Every business has employees who are essential to the company’s operations and financial success. Key person insurance (also known as key employee or key man insurance) is a life insurance policy that financially supports a business if an essential employee — like an owner, partner, CEO, or other major executive — passes away.
What is key person life insurance?
Key person insurance pays a death benefit to your business if a crucial employee dies. The business owns the policy, pays the premiums, and is the beneficiary of the payout. [1] Businesses can’t take out a key person policy on an employee without their knowledge and consent (known as dead peasant insurance).
The payout can be used to:
Absorb losses in revenue after the death
Buy out the deceased’s share in the business
Cover outstanding business loans
Pay for recruiting and hiring a replacement
Provide severance if the business has to shut down
You can use term life insurance or permanent life insurance in a key person agreement. If you or your family will get some of the benefits of the policy, it’s known as a split-dollar life insurance agreement.
Key person insurance is also transferable if the business shuts down. Usually, the insured person can either transfer their policy to their next employer or convert it into a private policy.
A key person policy protects your business and rarely benefits your loved ones. If you have key person insurance, you still need your own personal life insurance policy if you have dependents.
Who needs key person insurance?
Businesses of all sizes can benefit from key person life insurance. Consider protecting any employee whose death would cause a significant financial or operational loss. For most businesses, that’s a CEO, CFO, owner, or partner.
“There’s no excuse for most businesses, especially small businesses, not to have a life insurance policy such as key person insurance,” says Warren Robbins, a senior sales associate at Policygenius. “Businesses often skip this step in risk evaluations for business planning, but if you don’t have life insurance for your top employees, you’re taking a potentially devastating risk.”
How to buy key person insurance
The process for buying key person coverage is generally the same as buying individual life insurance. The big difference is that in addition to underwriting the insured employee, your business also goes through underwriting.
Learn more about the life insurance underwriting process
Financial underwriting for key person insurance
When buying key person coverage for an employee, insurers evaluate your company’s overall financial situation and the business value of the key employee you’re insuring. They may ask for:
Annual sales figures
Estimated cost to replace key employee
Fair market value of the company
Gross compensation of key employee
Net profit of the business
Tax statements
This information, plus the health of the employee and amount of coverage you need, will impact how much the policy costs.
We recommend combining key person life insurance with a buy-sell agreement. If a key person (like a partner) dies, the payout from a key person policy gives the surviving executives enough cash to buy out the deceased partner’s shares.
Learn more about how to buy life insurance
How much key person coverage do businesses need?
After underwriting, your insurer will set a limit for how much insurance coverage you can get. “You don’t get to just make up how much coverage you want,” says Megan Kopka, a certified financial planner and managing partner at Apprise Wealth Management. “You’ll answer questions about the valuation of your firm and its ownership.”
Experts recommend key person coverage of between five to 10 times the employee’s gross compensation. Gross compensation includes:
Salary
Bonuses
Equity/stock
Business expenses
Transportation services
For example, a CEO might have a gross salary of $250,000. But if they also own $80,000 in restricted stock, earn $20,000 in annual bonuses, and have a $10,000 yearly stipend for meals, their gross compensation is $360,000. The business would need between $1.8 million and $3.6 million in key person life insurance for the CEO.
For key person life insurance, like individual life insurance, the advantages of having a policy outweigh the disadvantages. “When shopping for life insurance, many businesses, like many families, say, ‘we’ll do it later,’” says Robbins. “But life insurance is just as vital to a business as it is to a family.”
A Policygenius agent can help you choose the best policy to cover your key employees and protect your business.
