Key person insurance is life insurance and/ or illness insurance on a key employee of a business. A key person is a business partner/owner or employee whose skills and expertise are extremely valued such that the business would suffer substantial financial losses should that person fall sick to an illness or die.
Key person insurance is life insurance and/ or illness insurance on a key employee of a business.
Key person insurance is a risk management strategy, called risk transferring, that deliberately passes on risk to another party.
It is especially important for small businesses, as the loss of a key person could result in the death of the business.
How It Works
The loss of a key person (caused by death or a severe illness) in a business is detrimental – business operations are interrupted, and sales are typically negatively impacted (for example, clients may take their business elsewhere). Furthermore, investors and creditors of the business may be concerned and force the business into liquidity. At an extreme, the business may face a going concern issue.
To lessen the adverse business impact caused by the loss of a key person, key person insurance can be purchased by a business. The business acts as the beneficiary of the policy and pays the required insurance premiums.
If the key person dies or develops an illness, rendering them unable to satisfy their work commitments, the company is entitled to the insurance payout (which is non-taxable). The insurance payout can be used to offset financial losses.
Key Person Insurance as a Risk Management Strategy
Key person insurance is a risk management strategy, called risk transferring, that deliberately passes on risk to another party (the insurance company). If a key person dies or contracts a severe illness under key person insurance, it can provide a business with working capital required to:
Maintain business operations and offset financial losses; and
Fund the recruitment or training of a replacement.
Key person insurance is especially important for small businesses, as the loss of a key person could result in the death of the business. According to a survey of small businesses conducted by the National Association of Insurance Commissioners, 71% of small businesses surveyed indicated that they were very dependent on one or two key people for their success, but only 22% of the respondents took out key person insurance.
Example of Key Person Insurance
Question: Tim is the owner of an electric car manufacturing company that recently witnessed tremendous growth due to Colin, the general manager. Colin keeps deep relationships with suppliers and clients. If the company loses Colin, the company will suffer a significant financial loss from the loss of clients and incur costs associated with finding a new general manager. As an advisor, what could Tim do to mitigate the potential financial loss?
Answer: Tim should consider purchasing key person insurance for Colin, as it would insure against financial losses should Colin die or contract an illness that would render him unable to work. With that said, it is important to note that if Colin leaves the company, or retires, the company would not be entitled to an insurance payout.
Key Considerations for Key Person Insurance
When deciding to purchase key person insurance, two key considerations are the amount of insurance desired, and the key persons’ commitment to the company.
Amount of Insurance to Purchase
The amount of insurance to purchase should reflect the dollar value financial impact from the loss of that individual. Insurance companies may provide a formula to calculate the dollar value.
Alternatively, a company can retain a financial advisor to calculate the dollar value. When determining the amount of insurance to purchase, it is recommended to, at a baseline, consider (1) the potential amount of lost profits and (2) the cost to find and train a replacement.
The Key Person’s Commitment to the Company
It is important to assess whether the key person is committed to the company. Key person insurance is more valuable if the key person stays with the company over the long term. In modern society, key person insurance has been decreasing in popularity due to the increasing frequency that executives and top talents are switching companies for a better work environment and/or compensation package.