In Canada, small businesses made up 98% of all businesses. Many small businesses rely on a few key employees.

While most business owners understand the importance of protecting their business against unforeseen risks, the risk of losing a key employee to illness or injury is often overlooked.

How would your company be impacted if one of your key members — a technical specialist, a senior marketing executive, or a business partner, for instance — were unable to work due to illness, injury, or accident? Does your company have enough cash flow to deal with such an emergency? 

If not, it's time to consider key person disability insurance. This insurance protects your company if a key employee cannot perform the demands of their job due to a disability. Let's go over how it works.

What Is Key Person Disability Insurance?

Key person disability insurance — also known as key person replacement coverage or key man disability insurance — protects your business from financial loss if an important employee cannot work due to a serious illness or injury. A key employee could be a business partner, a chief financial officer, a senior marketing executive, or any critical employee. 

If a significant revenue producer of your company is unable to perform their role due to disability, the policy will pay a fixed benefit amount for a period of time. This benefit period — the period for which monthly payments are payable — is usually up to 24 months.

The policy's payments kick in after an initial waiting period (also known as the qualifying period or elimination period), which is typically 30, 60, or 90 days. 

By covering the short-term loss of key individuals, the key person disability insurance ensures your company does not lose momentum through tough times. Disability benefits can help meet a range of business needs, including: 

• The cost of hiring and training a replacement
• Offsetting loss of revenue
• Paying for necessary operating expenses, like rent or utilities
• Covering debt payments
• Ensuring the company stays viable until a buyer is found or the business is closed
• Supplementing overtime payments for staff members to cover the extra workload 

Who is a key person?

The term key person refers to an employee whose services are vital to the company. Without this person, the business will likely struggle to maintain or grow it's current revenue.

In the worst-case scenario, their total disability may push the company toward bankruptcy. The key person has specialized skills, knowledge, and experience, which cannot be easily replaced. 

How Does a Key Man Disability Insurance Policy Work?

Key person disability insurance is an important component of your company's risk management plan. It assures that, in the event that a key employee becomes disabled, corporate activities continue with the fewest possible interruptions.

The individual (i.e. the key person) covered by the policy is referred to as “the insured.” For example, if you want to cover your chief financial officer, he or she will be the policy’s insured. The business pays the premiums and is the policy owner or the policyholder. It is also the policy’s beneficiary, meaning in the event of a disability, it will be the one to receive benefits. 

Some of the main disability insurance terms that you should be aware of include: 

• Waiting Period

The waiting period, or the elimination period, is the time you must between the onset of an illness or injury and the date the benefits become payable. The waiting period starts on the date the insured is disabled.

For disability insurance, the waiting period can be anywhere between one week and one year, depending on the insurance carrier. Typically, the longer the waiting period, the lower the premiums. 

Because key person disability insurance covers short-term disability, the waiting period is usually not more than 90 days, with a 30-day elimination period being the norm.

If your policy comes with a 30-day waiting period, in the case of a disabling injury or illness, the benefits start from day 31. Disability benefits are typically paid at the last of each month and last until the insured recovers or the benefit period ends. 

• Key Person Disability Insurance Benefit Payouts

Most key person disability insurance policies issue monthly benefits. Depending on the insurer, some plans allow the policy owner to collect a lump-sum payment.

Monthly Disability Benefit Payout 

After the waiting period — usually 30 days — the policy pays a fixed amount at the end of each month for as long as the benefit period lasts. The benefit period typically lasts 1 or 2 years. This gives the disabled employee time to recover and resume work or, in case that is not possible, for the employer to hire and train a replacement.  

How much money the policy will pay every month depends on several factors, with the most important factor being the key employee’s salary. Generally, these policies pay up to 150% of the insured’s income. 

An Example of How a Monthly Disability Benefit Plan Works

Let’s say your business owns a disability policy on a key employee. The policy has a waiting period of 30 days, benefit period of 24 months, and monthly benefit of $20,000.

If a disability occurs, your company can receive up to $480,000 in benefits.

Disability benefits would become payable after the 30-day elimination period, meaning the first payment would be made on the 60^th day (at the end of the month following the 30-day waiting period). After that, your company will receive $20,000 every month for as long as the disability persists or until the benefit period expires. 

Lump-sum Disability Benefit Payout

Some insurance companies offer disability benefits as a large, one-time payment. However, this payout option involves a much longer waiting period, typically 180 days or more.

If at the end of the waiting period, the key employee is unable to return to work, the insurer pays a lump sum to the company and then terminates the policy. The benefit amount is usually two to three times the insured’s annual salary.

An Example of How a Lump-sum Benefit Plan Works

A disability plan with a benefit amount of $200,000 and a waiting period of 180 days will pay the insurance proceeds to the company if the insured does not recover after 180 days. Once the beneficiary receives the payout, the coverage terminates. 

When deciding between a monthly benefit and a lump-sum payment option, consider your company’s cash flow and the amount of time needed to hire and train a replacement.

If your business has limited funds, you may be better off buying a policy that pays monthly benefits. But if you have reserves to handle a short-term disability, but not the long-term impact of losing a key employee, opt for the lump-sum payout option.  

• Benefit Period

The benefit period is the maximum amount of time for which the insurer pays disability benefits when the insured is disabled. Since the purpose of key person disability coverage is to provide short-term financial relief to a company if one of its key employees is too sick or hurt to work, its benefit period is rather limited.

It is uncommon for a key person disability insurance to have a payout period longer than two years while the minimum benefit period is six months.  

Do I need Key Person Disability Insurance?

Think about your company’s key employees. Maybe they are your top marketing people, or even you and your business partner. Now ask yourself: Can your company bear the financial impact of losing a key employee? If the answer is no, your company needs key person disability insurance. 

What are the key exclusions of Key Person Disability Insurance?

Insurance companies can reject a claim filed within the first two years if the insured lied on the application. Not disclosing key information, like a pre-existing illness, on the application form amounts to fraud and is referred to as material misrepresentation. During the first two years of the policy, the insurer can investigate a claim and reject it if the insured intentionally withheld information that would have impacted their insurability or premium rate.  

Other key exclusions include self-inflicted harm and disabilities caused by acts of war. Additionally, most insurers might not cover pre-existing illnesses and conditions. 

How much coverage can you buy?

How much coverage you can buy depends largely on the insured’s salary. Key person disability coverage pays either monthly benefits or a lump sum. A monthly benefit plan pays a fixed dollar amount — typically not more than 150% of the insured’s monthly salary. In contrast, the maximum benefit amount offered by a lump-sum benefit policy is three times the key employee’s annual salary. 

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How much does key person disability insurance cost?

The cost of key person disability coverage depends on a number of personal factors, such as age, health history, and policy choices, like waiting period and coverage amount.  

• Age

Age is among the biggest determining factors for disability insurance. Statistically speaking, the risk of becoming disabled increases as you get older. As a result, the older you are, the more the coverage will cost. 

• Gender

There is no sugarcoating this: Women get the short end of the stick when it comes to disability insurance. They pay up to 40% more for disability coverage than men. 

Research shows not only women are more likely to suffer career-impacting disabilities, such as autoimmune disorders, than men, but they also file heftier disability claims.  

• Health

Whether it is key person life insurance or key person disability insurance, your medical history counts. 

As part of the underwriting process, the insurer will ask you about: 

• Your medical history (like do you have any pre-existing health conditions? If so, which ones)
• Your family’s medical history (e.g. did any or both of your parents die from a hereditary illness?)
• Any medications that you are currently taking

You will also be asked to undergo a paramedical exam similar to an annual physical. A technician will collect your blood and urine samples and record vitals like blood pressure, pulse, BMI, height, and weight. Depending on your age, you may also have to take an electrocardiogram (EKG). A high BMI might push up your premiums, as might high blood sugar levels or any above-normal reading. 

A history of tobacco use is another thing that will increase the cost of coverage. Smokers pay 20% more for disability insurance than non-smokers, on average.  

• Benefit amount

The amount of key person disability coverage you need also impacts the monthly premium rate. If the benefit amount increases, so does the insurance cost. 

• Benefit period

The benefit period refers to the maximum period for which the policy will pay benefits. For key person disability coverage, the benefit period is usually 12 to 24 months. The longer this period is, the higher the premiums will be, other things being equal. 

• Waiting period

Also known as the elimination period, this is a small period you must wait after becoming disabled before your coverage kicks in. For example, a disability insurance plan with a 90-day waiting period would not pay benefits for the first 90 days after you become disabled. 

The cost of disability insurance is inversely related to the waiting period. The longer this period is, the lower your monthly premiums. Ninety-day waiting periods are less expensive than 60-days elimination periods, which in turn cost less than 30-day periods.

• Riders

Riders are optional features that you can add to your policy — usually by paying an additional extra fee — to fit your needs and preference. The more paid riders you add to your key person disability coverage, the greater the cost of coverage. 

Why Buy Business Disability Insurance?

Key employees are the backbone of any company. If a key contributor becomes disabled and is unable to work, your business may face several challenges, including: 

• Disruption of revenue generation  
• Slow business growth
• Loss of credit approval
• Loss of specialized expertise
• Increased costs to hire and train a replacement 

Key Person disability coverage provides a financial cushion to handle the loss of a crucial employee. In the event of a key revenue earner becoming disabled, your company can use the payout to offset the loss of revenue, cover the expenses of finding a suitable replacement, and show credit worthiness to creditors and stakeholders.

How do you qualify for key person insurance?

To be eligible for key person insurance, the insured must be in reasonably good health and a key member of your company. When applying for key person coverage, be prepared to answer questions such as: 

• Is the insured a business partner of the company? (If yes, what is his or her ownership percentage?)
• What will be the financial impact on the business if the key person were too sick or injured to work?
• How much salary the insured is presently drawing?
• How long has the insured been working for the company?

Conclusion

Key person disability insurance helps minimize the impact of losing a crucial employee. If a key employee were to become disabled, the policy pays monthly benefits for a fixed period or a lump sum. You can use the payout to offset the financial burden of losing a vital member of your business. 

If you want to take out key person disability coverage, Dundas Life can help you. We work with top-ranking insurance companies and help you secure the needed coverage at an affordable price. Reach out to discuss your business needs with an advisor today.

Frequently Asked Questions

Who owns a key person disability insurance policy? 

The business is the policy owner of a key person disability insurance plan. It is also the sole beneficiary of the policy, meaning it will receive disability benefits if the insured becomes disabled.

Can a business write off the key person disability insurance premiums as a business expense? 

The premiums your company pays for key person disability coverage are not considered tax deductible. However, any benefits that it may receive are tax-free. 

How much key person disability coverage does my business need? 

Insurance needs are rarely one-size-fits-all. To get an estimate of your needs, ask yourself: What would be the financial impact of losing a key employee for one year? The answer will give you a fair idea about how much protection is needed.