Key Person Insurance: A Quick Guide

Summary: This article explains key person insurance, which provides coverage if an essential employee or owner dies, helping your business cover lost revenue, recruit replacements, and maintain stability.

A key person is vital to your business’s success. They represent the heartbeat of your business, and losing such an employee could seriously affect operations or profits. Suddenly, you’re scrambling to replace their skills, knowledge and connections, while also keeping the business afloat.

That’s where key person insurance comes in. It’s designed to help protect and sustain your business if an essential employee or owner dies or becomes disabled.

Wondering if your business needs it? Let’s break it down.

Who qualifies as a key person in your business?

So, who exactly is considered a key person? This is usually someone whose absence would seriously disrupt your business operations or profits. This person could be your top salesperson, your lead dealmaker, or even yourself, anyone whose unique skills, leadership or connections are vital to your business’s success.

Many times, the key person is the business owner or a partner, especially in smaller companies where leadership plays a hands-on role in daily operations. Other examples include chief executive officer, chief operating officer, heads of product development or engineers.

From an insurance coverage standpoint, not every employee qualifies as a key person. Insurance companies usually require proof that a person is essential to their business. They may ask for job descriptions, financial statements or other documentation that shows just how critical that individual is. You’ll also need the employee’s consent before taking out the policy.

How does key person insurance help protect your business?

With key person insurance, the business owns the policy and collects the payout in the event that the key person passes away. The insurance payout can be used to:

• Cover lost revenue
• Recruit and train a replacement
• Keep the business stable during the transition
• Handle expenses if you’re planning to sell the business

In short, key person insurance gives your business breathing room during a tough time.

Choosing the right key person insurance coverage

When purchasing key person life insurance, most businesses opt for a term life policy. This type of policy covers a specific number of years, such as five, 10, or 20 years, and is usually more affordable.

Choosing between term and permanent life insurance depends on the business’s specific needs. Term life insurance is often suitable when the insurance need is temporary, such as covering the duration of a specific project or loan. Permanent insurance might be the better choice for long-term needs, especially in family-owned businesses or when accumulating cash within the policy is a priority.

Here are additional factors to consider when choosing between the two:

1. Business structure: Family-owned businesses might lean toward permanent insurance for lasting protection.
2. Financial goals: If accumulating cash value or using living benefits is important, permanent insurance can offer these advantages.
3. Flexibility and benefits: Permanent insurance provides options like borrowing against the policy and using living benefits, which can be crucial for ongoing business operations.

These factors are also important when deciding on coverage length:

• How long is this person likely to remain essential to the business?
• Is this a long-term partner or someone who may leave in a few years?
• How much would it cost to replace them, including recruitment and onboarding expenses?

Since every business’s needs are unique, it’s a good idea to consult with a financial advisor to determine the right mix of coverage for your situation.

Key person insurance benefits for employees

Key person insurance is not designed to provide a direct benefit to an employee, only the employer, but some organizations have found creative ways of using it to provide support to key employees.

Here’s how it can work:

• If the business purchased permanent insurance, it should build cash value over time.
• When a key employee retires or leaves on good terms, you may offer them:
  • A portion of the policy’s cash value
  • A lump-sum payout as part of their exit package
  • A goodwill bonus as a thank-you for their loyalty

Many executive bonus plans are funded by life insurance policies, so the key person coverage can be used to:

• Reward key employees for staying long-term
• Offer additional financial incentives beyond salary or benefits
• Boost employee retention, especially for hard-to-replace roles

Is key person insurance the right move for your business?

Still not sure if key person insurance makes sense for your business? Here’s a simple way to know.

Ask yourself:

• What would happen to your business if a key employee or owner passed away unexpectedly?
• Could your business continue operating smoothly if they could not work for months or longer?
• How much does your business rely on the leadership, knowledge or connections of just a few people?

If these questions raise concerns, it may be time to explore your options for business key person insurance.

We are here to offer helpful advice on your life insurance options to help you protect what matters most. To learn more, visit our Life Insurance section in Planning and Advice.

Frequently asked questions (FAQs)

What are the tax considerations of key person insurance?

Life insurance premiums usually can’t be deducted from taxes. However, the life insurance death benefit will be paid tax free to the beneficiary (here the business), provided that the arrangement was set up correctly.

If the business has a permanent life insurance policy on a key person, any cash value it gains grows without being taxed. The business often has the option of borrowing against the cash value without triggering a taxable event.

It is possible that if the business owner owns the life insurance policy, rather than the business, the business may deduct the premiums as part of the owner’s compensation. It’s best to speak to a tax professional who can help you determine the specific tax implications of your key person insurance.

How much does key person insurance cost?

The cost of key person insurance depends on a few factors, like the age and health of the person insured, the amount of coverage you choose and the type of policy (term or permanent). Generally, term life key person policies are more affordable than permanent ones.

Can you deduct key person insurance premiums as a business expense?

In most cases, the premiums for key person life insurance aren’t tax-deductible because your business is the policy beneficiary. As previously mentioned, it’s always best to check with your tax professional to understand how it applies to your specific situation.

Disclosures:

All investing involves risk, including the possible loss of principal, and there can be no assurance that any investment strategy will be successful.

Mutual of Omaha and its representatives do not provide tax and/or legal advice, and the information provided herein is general in nature and should not be considered tax and/or legal advice.

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