If you’re a business owner, a “key person” is someone who is critical to your business.

A key person could be a partner, executive or an individual with hard-to-replace skills. If the death of that person would devastate your business, you may want to consider insurance as a safeguard.

That’s why key person life insurance can be a vital asset for business owners.

What Is the Purpose of Key Person Insurance?

Key person insurance is designed to pay a life insurance death benefit to a business rather than individual beneficiaries if the insured person dies.

Every small business should have a contingency plan for worst-case scenarios. That includes what to do if a crucial member of the business dies. Fortunately, tools are available to help business owners navigate this exact scenario, including key person insurance. You may hear “key person insurance” called “key man insurance” or “key woman insurance.”

The business typically pays the premiums on this type of life insurance, and the insured person must give written consent to the company owning the policy.

What Is a Key Person?

The “key person” named on the policy is someone who is considered essential to running the business, whether it’s an owner/partner, top executive or someone with specialized knowledge and skills. Losing this person would cause the business to suffer financially, as it would be difficult and/or expensive to replace them, or because they bring in a significant amount of revenue.

Who Needs Key Person Insurance?

If you run a business by yourself, you probably don’t need key person life insurance. But if you have a business partner or a certain employee who is invaluable to the company, it’s a good idea to be insured. In fact, some commercial lenders may even require key person life insurance for certain individuals, so it’s something to consider if you’re looking to expand your business with a loan.

What Does Key Person Insurance Cover?

Key person insurance provides a death benefit to a business so that it can continue operating if the key person dies. There are no restrictions on how the death benefit is spent. The funds can be used for any expense, including daily operational costs, training a new hire or paying off debt.

In some cases, closing down the business is the best course of action, in which case the death benefit can help ease the transition by covering costs such as paying out severance to employees, distributing funds to investors, paying off creditors and more.

In addition to a death payout, key person life insurance policies come with benefits you can leverage while the insured is alive. For example, you may be able to borrow against the value of the policy or withdraw cash (which could reduce the death benefit).

Key Person Insurance Policy Types

Similar to individual life insurance policies, key person life insurance falls into two main types: term and permanent.

Key Person Term Life Insurance

Term life insurance is designed to cover the insured for a specific time period (the term)—usually 10 to 30 years.

This type of coverage tends to be more affordable than permanent life insurance, though it is also more bare-bones in terms of policy features. Once the term is up, if the policy isn’t renewed, it expires with no death benefit payment. If you renew the policy, expect a much higher premium.

A term life policy can also sometimes be converted to a permanent life insurance policy, depending on the insurance company and the policy.

Key Person Permanent Life Insurance

As the name suggests, permanent life insurance generally does not expire as long as the premiums are paid. It covers the insured for a lifetime, and may provide benefits you can access while they’re still living. For instance, permanent life insurance accumulates cash value, which can be accessed for business needs. The growth rate and investment options for the cash value depend on the type of policy, such as whole life, universal life or variable life insurance.

Related: What Is Whole Life Insurance?

Key Person Insurance Riders

Both term life and permanent life insurance often offer a disability coverage rider. After all, your business may be impacted whether a key person dies or becomes severely disabled.

A key person disability income rider on a life insurance policy generally pays 40% to 70% of the disabled employee’s earned income.

There may be other riders available depending on the insurance company and specific type of policy.

Which Key Person Insurance Policy Type Is Best?

Permanent life insurance policies, like universal life, variable life and whole life insurance are usually more expensive than term life but provide a payout no matter when the insured person passes away. They also offer the benefit of cash value accumulation.

Term life is cheaper but doesn’t provide a payout if the insured person dies after the term expires (unless it’s renewed) and doesn’t have any cash value within the policy.

Which is best for you will depend on the age of the key person and the specific needs of the business.

How Much Does Key Person Insurance Cost?

The cost of key person life insurance is based on many factors, such as:

  • The age, gender and health of the insured
  • The specific type of policy
  • Any riders added

How Much Key Person Insurance Coverage Do You Need?

A good rule of thumb is to buy key person coverage between eight to 10 times the person’s salary.

Another way to determine coverage needs is to identify the key person’s monetary value to the business. Doing this can be challenging but is a more precise way to identify coverage needs.

You might choose one or all of these methods.

Consider the following:

  • The key person’s contribution to the company’s profits, including income that would be lost and the key person’s impact on meeting business objectives.
  • How much it would cost to replace the key person, including unique skills, total compensation, recruitment costs and lost sales.

Once you’ve estimated a dollar amount for these considerations, you’ll have a better understanding of the coverage needed for your key person.

Tax Considerations for Key Person Insurance

Life insurance premiums are not tax deductible typically and can’t be counted as a business expense. However, the life insurance death benefit is paid tax-free to the beneficiary.

“In some instances where a business owner owns the life insurance policy—rather than the business—the business may be able to deduct the premiums as compensation to the owner,” says President and CEO Brooks Tingle of John Hancock.

If you have a permanent life insurance policy, any cash value grows tax-deferred. Plus, the business can usually borrow against the cash value without creating a taxable event.

Key Person Insurance and Buy-Sell Agreements

In addition to key person life insurance, it’s a good idea for small business partners to consider a buy-sell agreement. This type of agreement is funded by life insurance and states that if one partner dies, or becomes so disabled they can’t function, the other partner has the legal right to buy out their stake in the company.

The life insurance payout provides the funds for the partner to do this.

A buy-sell agreement is a binding legal document and should be updated on a regular basis as the business’s earnings and balance sheet change.

There are two main types of buy-sell agreements:

  • Cross-purchase agreements. With this type of agreement, business partners purchase a key person life insurance policy on each other so that if one passes away, the other can keep the business going or buy out the deceased partner’s family.
  • Entity purchase or stock redemption agreements. With this type of agreement, the business owner uses life insurance proceeds to purchase an owner’s shares if they pass away.

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