Key man insurance: What it is and how it works

Although life insurance is more commonly known to cover personal needs, it can also be used to protect businesses following the death of a critical employee. Key man insurance, also known as key person or key employee insurance, is one way companies hedge against losses after an owner, executive or other employee passes away.

The company can use the death benefit proceeds to recoup lost business or invest in hiring and training the next person to fill the essential role. Not all insurers offer key man life policies, and there are considerations to weigh in determining if this is the right solution to keep a company solvent during a transition.

What is key man insurance?

Key man insurance is a type of life insurance policy that a company purchases to cover a founder, owner, executive or anyone else essential to a business’ operations. The beneficiary is the company and the premiums are paid by the business. It falls under the umbrella of a corporate-owned life insurance policy, where a company takes out a policy on a specific employee or group of employees. The company needs the employee’s written consent to take out a policy.

A key person could be considered an owner, founder, top executive, salesperson or even someone with special knowledge and skill sets essential to a company’s success. The idea behind key person insurance is that the company receives the death benefit to add a financial buffer after the sudden loss of someone critical to its revenue. The payout could potentially buy the company time to strategize and determine the next steps for the business, or to hire and train a replacement.

Who is considered a key person?

Business owners are, of course, often key to the success of a company. But employees can be critical as well, depending on their roles. They might have established relationships with customers who feel a personal loyalty to them. Or, they may have in-depth knowledge of the business because of years of experience. They may be critical to the brand or the firm’s reputation, or be the one person who knows how to obtain capital or credit lines. 

A lender may require a company to have key person insurance in place for the top executives or other specified key employees. This is especially true if the company is solely dependent on one or two owners.

Those who run their business alone and aren’t dependent on securing loans typically don’t need key man insurance, but they might benefit from a personal life insurance policy.

How is key man insurance taxed?

The premiums for key man insurance are not tax-deductible. However, like other types of life insurance policies, the company receives the death benefit tax-free in most cases. There are exceptions to this and a trusted tax advisor would be able to walk the company through the regulations and documentation needed. 

The tax forms would have to include how many employees have the key person insurance, if there was consent given by each employee and the amount of coverage in place. Tax law has restrictions on employer-owned policies to protect employees – life insurance death benefit proceeds that exceed the cost basis will be subject to income taxation if specific requirements aren’t met.

Key man insurance policy types

Much like personal life insurance policies, key man insurance can be structured under different categories of life insurance. The most common categories are term and permanent life. There are pros and cons to both term and permanent life insurance, with the latter offering several different policy types.

• Term life insurance: Term life policies provide coverage if the policyholder passes away within a certain term or time period. Typically, this is a 10-, 20- or 30-year term. However, with key man insurance, the policyholder is the company and the term period could be tied to a key date, such as retirement. Term life is usually a much less expensive option than a permanent life insurance policy.
• Permanent life insurance: Permanent life insurance provides lifelong coverage as long as premiums are paid. The policy builds cash value over time, in addition to providing a death payout. Because the policy builds cash value, the business is able to access this and use it as collateral for loan purposes, as an example. If the key person survives to retirement, it’s common for the company to use the cash surrender value to fund a retirement benefit for the employee. A permanent life policy can also be sold if the company no longer wishes to maintain the policy or surrendered back to the insurer for the cash surrender value. However, these benefits make the policy more expensive than term life options. Permanent life insurance offers several policy types, including whole and universal life insurance. 

How much key man life insurance should you purchase?

There is not one specific method to use to determine how much key man life insurance you should purchase. There are several factors to consider and it can be difficult to determine the amount. You might want to start by considering the overall cost of losing a key employee, including losses to productivity, sales, operations and recruiting efforts. A professional risk manager can be beneficial in valuing the key person.

You may also want to consider working with a licensed life insurance agent or certified financial planner to determine whether and how much key man insurance is right for you and your business. Here are a few common estimation figures to consider when determining the amount of key man employee insurance to purchase:

• Cost to replace: Consider an approximate figure the company will bear to recruit, hire and train a replacement employee, including revenue and sales losses.
• Compensation multiplier: Take the number of years the company expects it to take to recover from the death and replace the key person. Then multiply this by the employee’s annual compensation.
• Percentage of profits or revenue: This figure is the amount of profit or revenue the insured person contributes, then multiply by the number of years it could take to replace them. The company and structure will determine whether profits or revenue is the best metric to use.

Companies that offer key man life insurance

When purchasing key man life insurance, the first major consideration is budget. Term life policies are typically less expensive than permanent or whole life options and may be a better fit for the company budget. The second consideration is how much of a death benefit is needed. The higher the death benefit, the higher the premiums. The age, health and lifestyle of the insured employee will also influence the cost of premiums.

Most large life insurance companies offer key person insurance and can walk a business through these considerations. Like other life insurance policies, smart consumers compare several carriers to determine which would suit the company’s needs best, including the carrier’s reputation for claim payouts and customer service. 

Frequently asked questions

• Is key man insurance worth it?
  

  For business owners, having a key person insurance policy may be worthwhile in order to help cover outstanding loans or cover lost profits that might occur from the loss. A lender may require business owners to have a key person insurance policy in place as a guarantee that funds will be available to repay the loan. Sole proprietorships likely do not need to have key person insurance, but any business with multiple partners in which the loss of one person may result in significant changes in the business may want to consider having key person insurance.

• Is key man insurance expensive?
  

  The cost of key person insurance depends on a number of factors. The term of the policy, including the death benefit, will be the primary determiner in how expensive the policy will be. The age, health and lifestyle of the people who are covered under the key person insurance policy will also play a factor in determining the cost of the premiums.

• What is key employee disability income insurance?
  

  Another way to protect a company from the loss of critical workers is key person disability insurance. It provides a cash benefit to cover costs such as hiring and training a replacement or paying for overtime to cover the role of a key employee who becomes disabled.

• What is a buy-sell agreement with life insurance?
  

  A buy-sell agreement, also known as a buyout agreement, is a contract outlining what will happen if a business owner dies, retires or becomes disabled. It’s a way for a partner or key employees to purchase a deceased owner’s share of a business, funded with a life insurance policy.