Advertiser Disclosure

Key Person Life Insurance: When Does It Make Sense for a Business

Learn how and why businesses may consider key person life insurance policies to cover the possible loss of a valuable business executive or employee.

Companies, both large and small, have certain employees that are vital to their success. 

Sometimes, a CEO provides the vision and drive to help a company go from an idea to scaling growth. In other cases, a key salesperson could be responsible for 25% or more of the company’s sales.

No matter the circumstances, certain people within a company are vital. Having them die could put the company in a bad position. 

Depending on the company’s reliance on that person, it could completely fail. In other cases, revenue could decrease without a backup plan in place.

Thankfully, there are tools to help you enact a backup plan. One option to help companies survive a key employee’s unexpected death is key person life insurance. 

Here’s what you need to know about it. Then, you can decide if it is a good fit for your company’s needs.

What is Key Person Life Insurance and How Does It Work?

Key person life insurance is a life insurance policy taken out by a company. 

These policies often go by other names such as: 

  • Key man life insurance
  • Key woman life insurance
  • Business life insurance 
  • Corporate-owned life insurance (COLI)

The company insures the life of a key employee or owner of the business, hence its name. 

The company usually names itself as the beneficiary of the policy. When the insured key person dies, the company receives a death benefit payment. 

The idea is:

The death benefit payment can help the company survive or wind down the business without putting an unnecessary financial strain on others.

The money could be used to cover lost revenue. It could also pay down debt or for costs associated with replacing the employee.

Key person life insurance may work in different ways. It depends on the type of policy the business purchases. 

No matter which type of policy the company buys, the employee must consent to be named an insured person by a policy.

When Does Key Person Life Insurance Make Sense?

Key person life insurance can be used to fulfill a variety of needs. 

Believe it or not:

It may be required in certain business situations.

Business loan liability

One typical example is when a business takes out a loan. 

The lender may make key person life insurance a requirement to qualify for the loan.

Lenders do this to make sure they’re paid back in the unfortunate case the business owner or other key employee passes away.

Tough to replace

Another reason to consider taking out key person life insurance is when an employee will be costly to replace.

While businesses should do their best to avoid being put in this situation, it does happen. 

The top executives in an industry often get massive compensation packages. This may be due to their track record of excellent results. Alternatively, other executives have unique knowledge and specialties that make them valuable. 

If you’ve secured one of these executives already, you know replacing them could be even more costly. 

You may have to pay large headhunter fees and incur other costs. Searches for the perfect executive can take a while, too.

A key person life insurance policy could be bought to help offset the costs of replacing an executive that dies. 

Companies should think about the potential expenses they’d incur when finding a new executive. This includes the possibility that a new executive may require a better compensation package if the job market has changed. 

Then, the business can take out a policy to cover this cost, naming the company as the beneficiary.

Loss of a great employee

Even if an employee isn’t expensive to replace, a business’s finances can suffer when a key employee dies. If your company has an outstanding salesperson, it’s easy to see how this can be the case.

Small family-run businesses may only have a couple of salespeople. If the top salesperson brings in 50% of the revenue of the company, the loss of that person could devastate the business’s finances.

You’ll likely keep some of the business the employee developed. You may not keep all of it, though. 

You’ll also have to find a new salesperson to step in. It will take time for them to rebuild the remaining relationships.

These costs could put a business running on tight margins in a position where they can’t stay afloat. 

Purchasing a key person life insurance policy and naming the company as the beneficiary can provide enough money to buy time. They can use the funds to make it through the transition process.

When Key Person Life Insurance Doesn't Make Sense

In some businesses, a key person life insurance policy doesn’t make much sense. 

For instance, a business run by a single person would likely end after the person dies. In this case, the business itself may not need key person life insurance. 

Life insurance should still be considered. Their spouse may want protection from the financial impact of the business owner’s death. 

In this case, a standard personal life insurance policy would probably work better.

Are There Different Types of Policies or Riders to Consider?

Like a personal life insurance policy, key person life insurance policies have many types to choose from. There are also riders you may want to consider adding.

Key person life insurance is usually purchased as a term life insurance policy.

That said:

Permanent life insurance options exist, too.

Permanent life insurance options don’t normally make sense unless a company wants to use it as an employee benefit. To make this an employee benefit, businesses can transfer the beneficiary of the policy to the insured person if they stay with a company for a particular time.

Term life insurance policies are often cheaper. This can save a business money on premiums. 

These policies can generally be bought for reasonably long terms. A long term policy may cover most key employees until they reach the age where you expect them to retire. 

As a business, you don’t need coverage after the employee no longer works for the company. This is another reason permanent life insurance often doesn’t make sense for this policy type.

As far as riders go, which essentially are add-on options to an insurance policy, they’ll vary depending on the company used to buy the life insurance policy.

Some policies may offer a business exchange rider to let you change the person the policy insures.

This makes sense if you don’t know how long an employee will be with your company. If they leave, you could transfer the policy to another key employee.

Where You Can Buy Key Person Life Insurance

Key person life insurance policies can be purchased at most typical life insurance companies.

You may want to check with your business insurance providers to see if they offer key person life insurance, as well.

As with most purchases, it makes sense to shop around for a key person life insurance policy.

Unless you are only concerned with the convenience of using your current business insurance provider, you may find a more favorable policy or better rates by shopping around.

Tips When Considering This Type of Life Insurance

When you’re considering buying a key person life insurance policy, you’ll need to think through a few things.

Obtain consent

Before you get started, verify the employee will consent to the policy.

Some employees may be offended you want to buy life insurance on them and may not allow it

If they don’t approve, there’s no point in going through the rest of the process.

Review the policy types

Next, consider what type of key person life insurance makes the most sense. 

For most businesses, this is generally term life insurance. It’s cheaper and still fulfills the usual purpose of a life insurance policy. Permanent life insurance could make sense in some instances, though.

Determine coverage needed

Then, think about how much coverage you need to purchase. If the policy is a requirement for a loan, find out how much coverage is required.

You may be purchasing the policy to cover lost revenues or the stress a business would go through when losing this particular employee. 

In this case, figure out how much money is needed to make the situation flow more smoothly.

Consider lost revenues, additional expenses and any business interruptions that may occur.

Once you know these factors, call many life insurance providers. When speaking with them, ask what types of policies and riders they offer. 

If they have a policy you’re interested in, ask for quotes. Let them know you’ll be shopping around for the best policy. 

After you get quotes and understand how the policies work, compare quotes to find the best option for your business.

Summary

Key-person life insurance can provide a lifeline for a company when one of their key employees dies. No one wants to think about this situation becoming a reality, but it can happen. 

If you avoid thinking about it, you may have to shut down a business after a key person dies.

It’s better to be prepared. That way, you have the financial resources to continue running the business.