Some businesses depend heavily on one person. That person might be the founder, the top salesperson, a technical expert, or someone whose relationships keep the company running.
If that person dies unexpectedly, the business may face serious financial strain - lost revenue, difficulty securing credit, or the cost of finding and training a replacement.
Key person insurance doesn't replace the person - it buys the business time and resources to adapt.
What is key person life insurance?
Key person life insurance is a life insurance policy that a business owns on the life of an essential employee or owner. The business pays the premiums and is named as the beneficiary.
Who qualifies as a key person?
There is no legal definition. A key person is generally someone whose death would cause a measurable financial loss to the business.
A small accounting firm has three partners. One partner manages 60% of client relationships and brings in most of the new business. If she dies, the firm could lose a significant portion of its revenue while it rebuilds those relationships. She would likely qualify as a key person.
How much coverage does a business need?
Common approaches to estimating the coverage amount include: a multiple of the key person's annual compensation (often 5–10x), an estimate of lost revenue during the transition period, or the cost of recruiting and training a replacement.
There is no formula that works for every business. The right amount depends on the business's size, the key person's role, and how long it would take to recover from their loss.
Term vs. permanent for key person coverage
Term life insurance is often used for key person coverage because it is less expensive and can be matched to a specific period - for example, the remaining years of a business loan or a succession plan timeline.
Permanent life insurance can also be used. Some businesses use the cash value component as a supplemental benefit or executive retention tool. The tax treatment of premiums and benefits can be complex - consult a tax advisor.
Consent and disclosure requirements
Federal law (the Pension Protection Act of 2006) requires that employers notify employees in writing and obtain their consent before taking out life insurance on them. There are also tax rules that apply when an employer-owned policy pays a death benefit.
A planning tool, not a replacement
Key person life insurance does not replace the person or guarantee business continuity. It provides financial resources that give the business time and flexibility to respond.
For businesses with one or two essential people, it is often one of the most cost-effective risk management tools available.
This article provides general education. Tax treatment of employer-owned life insurance is complex. Consult a licensed tax advisor and a licensed insurance agent before purchasing coverage.