That small business you started with your college roommate isn’t so small anymore, with a few million 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 one after another without a plan. She transfers her share of the business to her jerk husband. He starts talking about how he will “improve” the excellent oil company. The company’s sales slide and revenue dry 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 receive 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 buys 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 (or “key”) insurance,” “key woman insurance,” and “business life insurance.”
Key person life insurance is a policy that covers a key employee or employee in your business—also known as main person insurance or main man insurance.
Basic life insurance works a lot like typical life insurance. The most significant difference is that the business will benefit from having this policy. That is, if the insured person dies while this policy is in force, he is entitled to the payment of the death benefit.
In most other life insurance scenarios, the policy owner and the insured are the same people. A beneficiary is a close relative, such as a spouse or child.
What is the key person?
A key person is anyone considered essential to the company’s continued success. In many cases, a key person is indispensable. Their absence threatens the existence of the company.
The tragicomic hypothesis that we begin to dissuade our spouse from meddling in small business is only one potential for key people’s life insurance. You can also use this life insurance to compensate for losing a vital employee’s skill or talent.
A key person can be:
- An employee with unique, critical skills as 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 official responsible for day-to-day company operations
- An employee whose capital supports a 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. However, since your company owns the policy, you must apply, not the insured employee.
Your company cannot unknowingly take out key person insurance for someone. The principal must agree to be insured and cooperate during the insurance application and underwriting process. Your business may require key persons’ insurance as a condition of employment.
If it’s more than $1 million, the employee may need a medical exam to ensure they’re healthy.
Once the policy is in force, you pay to keep it in detail. If the insured dies during the term, your company collects the death benefit and can use it as it sees fit. Under normal circumstances, this death benefit is tax-free. Business income is not considered. He is not required to pay income tax.
What does the key person’s insurance cover
Kerson insurance is available to cover expenses associated with the death of a covered employee. These costs include:
- Finding a replacement and training
- Replacement of income for which the person is directly responsible
- Reimbursement of additional expenses incurred due to the death of the individual, such as overtime wages or temporary workers
- Eliminate indirect losses resulting in the death of a person, for example, customers leaving the company
- Purchase of an individual’s interest in a company. It is also possible to buy their heirs
- Repayment of debts arising on the death of a person, for example, a bank loan conditioned on their continued employment
Sometimes the death of a key employee or co-worker spells the demise of the company. If the business cannot remain current after they are gone, the key person insurance can cover the expenses incurred by the business:
- Redundancy of employees
- Payments on loans and credit lines
- Lawyers’ fees
- Preparation of 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.” But you can 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 the principal. It remains in effect for a fixed, limited period, usually 10-30 years. Premiums remain level throughout.
You can choose the length of the term and have the option to extend the policy after its expiry. But the new amount will be higher, so it may not be worth anything. 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
All life insurance is the most expensive type of person. It is a type of permanent life insurance. This means that 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 is a potential source of liquidity and flexibility for your business. You can find the cash value by taking loans against it or partial withdrawals, whereas if you don’t repay them, you 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. This creates more conditions than all of life, especially around how the cash value component is invested. Variable universal life premiums are also 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. Increasing your upside during good years for the market can also increase your risk of loss if the market goes down.
You may also be able to adjust the amount of coverage while adjusting upwards can increase your money. So, flexible universal life is a good choice for businesses that value flexibility over predictability.
Disability insurance for key employees
Primary disability insurance is a long-term disability policy. It pays permanent benefits if the covered person cannot work because of the covered disability. It is a good option for businesses that want to protect the income earned by the main employee even after they hire and train their replacements.
Do you need a key person life insurance policy?
If the death of an employee or co-worker seriously damages your business, you probably need a basic life insurance policy.
Start with your employees and collaborators. Their loss threatens the company’s long-term profitability, if not its existence. They are the most important people to insure.
For less critical but still important employees, think about how much it will cost to replace them and how long it will take to get their replacement up to speed. Since your business will likely generate less revenue during this period, you need to calculate the total costs. The salary from them can be a small part.
At some point, even if it’s integral to your company’s success, taking out an employee life insurance policy isn’t worth the hassle and expense. It’s always cost-effective to replace an employee, but that doesn’t mean you have to ensure everyone who works for you for the expected cost and hire and train their replacement.
Key person life insurance FAQs
Key person life insurance is 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 many factors. The most important are:
- 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
- Sex 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. It 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 significant policies. Since you can’t deduct principal on your business taxes, every dollar you spend for this policy reduces your income.
Where can I get key person insurance?
Key person insurance is more niche than individual life insurance, so few companies sell it. If you have an insurance agent who helps you with other business insurance, ask them to help you.
If you don’t want to work with an insurance agent, go to 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?
How much basic life insurance you need depends on a few key considerations about who you’re covering:
- Replacement price. How much will it cost to replace an employee? If their job is a highly skilled or executive-level employee, 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 accounts in the company – compatriots and employees. Valuing closely held companies is always rash, 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 would 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 the key person insurance tax-deductible?
Unlike most business expenses, key person insurance premiums are not taxed or taxed in any way. Your premium payments reduce your company’s earnings dollar for dollar.
On the bright side, the key person’s 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. The IRS may treat the death benefit as taxable business income in such a case.
To prevent this from happening, submit all key personal 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.
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 fail a co-worker prematurely. But it happens. And when they do, 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.