How Does Key Person Life Insurance Work?
Whereas individual life insurance plans apply to an individual and their personal finances, key person life insurance considers a business’s financial situation. For key person insurance, a company purchases a life insurance policy on a certain employee(s), pays the premiums and is the policy’s beneficiary. If the insured person passes away, the business receives the policy’s death benefit.
The insurance proceeds can cover all costs of replacing the key person, including recruiting, hiring and training a new employee. If the company cannot continue to operate without the deceased, it can also provide severance funds to employees, pay off investors or shut down the business methodically. Also known as business life insurance, key person insurance can give the business an alternative to filing for bankruptcy.
Similar to other forms of life insurance, a business considering key person insurance must decide between term life insurance and permanent life insurance.
Key takeaways:
- Key person life insurance can offer financial protection to a business by covering certain employees.
- The amount of coverage needed is based on the insured person’s financial contribution to the business, and the impact that person’s death would have on the company’s bottom line.
- Rates for key person coverage depend on several factors, including the insured person’s age and health and the type of policy.
- Key employee insurance stays in effect as long as the insured person remains in business and premiums are paid (for whole life policies) or the term ends (for term life policies).
Why Is Key Person Life Insurance Important?
Key person or key man life insurance protects your business financially should a key member of the company pass away. The payout goes toward the costs associated with replacing the key employee. The company can also use insurance proceeds to pay off debts and offset the financial consequences associated with losing the insured person.
Key person insurance may make sense in several circ*mstances:
- Helping the business survive: A company may consider a business succession plan using key person life insurance if its reputation and financial viability are critically linked to a specific employee. This includes connections to the employee’s name, unique skills or if their death could cause the business to shut down.
- Protecting profits: Key person policies can offset lost income from sales or the delay or cancellation of any business project involving a key person.
- Safeguarding partners: A key life policy can protect shareholders or partnership interests. In a buy-sell agreement, you and your business partner own policies covering each other’s lives, allowing surviving partners to buy out the financial interests if the insured person passes away.
- Guaranteeing loans: Lenders sometimes require collateral to guarantee a business loan. This stipulation is called a collateral assignment and offers a way for the lender to collect the loan balance if a key person passes away.
We recommend consulting with a financial professional or licensed life insurance agent for guidance on what makes the most sense for your business.
How Much Does Key Person Life Insurance Cost?
When it comes to cost and the amount of coverage needed for key person life insurance, it is important to consider your company’s business needs and financial situation. While the exact cost of key person insurance can vary significantly depending on the situation, there are a few general guidelines to keep in mind.
The amount of coverage a business needs will depend on the size and industry of the company, along with the key person’s role. Policy coverage amounts generally range between $250,000 and $1 million, though one rule of thumb advises buying eight to 10 times the key employee’s salary.
As with individual life insurance policies, key person life insurance falls into two main types: term and permanent. Term life is almost always the cheaper option, though exact costs will vary.
Additional factors determining the cost of coverage include:
- The employed person’s health, gender and age
- The type of policy and amount of coverage
- The type of company, its financial standing and its industry
Another form of coverage is called key person disability insurance. This plan type offers a payout if a key employee becomes fully or partially disabled. Unlike standard disability insurance, key person disability insurance covers lost revenue and the costs of hiring and training a new employee.
How To Choose the Best Key Person Life Insurance Option
Choosing the best key person insurance for your business is a highly customized process. Putting a precise dollar amount on exactly how much key person insurance you need can be challenging. Still, we can offer some guidelines on how much insurance coverage to buy.
In some cases, examining an employee’s responsibilities and direct monetary impact can help estimate their value. For example, when considering a top salesperson, you could determine the projected loss in profit from that person’s sales versus the profit the business expects from hiring a replacement.
Other expenses to consider include the anticipated costs of replacing the insured employee, from recruiting fees and moving expenses to training and salary expectations
How To Buy Key Person Life Insurance
Key person life insurance is a combination of life insurance and business insurance. In assessing coverage options and costs, look at the employee’s skill sets and the potential loss of revenue if that person were to pass away.
Permanent insurance is generally costlier than equivalent coverage for term insurance. With term insurance, you can customize the number of years you have coverage — for instance, most companies offer 10-, 20- or 30-year terms. Permanent life insurance, such as whole life and universal life, also features a cash-value component you can use as an asset for your business.
If a covered employee leaves the company because of retirement or taking a new job, the business has several options:
- The company can surrender the key life insurance policy and retain the cash value if there is one, as with a whole life plan.
- The company can stop paying the premiums and surrender the policy, as with term coverage.
- The company can transfer the policy to another key employee, who would be subject to a new underwriting process.
- The company can transfer the policy to the key person, who will now manage the policy as individual coverage. Under these circ*mstances, the company would not receive a payout if the person passes away.
Our Conclusion: Is Key Person Life Insurance Worth It?
If you are a sole proprietor, it is unlikely you will need key person life insurance. However, if you plan on selling your business down the line, you might want to explore key person life insurance options. If you have a business partner or essential employee(s), it can be beneficial to look into options for this form of business insurance.
Commercial lenders sometimes require key person life insurance to secure a loan, so it’s also something to consider if you’re looking to expand your business. We recommend consulting with a financial professional or licensed life insurance agent to learn more about your options.
Frequently Asked Questions About Key Person Life Insurance
Under key person life insurance policies, the business taking out the coverage is the beneficiary and receives a payout upon the death of the covered employee. Businesses can use this payout to cover actual and potential losses associated with the covered employee’s death.
The IRS does not consider premiums paid for individual or business life insurance policies a tax-deductible expense. Payouts from a life insurance policy are not typically taxed, however, and policyholders can generally withdraw cash value from permanent policies tax-free.
There are some limitations to key person insurance. If a covered employee leaves the company, a plan does not cover that loss. In that case, the insurer would cancel the policy. Additionally, you can only purchase coverage for employees who are considered crucial to producing or maintaining revenue for your business.
Key person life insurance measures the insured person’s contribution to the company’s profits, including lost income and future impact on financial goals. Policies also take into account how much it would cost to replace the key person, including unique skills, total compensation, recruitment costs and lost sales.
If you have feedback or questions about this article, please email the MarketWatch Guides team at [email protected].
