Key Person Insurance

Quick Definition

Key person insurance (also called key man insurance) is a life or disability insurance policy that a business purchases on an employee or owner whose loss would cause significant financial harm to the company. The business owns the policy, pays the premiums, and is the beneficiary — receiving the death or disability benefit if the key person dies or becomes disabled. The payout helps the business survive the transition, recruit a replacement, or repay business debts.

What It Means

Most businesses have one or a few people whose knowledge, relationships, or skills are disproportionately valuable to the company's success. A startup where the founder built all customer relationships, a law firm where one rainmaker generates 60% of revenue, or a manufacturing company where the chief engineer holds critical process knowledge — the sudden loss of these individuals could threaten the business's viability.

Key person insurance provides the financial bridge: cash to hire and train a replacement, sustain operations during the transition, reassure creditors and investors, and — in the worst cases — provide a wind-down fund if the business cannot continue.

Key Person Insurance vs. Personal Life Insurance

What Businesses Use Key Person Insurance For

Who Qualifies as a "Key Person"?

How Much Coverage?

There is no universal formula, but common approaches:

Example: A startup founder earning $200,000 who generates $2M in annual revenue:

• Compensation method: $1M-$2M coverage
• Revenue method: $2M-$6M coverage
• A $2M term life policy at ~$50-80/month is a reasonable starting point

Policy Type: Term vs. Permanent

For most small businesses, term life is appropriate — it provides the highest coverage for the relevant risk period at the lowest cost.

Key Person Disability Insurance

The death benefit addresses mortality risk, but disability is statistically far more common during working years:

• A 40-year-old is 3x more likely to become disabled than to die before age 65
• Key person disability insurance pays a monthly benefit (or lump sum) if the key person cannot work
• Elimination period is typically 90 days (business absorbs the initial period)
• Benefit period varies: 2 years, 5 years, or to age 65

Long-term disability insurance for the business is often more important than life insurance for a company heavily dependent on a specific individual who is young and healthy.

Buy-Sell Agreements: The Ownership Transfer Partner

Key person life insurance often works alongside a buy-sell agreement — a legal contract defining what happens to a deceased owner's business interest:

Without insurance funding, surviving owners may need to buy out a deceased owner's estate using cash, loans, or installment payments — creating financial strain. Insurance provides immediate liquidity for a clean transition.

Tax Treatment of Key Person Insurance

IRS Notice 2009-48: Requires companies to notify insured employees in writing that the company is purchasing life insurance on them and disclose the maximum death benefit.

Key Points to Remember

• Key person insurance protects the business — the company owns, pays for, and is the beneficiary
• Premiums are not tax-deductible but the death benefit is typically tax-free to the business
• Most appropriate for founders, key salespeople, technical leads, and others whose loss would materially harm operations
• Coverage = 5-10x compensation or 1-3x revenue contribution are common sizing approaches
• Disability is statistically more likely than death for working-age key persons — disability coverage often equally important
• Frequently paired with a buy-sell agreement to fund ownership transition at death

Frequently Asked Questions

Q: Can an employee take the key person policy with them if they leave? A: The business owns the policy — if the key person leaves, the company can continue the policy (naming a new key person as the insured, if possible) or surrender it for cash value (permanent policy) or let it lapse (term). The employee has no claim to a policy they did not own. Some companies offer "portability" — an arrangement where the departing employee can purchase the policy from the company — but this requires negotiation and the employee would pay full premiums going forward.

Q: Does the key person have to consent to the insurance? A: Yes — the insured employee must consent to and sign the application for key person insurance. The IRS requires written consent for corporate-owned life insurance (COLI). This protects employees from unknowing insured status and ensures the insurable interest rules are met.

Q: Is key person insurance required by lenders? A: Many SBA loans and commercial lenders require key person life insurance as a loan condition — particularly when the loan was approved primarily based on the skills and relationships of a specific individual. The business assigns a portion of the policy's death benefit to the lender as additional collateral. If the key person dies, the lender is repaid from the insurance proceeds before the business receives the remaining benefit.