death benefit to a business if a crucial employee, such as the owner, partner, or CEO, dies. So while a personal life insurance policy provides income replacement to family members or friends, a key person insurance policy ensures that your business and your employees have financial support and job security, too.
The death benefit can cover the costs of replacing the employee, or can pay for any lost business that results from their death.
Key person insurance can also be used to:
Recoup revenue loss for companies that would suffer from the death of a key employee (such as a high earning agent at a real estate brokerage).
Retain clients or uphold reputation for a business based on a particular employee’s skills or name (like a partner at a law firm).
Buy out shares in partnership businesses (like a dental practice) where one partner dies.
Repay any collateral assignment business loans that the key person held or co-signed.
Grow the business and secure new business loans for the future.
The business organization owns a key person policy, pays the premiums, and is the beneficiary of the death benefit. However, businesses cannot take out a key man policy on an employee without their knowledge. The person being insured must agree to the company’s purchase of insurance. If the business owner is a key person, it's possible for the business to have a policy out on the owner.
The structure for key person insurance differs from individual life insurance policies where the person being insured typically owns and pays for the policy, and chooses their beneficiaries. For a key person policy, the death benefit is paid to the business if the insured person passes and can be used for virtually any expenses related to the business.
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Businesses of all sizes can benefit from key person life insurance:
Start-ups: early and late-stage startups often have founders, CEOs, or a small group of key employees whose expertise is hard to replace. Buying key life insurance for start-ups can be more complicated during underwriting because the business’s track record is not as established, so we recommend working closely with a licensed insurance agent from the very beginning.
Small or private businesses: from mom-and-pop stores to private practice law firms, small businesses typically have owners or partners who would be hard to replace either because of their reputation with clients or their involvement in day-to-day business operations. If the business has been around for a while, the financial underwriting process is fairly straightforward.
Larger businesses or corporations: doctor’s offices, publicly traded companies, and big financial firms need key person life insurance policies too. If a top executive’s name or client base helps keep the business afloat, their death can affect everyone from the C-suite to entry-level employees.
The best way to determine which employees might be a good fit for key man life insurance is to figure out which employees would cause significant financial or operational loss if they were gone. For most businesses, that’s the CEO, CFO, owner, or partner, but it could also be an employee who handles key business dealings behind the scenes, such as a legal counsel.
“There's no excuse for most businesses, especially small businesses, not to have a life insurance policy such as key person insurance,” says Warren Robbins, senior sales associate at Policygenius. “Businesses often skip this step in risk evaluations for business planning, but if you don’t have life insurance for your top employees, you are not mitigating a potentially devastating risk.”
Key person insurance can help offset the cost of replacing these employees or the business profits the company could lose without them.
There's no excuse for most businesses, especially small businesses, not to have a life insurance policy such as key person insurance.
Any type of life insurance policy that can be used for an individual can also be structured as key man life insurance. The two most common types of life insurance are term life and whole life insurance.
Term life insurance is the right choice for most shoppers, even businesses, because it’s more straightforward and less expensive. Policyholders (in this case, the business purchasing key person insurance) pay monthly or annual premiums for the length of the policy’s term, which according to Policygenius offerings typically last between 10 to 30 years.
Whole life insurance is a type of permanent life insurance that does not expire or have a term limit. It can be a great option for businesses looking for key person insurance on an employee who will likely be at the company indefinitely (like an owner or founder). Whole life insurance is five to 15 times more expensive than term life, so it’s only a good option if your business can comfortably afford the premiums in the future.
|FEATURES||TERM LIFE INSURANCE||WHOLE LIFE INSURANCE|
|Duration||1 - 30 years||Life|
|Cost||$25-35/month||5-15x more than term|
|Guaranteed Death Benefit?||Yes||Yes|
|Guaranteed Cash Value?||No||Yes|
|How Cash Value Grows||N/A||Earns interest at a predetermined fixed rate|
|Premiums||Can increase periodically or stay level for the policy duration||Level|
|Notes||No risk of losing coverage, but no cash value when term ends||No risk compared to other permanent types, but you may find better investment options elsewhere|
Associated costs for term and whole life insurance policies are based on quotes from policies offered by Policygenius as of August 2020. Life insurance companies quoted include: AIG, Banner, Brighthouse, Lincoln, Mutual of Omaha, Pacific Life, Principal, Protective, Prudential, SBLI, and Transamerica.
Both term and whole life insurance have their benefits and drawbacks, and the cost of the life insurance policy will also depend on the amount of coverage and the insured’s age, hobbies, gender, and health.
In general, key person insurance can be more expensive because a business might need a larger coverage amount than an individual. If you’re seeking key man life insurance for an employee who is older, in poor health, or participates in risky pastimes, you can expect to pay more for the policy.
When shopping for individual life insurance policies, experts recommend 10 to 15x your income. For key person life insurance, experts recommend between 5 to 10x the employee’s gross compensation because most insurers’ coverage offerings max out at 10x gross compensation.
Gross compensation includes salary, stock, equity, transportation services, living expenses, phone plans, and other costs. Depending on your company and the employee, this amount can vary greatly.
For example, a CEO might have a gross salary of $250,000. But if they also own $80,000 in restricted stock, earn $20,000 in annual bonuses, and have a $10,000 yearly stipend for meals, their gross compensation is $360,000. Therefore the business would need between $1.8 million and $3.6 million in key person life insurance for the CEO.
It’s best to talk to a licensed insurance agent before applying for coverage to determine exactly how much your business needs.
Like any type of insurance, key person insurance has benefits and drawbacks. But most of the pros and cons lie in the type of policy you choose (term vs. whole). For key person life insurance itself, like individual life insurance, the advantages of having a policy outweigh the disadvantages.
The biggest advantage of life insurance is the financial protection it provides to your business. Key person life insurance is one of the best investments you can make.
|Pros of key person life insurance||Cons of key person life insurance|
|Financial protection for your business: in exchange for a small payment each month, key man life insurance pays out a tax-free lump sum of money if the insured employee dies||Costs can be high if the employee is unhealthy or old: premiums can get expensive quickly and are dependent on your employee’s health and age, as well as their hobbies|
|Cheap enough to fit most budgets: depending on your employee's health, age, and lifestyle, life insurance premiums (especially term life insurance) can be a small cost compared to other business expenses||Whole life insurance is expensive, regardless of age or health|
|Peace of mind: key person insurance offers peace of mind that your business won't flounder if the CEO, owner, or another significant person dies||It can be somewhat intrusive: because insurance companies underwrite the company as well as the employee, you’ll need to provide financial details about your business|
|It's easy to apply: in about 10 minutes, you can get quotes from different life insurance policies online (without taking up too much time on your calendar)|
The process for buying key person insurance is generally the same as buying individual life insurance, with one major difference. In addition to underwriting the individual who is going to be insured, the business seeking insurance must also undergo underwriting.
The basic steps to buying key person life insurance are:
This includes deciding which employees need key person insurance, but also involves determining your business’s need for a buy-sell agreement (basically a business will).
Because life insurance for businesses isn’t as straightforward as individual life insurance, we strongly recommend reaching out to an independent insurance broker, like Policygenius, at this stage. Key person insurance works best in tandem with additional business life insurance products (such as buy-sell agreements), and an agent can help you structure your plan correctly.
“Not a lot of business owners realize how complicated key person insurance and buy-sell agreements are,” says Robbins. “Life insurance, particularly for businesses, has to be structured correctly up front.”
If you talked to an insurance agent, this step is easy. You’ll not only need documents on behalf of the employee you’re seeking to cover, but also on behalf of your business. For the key person, you’ll need medical records, social security information, bank statements, proof of residency, proof of income, and possibly a few more documents. For your business, you’ll need profit and loss statements (P&Ls), tax returns, and other documents to show your business’s overall status.
Like any insurance product, you should compare rates and policies from different insurance companies to find the best price.
Once you’ve decided which insurance company and policy to apply for, the business fills out an application on behalf of the key person they’re seeking to insure. In some cases, like if the business is seeking key person insurance for the owner, the person applying might be the key person themselves. After that, the insurance company will follow up with a brief phone interview with the policyholder (the business representative) and the insured person (the key employee).
This step only applies to the key person who is being insured. The life insurance medical exam is the same as it is for an individual insurance policy and is similar to a physical.
If you’re seeking key man insurance for an employee, an insurance company needs to know more about your business’s overall state. They’ll look at your company’s losses year over year, gains, tax statements, and other aspects to determine the fitness of your business. In the same way that individual health is important to determine life expectancy and premium rates, a business’s “health” and estimated longevity helps determine key person insurance rates. Basically, the insurer wants to make sure the company seeking insurance is stable.
Once the policy is approved, the life insurance company will send the policy offer to the business’s representative for final review.
This typically falls on the business and not on the key person being insured. Of course, if the key person is the business owner or has more than 51% ownership in the business, they can sign on the business's behalf. Since the business is the policyholder, it is the entity responsible for premium payments.
Key person life insurance is a must-have for businesses of all shapes and sizes. Robbins likens the importance of key person insurance for businesses to individual policies for families. “When shopping for life insurance, many businesses, like many families, say, ‘we’ll do it later.’ But life insurance is just as vital to a business as it is to a family.”
And it’s important to note that key person life insurance policies are transferable. So, if something unfortunate happens to the business (policyholder), the person being covered can transfer ownership to their next business or to themselves to convert it into a personal life insurance policy without causing premiums to increase.
We recommend combining key person life insurance with a buy-sell agreement. In most situations, if a key person (like a partner) dies, the surviving partner won’t have sufficient cash to buy out the deceased partner’s shares from their estate. Without key person life insurance and a buy-sell agreement, the surviving partner might be forced to liquidate or take out a business loan that could plunge the company into more debt.
The peace of mind that key person life insurance offers a business is worth the cost of premiums.
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Premiums paid on business policies are not tax deductible, but the death benefit is tax free.
The business owns a key person life insurance policy, pays premiums, and receives the death benefit if the insured employee dies.
The premiums for key person life insurance are determined based on the individual person being insured, so they won’t be more expensive than a typical policy. However, because key person life insurance coverage amounts are based on gross compensation (as opposed to individual salary alone), a business might pay more in premiums to compensate for the employee’s overall contribution to the business.
Rebecca Shoenthal is a life insurance editor at Policygenius in New York City, specializing in buying life insurance and the ins and outs of life insurance ownership. She's edited business books by the country’s top academics, politicians, journalists, thought leaders and CEOs, including venture capitalist John Doerr’s Measure What Matters, entrepreneur Scott Belsky's The Messy Middle, NYU Stern professor Scott Galloway's The Four, and technologist John Maeda's How to Speak Machine.