What Is a Key Man Insurance Policy and How Does It Work?

Key person insurance is a specialized life insurance policy a company purchases on the life of an individual whose unique contributions are vital to the business’s operation and financial health. Its primary purpose is to provide a financial safety net to the business if the insured key person dies or becomes incapacitated. This coverage mitigates financial risks, allowing the business to maintain stability during a challenging transition. It provides a financial cushion, offering time to recruit and train a replacement or implement other strategies for continuity.

Identifying a Key Person and Business Need

Identifying a key person involves assessing individuals whose absence would significantly disrupt operations or cause substantial financial loss. These individuals possess unique skills, specialized knowledge, leadership capabilities, or critical client relationships that are difficult to replace. A key person might be a founder, a top executive, a leading salesperson, or an employee with highly specific technical expertise. Their contributions directly impact revenue generation, strategic direction, or the overall value of the business.

Businesses consider key person insurance to protect against various financial impacts. The death or incapacitation of such an individual can lead to lost income, disrupted sales, and delays in critical projects. This insurance provides funds to cover operational expenses, recruit and train a successor, or maintain cash flow during a period of transition. It also helps protect the company’s creditworthiness and can reassure investors or lenders, demonstrating a plan for continuity. In partnership structures, it can facilitate buy-sell agreements, allowing surviving partners to purchase the deceased’s shares and ensure the business continues.

How Key Person Insurance Policies Work

Key person insurance policies are structured with the business as the central entity. The business acts as the policy owner, pays the premiums, and is designated as the beneficiary of the policy. This arrangement ensures that any payout directly benefits the company, providing financial stability rather than going to the individual’s personal beneficiaries. The insured individual must provide written consent for the business to take out a policy on their life.

These policies commonly utilize either term life insurance or permanent life insurance structures. Term life policies offer coverage for a specific period, such as 10, 20, or 30 years, and are generally more affordable, making them suitable for temporary needs or start-ups. Permanent life insurance, including whole life or universal life, provides lifelong coverage and can accumulate cash value over time, which the business might access or use as collateral. Payouts are primarily triggered by the death of the insured key person. Some policies also offer riders or provisions for disability or critical illness, providing funds if the key person becomes unable to work.

Securing a Policy and Tax Considerations

Securing a key person insurance policy involves several steps, beginning with determining the appropriate coverage amount. Businesses often value a key person based on multiples of their income, typically 5 to 7 times their annual salary and benefits, or by assessing the cost to replace them, including recruitment and training expenses. Another method involves calculating the key person’s contribution to company profits and the time needed to replace that contribution. The goal is to justify an insurance amount that realistically covers the potential financial loss to the business.

The application process typically requires detailed information about the business and the key person. This includes financial health of the company, the key person’s role, and their personal health and lifestyle details. The insured individual may undergo a medical examination and underwriting to assess risk, influencing the premium cost. Once approved, the policy is issued, and the business begins paying regular premiums to keep the coverage in force.

Regarding tax considerations, premiums paid by the business for key person insurance are generally not tax-deductible. Conversely, the death benefit received by the business upon the key person’s death is generally tax-free. This ensures the full benefit amount is available to the company without being reduced by income taxes. However, if premiums were somehow deducted, the death benefit might then become taxable.