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.
A business – whether it’s a start-up or longstanding company – needs financial protection from unexpected death. If you’re a business owner, partner, or high-ranking executive, key person life insurance (also called “key employee” or “key man” insurance) is a life insurance policy that 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 to 10 times 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 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 (also known as dead peasant insurance). 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.
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.
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Businesses of all sizes can benefit from key person life insurance:
Larger businesses or corporations Doctor’s offices, publicly traded companies, and big financial firms need key person life insurance policies. 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.
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.
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|
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 15 times your income. For key person life insurance, experts recommend between 5 to 10 times the employee’s gross compensation because most insurers’ coverage offerings max out at 10 times 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. 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.
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.
“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.”
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.