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Key Person Insurance: What Is It and How Does It Work?
Key person insurance can help a company survive the death or disability of the business owner or core employees.
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Key person insurance, also called key man insurance, is life or disability insurance that a business carries on its core employees. If the key person dies or becomes disabled, the insurance policy pays the business to help replace them.
Key person insurance is valuable for companies with revenue that is dependent on one person’s expertise, performance or personal network. But if you work in an industry where employees have more generalized skill sets, this business insurance coverage probably isn’t necessary.
What is the purpose of key person insurance?
The purpose of key person insurance is to help a small business maintain its financial footing after the death or disability of an owner or a core employee. Investors and lenders often require key person insurance on a business’s management team.
In addition to the owner, key people in your business might be those who:
Have highly specialized technical knowledge or industry expertise.
Have a reputation in your industry or community that is key to business success.
Are responsible for bringing in a significant amount of revenue that will take time to replace.
Key person insurance can also be used in situations where there’s no key member of your business. For example, in a small-business partnership, partners can purchase key person insurance to buy out the shares of former partners.
Key person insurance covers the death or disability of an employee. If that person otherwise leaves the company, you can cancel your policy or transfer it to the insured; they can then adapt the policy to their own personal needs and start paying the premiums.
For businesses, the proceeds from key person insurance can be put toward any of the following:
Covering operating expenses until you find a replacement hire.
Training the replacement hire.
Offsetting lost income.
Purchasing a former owner’s ownership interest in the business. (You should also have a buy-sell agreement if you plan to use key person insurance for this purpose.)
If you determine that it’s better to close the company, key person insurance proceeds can also be used to pay off debts, distribute money to investors, pay severance to employees and otherwise wind down the business.
In addition to the cash proceeds of the policy, buying a key person insurance policy can benefit your company in other ways. For example, you might be able to borrow against the policy’s cash value or withdraw cash from your policy, though this will reduce the amount of the death benefit.
Types of key person insurance
Key person insurance falls in the category of life and disability insurance. When you shop for key person insurance, you’ll be able to purchase the following types of insurance policies:
Term life key person insurance
Term life insurance is the most popular and affordable option for life insurance. Similar to car insurance or homeowner’s insurance, you pay premiums on a term life policy every month or every year, and you’re covered if the insured passes away anytime during the term of the policy. Typically, you can purchase term life insurance for a period of up to 35 years, and you can renew when the policy expires.
Whole life key person insurance
Whole life insurance, also called permanent life insurance, doesn’t have an expiration date. The policy remains in effect for as long as you pay the premiums. Whole life insurance is more expensive than term insurance, but your premiums go into a savings account. As a result, the policy gains cash value that you can borrow against or withdraw money from.
Variable life key person insurance
Variable life insurance is similar to whole life insurance because the insurance stays in effect for as long as you pay premiums. The difference is that the premiums are placed in investment accounts rather than a savings account. Investments can lose value unpredictably with market highs and lows, so a variable policy can be risky.
Disability key person insurance
You can add a disability insurance component to your key person insurance as well. The insurer will pay a benefit — usually 40% to 70% of the key employee’s salary, according to the Insurance Information Institute — if the insured experiences a disability that prevents them from performing their job responsibilities.
You’ll need to purchase a separate key person policy for each of your key employees. How much you’ll pay for each will depend on:
The age, gender, and physical health of the insured. (Insurers might require the insured to take an exam before issuing the policy.)
The insured’s occupation and industry.
The insured’s total compensation.
The amount of coverage your business needs.
Is key person insurance tax-deductible?
The IRS generally doesn’t allow businesses to deduct key person life and disability insurance premiums. However, key person insurance proceeds are tax-free as long as you obtain the key person’s consent before purchasing the policy and file form 8925 with the IRS.
How much key person insurance coverage do you need?
To help ensure that you’re neither over-covered nor under-covered, consider:
Cost to replace: Add up the costs required to find, hire, and train a replacement for the insured owner or employee. You should also include any lost business income during this time.
Contribution to earnings: Multiply the revenue or profit that the insured individual brings to the business by the number of years your business will take to replace those earnings. New businesses can use revenue figures, whereas more established businesses should think in terms of profit.
Multiple of compensation: If you use performance-based compensation, take the key person’s compensation and multiply it by the number of years that your business will take to fully recover from their loss. For instance, it might take a junior lawyer five years to reach the same competence as a partner who exits the firm.
Where to buy key person insurance
Key person insurance is a fairly specialized type of insurance, so it’s usually sold by longstanding insurance companies rather than startups that focus on selling business insurance online. You may need to consult an insurance broker to find coverage.
Comparing quotes from several companies can help you find the best coverage for your business at the best price.
What's the best fit for your business?
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In addition to selling you a key person insurance policy, State Farm can help you create a buy-sell agreement if people want the opportunity to buy out a key employee’s interest in the business after their death. State Farm placed first and second, respectively, in J.D. Power’s 2021 customer satisfaction rankings of life insurance providers and commercial insurance providers. Read NerdWallet's review of State Farm business insurance.
Nationwide: Help with investing your key person insurance policy
Nationwide offers two different universal life insurance policies, both of which can be invested to fund other employee benefits. To help you navigate those investments, Nationwide can also help you connect with a financial professional. Nationwide was also highly rated for customer satisfaction in J.D. Power’s 2021 life insurance survey. Read NerdWallet’s review of Nationwide business insurance.
Allstate: Several types of life insurance
Allstate offers term, universal, whole and variable life insurance policies, so you can choose which best fits your business needs. Allstate topped J.D. Power’s 2021 list for customer satisfaction among commercial insurance providers. This insurer’s policies are sold by Allstate agents nationwide. Read NerdWallet’s review of Allstate business insurance.
A version of this article originally appeared on Fundera, a subsidiary of NerdWallet.