Key Person Insurance: Essential Guide for Businesses

Key person insurance is a life (or disability) policy a company purchases on an owner, executive, or other essential employee to protect the business from financial loss if that person dies or becomes incapacitated. The company pays the premiums and is the policy beneficiary; the benefit proceeds are used to stabilize operations, pay debts, recruit replacements, or otherwise manage the transition.

Key takeaways

• Protects a business from the financial impact of losing a vital individual.
• Company owns the policy, pays premiums, and receives the benefit.
• Proceeds can fund recruitment/training, cover lost revenue, pay debts or investors, or facilitate orderly shutdown.
• Term life is usually less expensive than permanent life; disability coverage is also available.
• A common rule of thumb is coverage equal to about 8–10× the key person’s salary or estimated business value tied to that person.

What is key person insurance?

Key person insurance (sometimes called key man or key woman insurance) is a business-owned policy on an employee whose absence would significantly harm the company’s finances or operations. It creates a financial cushion to buy time for the business to find a replacement, reorganize, or otherwise respond to the loss.

Why it’s necessary

Losing a key individual can cause immediate costs and long-term revenue loss. Key person insurance:
* Covers short-term cash needs following a death or extended incapacity.
Funds recruitment, hiring, training and temporary operational expenses.
Helps meet loan guarantees or creditor obligations tied to the individual.
* Provides funds for shareholders or partners to buy out an interest if needed.

Key person insurance is especially relevant for small businesses where one person performs many critical functions.

Types of risks covered

Key person policies can be structured to address several business risks:
* Lost profits from reduced sales or delayed projects.
Costs to replace the person (recruiting, training, transitional support).
Protection tied to loan guarantees (coverage sized to the guarantee).
* Facilitating shareholder/partner buyouts or payouts.

Policies are available as life insurance (death benefit) and as disability coverage (benefit if the individual is incapacitated and unable to work).

How to implement key person insurance

1. Identify candidates whose absence would substantially affect cash flow, operations, customer relationships, or loan covenants.
2. Determine the role’s economic value—consider revenues tied to the person, replacement cost, and lost profits during transition.
3. Decide on policy type and amount (term or permanent; life or disability).
4. Purchase the policy with the company as owner and beneficiary; the company pays premiums.
5. Document ownership and beneficiary designations; ensure any legal or contractual obligations (loans, buy-sell agreements) are coordinated with the coverage.

How much coverage is appropriate?

Coverage needs vary. Common approaches:
* Rule of thumb: 8–10× the key person’s salary.
Value-based: estimate revenues or profits attributable to the person and the expected loss period.
Cost-based: total expected recruitment, training, and transitional expenses plus reserves for lost income.

Obtain quotes for several coverage amounts (for example, $100K, $250K, $500K, $1M) and compare costs against estimated needs.

Cost factors

Premiums depend on:
* Policy type (term is typically much cheaper than permanent).
Age, health, and gender of the insured.
Coverage amount and policy features.
* Company size, structure, industry, and the role’s risk profile.

Compare multiple insurers and policy structures to balance coverage needs with budget constraints.

Who pays and who benefits?

The company purchases the policy, pays the premiums, and is the beneficiary. The insured employee typically does not pay. Proceeds are paid to the company to be used as specified by its leadership or governing documents.

Conclusion

Key person insurance helps protect a business from the financial disruption that can follow the death or incapacity of an essential individual. Assess who is truly irreplaceable in the short term, estimate the financial impact of their loss, and choose policy type and coverage amount that align with your company’s needs and budget. Consider adding disability coverage where appropriate to broaden protection.