Key Person Insurance: Protect Your Business from the Unthinkable
What Happens If You Lose a Critical Employee?
Your business depends on key people. Learn how key person insurance protects your company from the financial impact of losing critical employees.
- Key person insurance provides immediate capital to stabilize the business if a critical employee dies unexpectedly
- Coverage amount typically ranges from 5-10x annual compensation or 1-2 years of revenue contribution
- Death benefits are generally tax-free to the business if notice and consent requirements are met
- Banks and investors often require key person insurance as a condition of financing
- Review and update coverage annually as the business grows and key person contributions increase
The Opportunity
Why Key Person Insurance Matters
Business Continuity Protection
If a key employee or owner dies unexpectedly, the business faces immediate challenges: revenue loss, customer defection, employee uncertainty, and potential failure. Key person insurance provides immediate capital to stabilize operations, hire replacements, and reassure stakeholders during the transition.
Lender and Investor Requirements
Banks and investors often require key person insurance as a condition of financing. They recognize that the business value depends heavily on specific individuals. Coverage demonstrates risk management sophistication and protects the lender/investor interests if a key person becomes unavailable.
Tax-Advantaged Death Benefits
Key person life insurance premiums are not tax-deductible to the business (premiums paid with after-tax dollars). However, the death benefit is generally received tax-free by the business under IRC Section 101. This tax-free payout can be critical during a difficult transition period.
Recruitment and Retention Tool
Key person insurance can be structured as part of executive compensation packages. The business owns the policy, but the coverage signals investment in the employee. Some arrangements allow the policy to transfer to the employee at retirement, creating a powerful retention incentive.
Implementation
Proven Strategies
Coverage Amount Calculation Methods
Determine key person value using multiple methods: (1) Multiple of compensation (5-10x annual salary), (2) Contribution to profits (capitalize their contribution at a discount rate), (3) Replacement cost (recruiting, training, productivity loss during transition), (4) Loan/investor requirements. Use the highest result.
Key executive earns $300K, contributes $500K annually to profits. Method 1: 10x salary = $3M. Method 2: $500K capitalized at 10% = $5M. Method 3: 2 years replacement disruption = $1M. Method 4: Bank requires $2M. Recommended coverage: $5M (highest amount).
Split-Dollar Key Person Arrangement
Structure key person insurance as split-dollar: the company pays premiums and receives death benefit up to premiums paid; the employee's beneficiary receives any excess death benefit. This provides key person protection while creating an employee benefit. Can be structured as loan or economic benefit regime.
Company purchases $2M policy on key executive, pays $30K annual premium for 20 years = $600K total. Executive dies: Company receives $600K (premium reimbursement), executive's family receives $1.4M. Key person protection plus employee benefit.
Permanent vs Term Key Person Coverage
Term insurance costs less but expires - appropriate when key person risk is temporary (until business matures, succession develops). Permanent insurance costs more but builds cash value - appropriate when key person risk is indefinite and cash value can serve as informal financing or executive benefit.
Founder essential for next 10 years until successor ready: 10-year term, $5M coverage, ~$5,000/year premium. Founder essential indefinitely with desire for cash value: Whole life $3M, ~$40,000/year premium, cash value accessible for business needs.
Avoid These Pitfalls
Common Mistakes
Underestimating Coverage Needs
Business owners often purchase $500K-$1M when they need $3M-$5M or more. Consider ALL impacts: revenue loss, customer attrition, employee departure, replacement costs, loan acceleration, and business value decline. Err on the side of more coverage - premiums are relatively cheap compared to risk.
Not Updating Coverage as Business Grows
Key person insurance purchased when the business was $1M in revenue may be inadequate at $10M. As the business grows, key person impact grows. Review coverage annually against current revenue, profitability, and key person contribution. Increase as needed.
Failing to Comply with Notice and Consent Rules
IRC Section 101(j) requires that covered employees be notified and consent to employer-owned life insurance. Failing to comply results in death benefits being taxable (except to extent of premiums paid). Document notice and consent BEFORE the policy is issued.
Questions
Common Questions
Here are the most common questions we receive about this topic.
Ask Your QuestionReady to Protect Your Business?
Every business has key people whose loss would be devastating. Let us help you identify coverage needs and implement the right protection.