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Understanding Key Person Insurance
Key person insurance is a business's life insurance policy on a key employee, such as a founder or executive. The company owns and pays for the policy and is the beneficiary. It receives a payout if the insured individual dies or becomes disabled.
This type of term life insurance or permanent life policy can reduce the financial impact associated with the loss of a key employee.
Key person life insurance is comprised of several essential elements, which include:
- Policyholder: The business owner owns the policy, pays the premiums, and gets the payout if the key person dies or resigns.
- Insured: The important employee who is essential to the company
- Beneficiary: The company or organization
- Death benefit: Insurance payoff paid to the business in the event of untimely death or disability. If the policy includes a disability rider, it may also provide benefits in the event the insured becomes disabled.
Key person insurance can help businesses manage financial risk and support continuity during leadership transitions. By getting a handle on the basics early on, you can help pave the way for a steadier future for you and your business.
Who Needs Key Person Insurance?
Businesses dependent on key individuals benefit from key person insurance. While larger firms have redundancies, small to mid-sized companies struggle with such losses.
Companies in Need of Key Person Insurance
- Startups often rely heavily on a single visionary founder, whose unique skills and leadership are vital to the company's success and future growth.
- Sole owners running a one-person business also face this reliance, as their business operations and revenue generation hinge on their efforts.
- Professional service firms, such as those specializing in law, accounting, or consulting, often depend on their top partners or leaders who drive significant business and client relationships.
- Medical or dental practices usually center around a lead practitioner whose expertise and reputation attract patients.
- Tech companies frequently depend on a lead developer or scientist whose innovative work is crucial for product development and technological advancements.
These businesses often use key person coverage as part of their risk management strategies, especially when seeking a business loan.
Key Employees to Cover with Insurance
- Founders and co-founders are invaluable to any company.
- Chief executive officers (CEOs) play crucial leadership roles, steering their organizations toward achieving their goals.
- Chief financial officers (CFOs) are essential to managing a business's economic health and strategy.
- Top-performing salespeople drive revenue and growth, often holding key client relationships.
- Individuals with unique expertise or client ties are crucial due to their impact on business success.
A policy can help if losing someone would delay work, hurt revenue, affect financing, or damage relationships. These are often valuable employees whose expertise is tied to business success.
How Does Key Person Insurance Work?
Securing key person insurance begins with identifying who qualifies as a key person. Once identified, the company must ensure its consent and apply for a policy.
Here's how it typically works
- Assessment of Value: The company evaluates the financial repercussions of losing a key employee, quantifying the impact on operations, revenue, and growth.
- Choose a Type of Policy: Select between term life insurance or permanent coverage with optional riders.
- Apply for Coverage: Similar to personal life insurance policies, the key employee undergoes a thorough underwriting process to determine insurability and policy details.
- Pay Premiums: As the policyholder, the business is responsible for paying the insurance premiums to maintain the policy's validity and coverage over time.
- Receive Death Benefit: If the insured key employee either passes away or becomes permanently disabled, the company receives the agreed-upon payout from the insurance policy to mitigate the financial strain.
Uses of the death benefit might include:
- Offsetting lost revenue that the company experiences due to the absence or incapacity of a key individual.
- Recruit and train a replacement to take over the responsibilities of the departed key person.
- Pay off outstanding debt obligations or business loans
- Keeping investors or lenders at ease
A business funds a key person policy, with costs varying based on factors such as age, health, coverage, and policy type. It prevents financial collapse if a key person dies or falls seriously ill.
Pros: Benefits of Key Person Insurance
Key person insurance serves as a financial lifeline in times of uncertainty. It can also strengthen your company's credibility and long-term planning. The main benefits include:
- Business Continuity: Assists in maintaining business operations during the challenging period of locating and preparing a suitable replacement.
- Financial Cushion: Compensates for potential loss of profits or covers unforeseen expenses that may arise.
- Loan Protection: Can meet the conditions set by lenders when a business seeks to apply for a loan.
- Investor Assurance: This demonstrates to investors that the business is well-equipped and strategically prepared to handle unforeseen events and situations.
- Succession Planning: Allows leadership additional time to carefully assess and determine the best action for future decisions.
Some businesses use the payout to restructure or dissolve the company if the employee is irreplaceable. Some also leverage the cash value aspects of life insurance coverage if they are using a permanent one.
Cons: Potential Drawbacks to Consider
While key person insurance is valuable, it has potential drawbacks. Businesses should weigh the pros and cons carefully before purchasing coverage. Drawbacks may include:
- Premium Costs: Premium costs vary by policy type and can be high for older individuals or those with health issues, making coverage more expensive.
- Limited Scope: Key person insurance is limited in scope, as it does not protect against other business risks, such as economic downturns, increased market competition, or shifts in industry trends.
- Employee Departure: If the insured individual decides to leave the company on their own accord, the existing policy may become ineffective or lose its intended value.
- No Direct Benefit to Employee: The policy does not provide any personal financial benefits or provide no direct benefits to employees.
While some assume this benefits the employee, it solely benefits the business. It's vital in business risk plans when its value surpasses the cost.
Key Person Insurance vs. Other Types of Life Insurance
Key person insurance is sometimes confused with other life insurance policies. It's important to understand how it differs. Here's how it compares to different types of business-related coverage. These are separate insurance structures and not interchangeable with key person insurance.
| Type of Policy | Who It's For | Who Benefits | Primary Purpose |
| Key Person Insurance | Critical employees | The business | Business continuity |
| Buy-Sell Agreement Insurance | Business partners | Surviving business partner | Transfer of ownership |
| Group Life Insurance | Employees | Employees' families | Employee benefit |
| Individual Life Insurance | Any person | Chosen individual/family | Personal financial protection |
Key person life insurance is designed to keep a company running in the event of a major contributor's death. Businesses may use a life insurance trust in estate planning to manage proceeds further. Key person insurance is purchased and owned by the business for business continuity—not for personal or employee benefit.
How to Choose the Right Policy
Finding the right key person insurance depends on several factors, including business size, industry, and the individual's role. Here are the steps to choose the right coverage:
- Identify Key Employees: Identify those crucial employees whose unexpected absence or departure from the company could significantly impact revenue generation or overall business operations.
- Evaluate Financial Risk: Determine the business's potential financial impact if that individual were no longer available to contribute to the company.
- Choose a Type of Policy: Term insurance typically comes with a lower premium, making it a more budget-friendly option. In contrast, permanent insurance can offer greater value over an extended period due to its lasting coverage and potential for accumulating cash value.
- Decide on Coverage Amount: Standard guidelines often involve calculating the coverage as a multiple of the key individual's annual salary or estimating it based on the expected impact on the business's revenue.
- Add Riders if Needed: Including additional options such as disability insurance or policy conversion features can provide increased flexibility.
- Compare Providers: Collaborate with an insurance provider that has knowledgeable brokers or financial advisors specializing in business life insurance policies who can provide practical guidance.
Blending this insurance with other solutions—like annuities to life insurance transitions or coverage for a blended family business—can help create a more robust protection plan.
Final Thoughts
Key person insurance isn't required, but it helps businesses prevent stalls, revenue drops, and reputational damage when a vital member is lost. It provides life insurance protection that helps offer financial stability and flexibility for leadership during challenging transitions.
Learn what key person insurance covers and why your business may need it. Get a Free Life Insurance Quote
