As a business owner are you worried about how your business would cope if you were to temporarily or permanently lose a key employee? If yes, you should consider key person insurance.
Key person insurance, also known as key man insurance, helps protect a business if a key employee dies or becomes disabled. This coverage is vital for businesses that depend heavily on one or a few persons’ knowledge, personal network, or performance.
A key person life insurance policy is a plan purchased by a business on a specific person. The business is responsible for making premium payments and is usually also the beneficiary. If the insured dies, the business is given the death benefit, which it can use to cover the cost of replacing the lost key employee or any other expense.
What is a Key Person?
If your business will suffer revenue loss if you lose a particular employee, that individual is likely a “key person” (or a "key man") for your business.
You can also identify whether an employee is a key person or not by considering the cost of finding a replacement. If your business would need to hire a headhunting company to find a replacement, the individual in question is likely a “key employee.”
The “key person” (or "key man") might be the Marketing Director, the CEO, the President or any other employee who is responsible for a large part of your company’s revenue or who cannot be easily replaced.
How does Key Person Insurance work?
Key person insurance works the same way as any other life insurance policy. The contract involves three key parties:
- the insured (the person whose life is covered by the policy)
- the policy owner (the person or entity that pays the premiums and has the right to make changes to the policy)
- the beneficiary (the person or entity that receives the death benefit).
In key person insurance, typically the business is the policy owner and the beneficiary. The premiums of this insurance are generally not tax deductible, but the death benefit is tax-free. The beneficiary is free to use the payout however they like.
Types of key person insurance
Three types of key person insurance are available. These are:
Key person life insurance
Life insurance provides a death benefit upon the insured’s death. When you shop for key person life insurance, you will have the following options:
- Term life key person insurance
Term life policies are more popular and cheaper than other types of life insurance plans. A term life key person insurance policy has a predefined expiration date, which can be as short as one year or as long as 35 years. Depending on your policy, you may be able to renew it until the insured reaches a certain age. If you do not renew the coverage after it reaches its term, the policy will lapse. The insurer pays the benefit to your business only if the insured passes away during the policy term.
- Whole life key person insurance
Whole life insurance provides protection as long as the insured lives, provided the premiums are paid. In addition, it bundles as an investment tool. A part of each premium payment goes into an investment account, which grows tax-deferred at a fixed rate. The policy owner can withdraw the money in this account at any time by making a withdrawal or taking out a policy loan. Upon the insured’s death, the insurer typically pays the beneficiary (which in the case of key person insurance is usually the same as the owner) only the death benefit amount. Any unspent cash value reverts to the insurance company.
- Variable life key person insurance
Just like whole life insurance, variable life insurance offers lifelong protection and accumulates cash value. However, unlike whole life insurance, variable life insurance may allow you to change the premium and the death benefit within permissible limits. In addition, the cash value is tied to sub-accounts selected by you and grows at a variable rate. If the sub-accounts you have chosen perform well, you can receive handsome returns. However, your cash value can also get wiped out completely if the market underperforms.
Disability key person insurance
You can purchase a disability insurance policy on a key employee. The insurance carrier will pay a monthly benefit if the insured is unable to work due to illness or injury.
Critical illness key person insurance
Critical illness key person insurance helps you protect your business against the financial loss it will likely suffer if the insured develops a critical illness. The insurance carrier will pay a lump sum if the insured is diagnosed with a covered health condition.
Benefits of Key Person Insurance
Key person insurance can help your business:
- offset lost income due to the death of a key employee
- cover the cost of finding and training a replacement
- buy out the shares of the deceased
- provide financial assistance to the deceased’s family.
Cost of Key Person Insurance
How much you will pay for key person insurance depends on several things. These factors include:
The type of coverage you want
Life insurance policies are either term or permanent. Term life insurance is cheaper and lasts for a specific duration. Generally, you can buy a policy for a term of up to 35 years and renew the policy up to a predetermined age. Compared to permanent life, term life insurance is 10 to 15 times more affordable.
Permanent life insurance does not come with an expiry date. The coverage remains in force as long as you pay the premiums. Besides providing lifelong protection, your policy includes an investment component, called cash value. The cash value earns interest or capital gains and grows tax-deferred. You can tap into it whenever you want by withdrawing money from it or taking a loan against it.
The amount of coverage your company needs
The greater the death benefit amount, the costlier the coverage, all other things being equal.
The younger the insured, the lower the premium. That is because the cost of insurance increases with age.
How much you will pay for coverage also depends on the insured’s life expectancy. The longer the insured is expected to live, the lower the premium rate.
Most life insurance policies involve medical underwriting. As part of the application process, the insured must provide information about their current health, medical history, and family’s medical history. They will likely also have to undergo a medical examination similar to an annual physical. The insurance carrier will assign the insured a risk class based on their test results, which, in turn, determines the premium rate.
Insured’s smoking status
People who smoke or use tobacco in any form have a lower life expectancy than those who do not smoke. As such, they receive higher life insurance rates. On average, smoking can increase the insurance cost by three to five times.
Key person insurance (also known as key man insurance) is designed for businesses that are dependent on the expertise of one or a few key employees. By taking out a life insurance policy on a key employee, a business can ensure that it does not lose its financial footing if that person passes away.
The business is the policy owner and the beneficiary. Upon the insured’s death the business receives the proceeds of the policy, which it is free to spend as it deems fit.