What is “Key Person” Life Insurance?

Sep 14, 2022

By Dan Schulte, Senior Vice President and Manager, Annuities and Insurance

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While all employees contribute to the success of a small business in some way, there are those employees that just cannot easily be replaced. A “key person” is an employee that may be the owner, a partner, a top executive, or an essential member of the organization with unique skills that are vitally important to the success of the business. The unexpected death or disability of any one of these individuals will often cause considerable losses and costs to the business.

When a key employee dies, some clients with whom the key employee enjoyed a close relationship may choose not to stay with the business, or they may successfully be retained only after the expenditure of substantial effort and money. Also, suppose the death of a key employee is unexpected or sudden. In that case, it can also create the significant expense of evaluating and ascertaining the status of work projects that may already be in progress and require redirecting other employees within the business to assume new responsibilities. In addition, there may be significant additional costs associated with searching for and hiring a successor.

These are all reasons many companies take out key person insurance on select employees to provide a critical financial cushion that can help stabilize business while leadership finds a new way forward. The life insurance death benefit would provide a lump sum of cash to help a business survive the expenses and losses caused by the death of a key employee and “buy time” until a replacement employee can be found.

When purchasing this type of life insurance, the business is typically listed as the beneficiary of the plan and pays the policy premiums. If the key employee should happen to die, an income tax free lump sum of cash would be paid to the business to help offset the loss of the key employee. Providing this protection can help assure the stability of the business for employees, customers, and creditors if a key employee should happen to pass away.

While there is no exact formula for determining how much coverage is necessary to insure a key person, factors to consider include:

  • Cost to replace: The cost to hire and train a replacement, considering the potential for lost business revenue during this period.
  • Contribution to revenue: Multiply the revenue that the key person brings to the business by the number of years your business will take to replace those earnings.
  • Multiple of 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.

One thing to remember is that key person life insurance is designed specifically to protect a business due to death or disability. These policies are not a substitute for personal life insurance coverage, which is designed to protect an individual’s family in the event of the death of a loved one. Contact your financial advisor to discuss all your individual and business life insurance needs.