Key person insurance protects a business against the death or disability of an individual who is essential to the company's survival. It is also called key executive, key man, or key employee coverage. Key person coverage is a type of corporate-owned life insurance (COLI).
Do You Need It?
Your company may need key person insurance if it depends on one or two individuals to succeed. For example, suppose you and your siblings own an auto dealership business. You employ five salespeople, one of whom generates more sales than the other four combined. If your top salesperson dies or becomes too disabled to work, your company could suffer a severe loss of revenue. Your business can protect itself against that risk by purchasing key person insurance.
You should consider purchasing key person coverage if your business has any of the following characteristics:
- It is highly dependent on an individual who has special skills or generates a substantial portion of its revenue.
- Your company's reputation is tied to a key individual's name.
- Your business has debt that would be difficult to pay off if a key individual died or became disabled.
- Your business is a partnership and the partners want to buy out the share of any partner who dies or becomes disabled.
- Your business is seeking a loan or investors. Most banks, private equity firms, and venture capitalists won't sign a contract unless life insurance is in place on the firm's key leaders.
Key Person Life Insurance
To purchase life insurance on a key person, a business must have an insurable interest in the key person's life. This means that the business must face a risk of a substantial financial loss if the key person dies. When a business buys a policy, the business is both the policy owner and the beneficiary. The key person is the named insured but does not receive any benefits from the policy.
Because a key person life insurance policy benefits the company, the policy won't be valid unless the insured person has provided written consent.
Key person life insurance is often written on a term policy. The coverage applies for a specific period of time, typically five to twenty years. The insurance ends when the term expires or the insured person dies, whichever happens first. If the insured dies during the policy period the insurer pays a death benefit.
Permanent key person life insurance applies for the life of the insured individual. The policy has a cash value that the firm can treat as an asset. Its value can be used for various purposes, such as expanding the business or buying inventory. If the key person dies, the policy pays a death benefit.
Key Person Disability Insurance
Key person disability insurance protects a company against the risk that a key employee will become disabled to the extent he is unable to perform his job. Policies include two important elements: an elimination (waiting) period and a benefit period.
The elimination period is the amount of time that must elapse before benefits are paid. It begins when the key person suffers an injury or becomes disabled. A typical elimination period is 90 days. The benefit period is the length of time the insurer will pay benefits. Benefits may be payable monthly or as a lump sum. When payments are paid monthly, the benefit period is typically between six to twenty-four months.
A key person disability policy is not purchased "off-the-shelf." Policies are custom-designed to meet the needs of the buyers.
Amount and Cost of Coverage
To determine how much life or disability insurance you should purchase, you'll need to estimate the economic loss your firm will suffer if a key person dies or becomes disabled. You will also need to consider the cost of recruiting, hiring and training a replacement employee. Some insurers offer formulas that can help you calculate the value of a key person.
The cost of key person insurance depends on the age, health, and sex of the insured individual as well as the size and nature of the business. Other factors include the type of policy and the limits you choose.
Key person life insurance is a cheaper option than permanent life insurance.
If your business has more than one key person, you can save money on insurance by purchasing a group policy that includes a "first to die" provision. The policy insures one life only. If a key person dies, the partnership receives a benefit and the coverage continues.
The premiums you pay for key person coverage are generally not tax-deductible. However, the death benefits your company receives generally are tax-free. Consult your tax professional to determine how the purchase of key person insurance will affect your firm's taxes.
Article edited by Marianne Bonner