How does a key person life insurance policy work?

Key person insurance is a type of life insurance policy designed to pay a business upon the death of the insured, as opposed to that person's beneficiaries. That "key person" could be a company owner or partner, or it could be an indispensable employee, such as someone with highly specialized knowledge or skills. A key employee could also be the person who brings in an outsized portion of the firm's revenue. These policies are generally reserved for employees whose absence will be a financial burden to the business and will be difficult and costly to replace. The policy provides funds that can help ensure business continuity if a key employee dies or becomes disabled, provided the policy has an additional disability rider. 

The business owns the policy, but the employee has to consent

Life insurance policies are typically owned by the insured or a family member. In this case, the business owns the policy and pays the premiums, so it is a form of company-owned life insurance, or COLI. When the insured dies or becomes disabled, the business serves as the beneficiary and receives the death (or disability) benefit. However, before a COLI policy can be taken out on a key employee, life insurance companies require the written consent of the person being insured. 

When should a business consider a key person insurance policy?

One of the most common reasons businesses take out this kind of coverage is because they are applying for a business loan or other financing, and the lender or investor requires this type of life insurance as collateral. With this kind of "collateral assignment" policy, the death benefit typically goes to repay the loan first, and any leftover money goes to the business. But there are several other situations and reasons for a business to consider taking out key person insurance, including:

  • If the business is named after the owner or other key person (for example, a part or former owner)
  • If the company is significantly linked to a person's reputation, skillset, or financial viability, and that person's loss would jeopardize the business 
  • If the loss of the key person could significantly impact the company's sales or finances
  • If you are the sole proprietor of a small business and want to provide an insurance payout that lets your heirs close the company and pay off any business debt
  • If the business is a partnership, and each partner wants funds to buy out the other's shares in case of an untimely death. This is typically done as part of a written buy-sell agreement among the partners

How much coverage is needed in a key person insurance policy?

When these life insurance policies are required as collateral for business loans, then it's clear that the benefit amount needs to be at least enough to repay the loan. But in other situations, the coverage amount can be harder to determine. You need to think realistically about the financial impact the key employee's death would have on the business. While there's no magic formula, you should try to think about the following effects that the key person's death might cause:

  • Management time and effort to find and recruit a replacement
  • The cost, including salary, incentives, and headhunter fees to hire a replacement
  • Operational disruption costs
  • Lost productivity
  • Lost sales
  • Slower time to market (if the key employee has a unique skillset)

If those factors prove too difficult to quantify, consider this starting point: add the person's salary to their direct financial contribution to your company's bottom line, then multiply the result by at least 5. 

The type of policy also matters

You also need to consider whether you should take out a term life policy or a permanent life policy.

Term life insurance is more affordable for a healthy employee, but coverage is temporary. Term policies last for a specific period of time – or term – that generally ranges from one year to 30 years. At the end of the policy term, you may be able to buy another policy. Yet, the premiums will be significantly higher due to age – and there is a chance the person will be uninsurable for health reasons. However, assuming the key person is not the business owner or partner, then term insurance may make sense because you can get a policy with a fixed period that lasts until the person's expected retirement or separation date. 

Permanent life insurance has higher premiums but can provide additional benefits for businesses. Unlike term, these policies don't expire as long as premiums continue to be paid.1 More significantly, permanent insurance builds cash value that the business can borrow against or withdraw from for future expenses.2,3 Unlike bank loans, there's no credit application required when borrowing against a permanent policy, and the interest rates are typically lower. The loans don't even have to be repaid to the insurance company, but any outstanding balance will reduce the death benefit. There are two main types of permanent coverage: 

  • Whole life insurance has a guaranteed premium that stays level for the life of the policy, with an accumulating cash value, tax-advantaged, at a predictable fixed interest rate.4 (Whole policies from mutual companies, like Guardian, may also pay dividends.5 While not guaranteed, these can further boost growth.)
  • Universal life insurance can also build tax-advantaged cash value while providing more flexibility: these policies let you vary payments within a specific range.6 Some policies even let you tie cash account growth to market investments, giving you more upside growth potential – along with exposure to market volatility and risk.

If the key person is the business owner or a partner, term life insurance is an option, but permanent may make more sense. For example, the policy can be used to fund an ongoing buy-sell agreement among partners, and when the key person ultimately leaves the business, the accumulated cash value can function as a retirement benefit.

What are some of the tax implications of key person insurance?

It's important to understand that generally speaking, premiums paid for a key person policy are not tax-deductible and cannot be counted as a business expense. However, any cash value that builds in a permanent policy is tax-deferred, allowing the policy to compound more interest. Small businesses can typically borrow against the monetary value of a permanent policy without causing a taxable event, and depending on the policy amount and the state where the policy is owned, the death benefit may not be taxable either. 

Talk to a financial professional

Key person insurance is just one of many ways life insurance can help protect and strengthen a business. Your needs are probably more complex than what a simple term life insurance calculator can provide a business owner. Consider working with a financial professional who will take the time to learn about your business and tell you about the options that best fit your immediate needs and long-term goals. If you have an insurance professional you already trust, that may be the best place to start. Otherwise, Guardian can connect you with a financial representative who can guide you to life insurance and wealth-building products that can help protect your family, business, and legacy.

Frequently asked questions about key person life insurance coverage

What is a key person life insurance policy?

Key person life insurance (sometimes called "key man" insurance) is a business life insurance policy taken out by a company to help protect against financial loss if an owner, partner, top executive, or essential employee passes away. Sometimes these policies also have a disability insurance provision or rider, in which case they also function as key person disability insurance.

Who is the owner, and who is the beneficiary of a key person policy?

With other life insurance policies, the insured person typically owns the policy. But with key person coverage, the business is always the owner of the policy and typically the beneficiary. That means the company pays the premiums (not the insured employee), and the insurance proceeds (death benefit) go to the business if the key individual passes away. However, in cases where the policy is used to secure a business loan, the benefit may be assigned to the financial institution as collateral.

What is the primary purpose of key employee life insurance?

Key person insurance is a type of business insurance designed to help a company recover from the financial loss caused by the death of an owner, partner, or essential employee. Key person insurance provides financial protection by giving businesses the time to find and train replacements for key employees. It can also protect heirs from paying off company debts after the owner dies. In a partnership, key employee life insurance can be used to buy out a partner's shares from family members in the event of their untimely death.

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Disclaimer

This article is for informational purposes only. Guardian may not offer all products discussed. Please consult with a financial professional to understand what life insurance products are available for sale.

1 All whole life insurance policy guarantees are subject to the timely payment of all required premiums and the claims paying ability of the issuing insurance company. Policy loans and withdrawals affect the guarantees by reducing the policy’s death benefit and cash values.

2 Some whole life polices do not have cash values in the first two years of the policy and don’t pay a dividend until the policy’s third year. Talk to your financial representative and refer to your individual whole life policy illustration for more information.

3 Policy benefits are reduced by any outstanding loan or loan interest and/or withdrawals. Dividends, if any, are affected by policy loans and loan interest. Withdrawals above the cost basis may result in taxable ordinary income. If the policy lapses, or is surrendered, any outstanding loans considered gain in the policy may be subject to ordinary income taxes. If the policy is a Modified Endowment Contract (MEC), loans are treated like withdrawals, but as gain first, subject to ordinary income taxes. If the policy owner is under 59 ½, any taxable withdrawal may also be subject to a 10% federal tax penalty. 

4 Guardian, its subsidiaries, agents and employees do not provide tax, legal, or accounting advice. Consult your tax, legal, or accounting professional regarding your individual situation.

5 Dividends are not guaranteed. They are declared annually by Guardian’s Board of Directors.

6 Universal Life Insurance may lapse prematurely due to inadequate funding (low or no premium), increase in cost of insurance rates as the insured grows older, and a low interest crediting rate. This does not apply to universal life policies which have a secondary guarantee, but if the secondary guarantee requirements are not met the policy will most likely lapse.

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