The small business you started with your college roommate isn’t so small anymore, with several million dollars in revenue and about a dozen employees. An independent appraiser values your 50% stake at more than $5 million each.
Then tragedy strikes: your business partner dies without a will or a plan in place. She transfers her share of the business to her jerk of a husband. He starts talking about how he will “improve” the excellent oil company. The company’s sales slide, and revenue dries up. You start thinking about doing something else with your life.
None of this would have happened if you had surrendered your co-worker’s primary personal life insurance policy. Upon her death, you would have received a death benefit significant enough to buy out her share and prevent her meddling husband from getting involved. This could have been avoided if you had known about primary personal insurance earlier.
What is key person life insurance?
Key person insurance is a life insurance policy that a company purchases on the life of an owner, senior executive, or another person considered critical to the business. The company is the beneficiary of the policy and pays the premiums. This type of life insurance is also known as “key man insurance,” “key woman insurance,” and “business life insurance.”
Key person life insurance is a policy that covers a key employee or employees in your business, also known as main person insurance or main man insurance.
Basic life insurance works similarly to typical life insurance, with the main difference being that the business benefits from having this policy. That means if the insured person dies while this policy is in force, the business is entitled to the payment of the death benefit.
In most other life insurance scenarios, the policy owner and the insured are the same individuals, and the beneficiary is typically a close relative, such as a spouse or child.
What is a key person?
A key person is anyone considered essential to the company’s continued success. In many cases, a key person is indispensable, and their absence threatens the company’s existence.
The tragicomic hypothesis that we begin to dissuade our spouse from meddling in the small business is only one potential use for key people’s life insurance. You can also use this life insurance to compensate for the loss of a vital employee’s skills or talents.
A key person can be:
- An employee with unique, critical skills, such as the head of research and development.
- An employee whose personal relationships are crucial to the company’s profitability and growth, such as a sales manager.
- The individual responsible for day-to-day company operations.
- An employee whose capital supports the company’s operations or whose business interests must be prevented from falling into the wrong hands.
How does key person insurance work?
Key person insurance works like any other life insurance, with the difference being that your company owns the policy, and the insured employee must agree to it and cooperate during the insurance application and underwriting process. Your business may require key person insurance as a condition of employment.
If the coverage exceeds $1 million, the employee may need to undergo a medical exam to ensure they are healthy.
Once the policy is in force, your company pays the premiums to keep it active. If the insured person dies during the term, your company collects the death benefit and can use it as needed. Under normal circumstances, this death benefit is tax-free, and it is not considered business income, so there is no requirement to pay income tax on it.
What does key person insurance cover?
Key person insurance is available to cover expenses associated with the death of a covered employee. These costs may include:
- Finding a replacement and providing training.
- Replacing income for which the person was directly responsible.
- Reimbursing additional expenses incurred due to the individual’s death, such as overtime wages or temporary workers.
- Mitigating indirect losses resulting from the person’s death, such as customers leaving the company.
- Purchasing the individual’s interest in the company, including from their heirs.
- Repaying debts arising from the person’s death, such as a bank loan contingent on their continued employment.
Sometimes, the death of a key employee or co-worker can lead to the downfall of the company. If the business cannot stay afloat after their loss, key person insurance can cover various expenses, including:
- Severance payments to employees.
- Payments on loans and credit lines.
- Legal fees.
- Preparing final distributions to investors.
Key Person Insurance Types
Key person insurance can take several different forms. Usually, this is a type of life insurance, hence the term “basic life insurance.” However, you can also implement a disability insurance policy for key workers and employees.
Term Life Insurance for Key Employees
Term life insurance is the most affordable type of coverage for principals. It remains in effect for a fixed, limited period, usually 10-30 years, with premiums remaining level throughout.
You can choose the length of the term and have the option to extend the policy after its expiry. However, the new amount will be higher, making it potentially less valuable. If the insured exceeds the policy term, the policy becomes worthless, and your company does not receive the death benefit.
Whole Life Insurance for Key Employees
Whole life insurance is the most expensive type of insurance for individuals. It is a type of permanent life insurance, meaning it remains valid as long as you continue to pay. Therefore, it is best suited for business owners and long-term employees.
Whole life insurance builds cash value over time at a predictable price. This cash value serves as a potential source of liquidity and flexibility for your business. You can access the cash value by taking loans against it or making partial withdrawals. However, failing to repay these loans can reduce the death benefit. You can also use the cash value to pay policy premiums.
Variable Universal Life Insurance for Key Employees
Variable universal life insurance is another type of permanent life insurance with more flexibility than whole life, particularly regarding how the cash value component is invested. Variable universal life premiums are typically lower than whole-life premiums.
You can invest some or all of your policy’s cash value in market-traded funds such as stocks. While this can increase your upside during good market years, it also comes with an increased risk of loss if the market declines.
You may also be able to adjust the amount of coverage. Increasing coverage can boost your benefits, but it may also increase your costs. Therefore, flexible universal life is a good choice for businesses that prioritize flexibility over predictability.
Disability Insurance for Key Employees
Primary disability insurance is a long-term disability policy that pays permanent benefits if the covered person cannot work due to a covered disability. It is a good option for businesses that want to protect the income earned by their key employees even after hiring and training replacements.
Do You Need a Key Person Life Insurance Policy?
If the death of an employee or co-worker seriously damages your business, you likely need a basic life insurance policy.
Start by assessing your employees and collaborators. Their loss threatens the company’s long-term profitability, if not its existence. They are the most important individuals to insure.
For less critical but still important employees, consider the cost of replacing them and the time it will take to train their replacements. Since your business may generate less revenue during this period, calculate the total costs, which may include more than just their salaries.
At some point, even if an employee is integral to your company’s success, taking out an employee life insurance policy may not be worth the hassle and expense. It’s usually cost-effective to replace an employee, but that doesn’t mean you have to ensure everyone who works for you. Evaluate the expected cost, hire, and train their replacements carefully.
Key Person Life Insurance FAQs
Key person life insurance is often not on the radar of many business owners. You probably still have questions if this is your first deep dive into the topic.
How much does key person insurance cost?
The cost of personal insurance depends on several factors, with the most important ones being:
- Type of policy – Term life insurance is much cheaper than permanent life insurance, especially whole life insurance.
- If it’s a term life policy, the term length.
- Age of the insured person.
- Gender of the insured person.
- Current health status, personal health history, and family health history of the insured person.
- The size of the death benefit or sum assured, which depends on your expected loss if the insured person dies.
- Occupation and lifestyle of the insured person – if they have dangerous jobs or hobbies, it is more profitable to insure them.
It always pays to shop around, especially for more substantial policies. Since you can’t deduct the principal on your business taxes, every dollar you spend on this policy reduces your income.
Where can I get key person insurance?
Key person insurance is more niche than individual life insurance, so only a few companies sell it. If you have an insurance agent who helps you with other business insurance, ask them to assist you.
If you don’t want to work with an insurance agent, consider established insurance companies like State Farm, Allstate, and Nationwide. They have well-developed business insurance departments and underwrite countless basic human policies.
How much key person insurance coverage do I need?
The amount of basic life insurance you need depends on several key considerations about who you’re covering:
- Replacement price: How much will it cost to replace an employee? If their job is highly skilled or an executive-level position, finding a suitable replacement will be difficult – and expensive.
- Earnings contribution: How much does an employee contribute to your company’s bottom line? Such a metric can’t be measured for all employees, but you should know how much people in sales and business development roles add to the bottom line.
- Purchase price: This approach applies to people who have ownership stakes in the company – partners and employees. Valuing closely held companies is always challenging, but consider investing in a third-party valuation to get a ballpark figure of the company’s total value. Then multiply this number by the insured person’s ownership interest.
- Business risk: This is usually the case for entrepreneurs and senior executives. Their demise could trigger a liquidity or credit crunch. For example, if a company’s primary business creditor requires immediate repayment of all outstanding loans, a significant enough life insurance policy is needed to cover it.
Is key person insurance tax-deductible?
Unlike most business expenses, key person insurance premiums are not taxed or subject to any taxation. Your premium payments reduce your company’s earnings dollar for dollar.
On the bright side, the key person insurance death benefit is usually tax-free. The most significant exception is if you don’t report the existence of a policy to the IRS while it is in effect. In such a case, the IRS may treat the death benefit as taxable business income.
To prevent this from happening, submit all key person insurance policies to the IRS using Form 8925. You should also report any other employer-owned insurance policies using this form, even if you don’t consider them your key person policy.
Conclusion
No one wants to get into an accident, but we all have car insurance. No one plans for their house to burn down, but we all have home insurance.
No one imagines they will suddenly lose their ability to practice medicine or lose a co-worker prematurely. But it happens. And when it does, in addition to personal harm, business suffers.
Key person insurance is a tool to plan for the unexpected and avoid significant strain on your business should the worst happen.
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