Key Person Insurance for Businesses

Key person insurance protects a business against the financial consequences of losing an essential employee, owner, or executive. When someone critical to operations dies or becomes disabled, the business may face lost revenue, recruitment costs, disrupted relationships, and weakened credit. Key person coverage provides funds to help the business survive this transition period.

Who Qualifies as a Key Person?

A key person is anyone whose absence would materially harm the business. This typically includes:

• Founders and owners whose vision drives the company
• Executives responsible for major client relationships
• Salespeople who generate disproportionate revenue
• Technical experts with specialized knowledge
• Individuals whose departure would trigger loan covenants or investor concerns

Not every senior employee is a key person. The test is whether their loss would create significant, measurable financial harm that insurance proceeds could mitigate.

Calculating Coverage Amounts

There is no single formula for key person coverage. Businesses use several approaches depending on their circumstances:

Multiple of compensation: Coverage equals 5 to 10 times the key person's annual compensation. A CEO earning $400,000 might be insured for $2 million to $4 million.

Percentage of revenue impact: Estimate how much revenue the key person directly influences, then cover 2-5 years of that impact. A sales director responsible for $3 million in annual revenue might warrant $6 million to $15 million in coverage.

Replacement cost method: Calculate the cost to recruit, hire, and train a replacement, plus productivity losses during the transition. Executive search fees alone can reach 25-35% of first-year compensation.

Contribution to profits: Estimate the key person's contribution to annual profits and multiply by the expected recovery period.

Lender or investor requirements: Banks and investors sometimes specify minimum coverage as a condition of financing.

Premium ranges for key person term insurance:

Premiums vary based on health, tobacco use, occupation, and insurer. These ranges assume standard health ratings.

Policy Types: Term vs. Permanent

Term insurance is the most common choice for key person coverage. It provides protection for a specific period (10, 15, 20, or 30 years) at relatively low cost. When the term ends, coverage expires unless renewed at higher rates.

Term insurance works well when:

• The key person's importance may diminish over time
• The business plans to develop succession or reduce dependence
• Budget constraints favor lower premiums
• Coverage needs are temporary (e.g., until a loan is repaid)

Permanent insurance (whole life or universal life) provides lifetime coverage and builds cash value. Premiums are substantially higher than term.

Permanent insurance may be appropriate when:

• The key person will remain essential indefinitely
• The business wants to accumulate cash value as a corporate asset
• Coverage is needed for buy-sell funding or estate planning purposes
• The business has strong cash flow and values the forced savings aspect

Premium comparison for $2 million coverage, age 45, standard health:

• 20-year term: $1,400-$2,000/year
• Whole life: $25,000-$35,000/year

The significant cost difference means most businesses choose term for pure key person protection.

Tax Treatment

Key person insurance has specific tax rules that differ from personal life insurance:

Premiums are not deductible: The business cannot deduct key person insurance premiums as a business expense. This applies whether the policy is term or permanent.

Death benefits are generally tax-free: When the key person dies, the business receives the death benefit free of federal income tax. This is the same treatment as personal life insurance.

Cash value growth: In permanent policies, cash value grows tax-deferred. If the business surrenders the policy, gains above the premium basis are taxable as ordinary income.

Corporate AMT considerations: For C corporations, life insurance proceeds may affect the corporate alternative minimum tax calculation. Consult a tax advisor for specific situations.

Transfer for value rule: If a key person policy is sold or transferred for valuable consideration, the death benefit may become partially taxable. Exceptions exist for transfers to the insured, a partner of the insured, or a corporation where the insured is an officer or shareholder.

Ownership Structures

Company-owned policies are the standard arrangement. The business applies for coverage, pays premiums, owns the policy, and receives the death benefit. This structure is straightforward and appropriate when the proceeds will fund business operations.

Trust-owned policies may be used in more complex situations. A trust owns the policy and distributes proceeds according to trust terms. This might be appropriate when:

• Multiple stakeholders have claims on proceeds
• The business wants to protect proceeds from creditors
• Coordination with buy-sell agreements requires specific distribution

Split-dollar arrangements involve shared ownership between the business and the key person (or their family). The business and individual split premium costs and death benefits according to a written agreement. These arrangements have complex tax rules and require careful structuring.

Worked Example: Tech Startup Insuring Founder for $3M

The Situation: DataFlow Analytics is a 4-year-old software company with $2.8 million in annual revenue. The company has 18 employees and recently closed a $5 million Series A funding round. Founder and CEO Sarah Chen, age 38, is responsible for product vision, key client relationships, and investor relations. Two other co-founders handle engineering and sales.

Coverage Calculation:

Multiple of compensation method: Sarah's total compensation is $280,000. At 10x compensation, coverage would be $2.8 million.

Revenue impact method: Sarah directly manages relationships generating approximately $1.2 million in annual revenue. Additionally, her departure would likely trigger investor concerns and complicate future fundraising. The board estimates 2-3 years of disruption. Coverage range: $2.4 million to $6 million.

Investor requirement: The Series A term sheet requires $2 million minimum key person coverage on the CEO.

Decision: DataFlow purchases $3 million in coverage—meeting investor requirements while providing meaningful protection without excessive premium cost.

Policy Selection:

DataFlow selects the 20-year term policy. While the 10-year term is cheaper, the company expects Sarah to remain essential well beyond 10 years. The 20-year term provides stable premiums through the company's expected growth phase. Whole life is rejected as too expensive for a company still reaching profitability.

Policy Structure:

• Owner: DataFlow Analytics, Inc.
• Insured: Sarah Chen
• Beneficiary: DataFlow Analytics, Inc.
• Premium payment: Annual, from operating funds

Use of Proceeds if Claim Occurs:

The $3 million death benefit would be allocated to:

• Executive search and recruitment: $200,000-$400,000
• Interim management costs: $300,000-$500,000
• Client retention efforts: $200,000
• Working capital during transition: $500,000-$1,000,000
• Reserve for revenue decline: $1,000,000+

Documentation: DataFlow's board passes a resolution authorizing the key person policy, documenting the business purpose. This creates a record supporting the legitimate business need if ever questioned.

Common Mistakes to Avoid

Underinsuring: Businesses often purchase less coverage than needed to save on premiums. A $500,000 policy provides minimal protection if the key person's loss would cost $3 million in disruption.

Failing to update coverage: As compensation increases and the person becomes more valuable, coverage should increase. Review annually.

Insuring the wrong people: Coverage should focus on those whose loss creates financial harm, not simply those with impressive titles.

Ignoring disability: Death is not the only risk. Key person disability coverage protects against incapacity, which may be more likely than death for working-age individuals.

No documentation: Without board resolutions and written policies documenting business purpose, the arrangement may face challenges from auditors or tax authorities.

Key Person Insurance Checklist

Identifying Key Persons

• List individuals whose absence would materially harm the business
• Quantify each person's contribution to revenue, profits, or operations
• Identify anyone required to be insured by lenders or investors
• Consider both death and disability risks

Calculating Coverage

• Apply multiple of compensation method (5-10x)
• Estimate revenue or profit impact over recovery period
• Calculate replacement and transition costs
• Verify coverage meets any lender or investor requirements
• Document the calculation methodology

Policy Selection

• Obtain term quotes for 10, 15, and 20-year periods
• Consider permanent insurance only if long-term need is certain
• Compare quotes from at least 3 insurers
• Verify insurer financial strength ratings (A.M. Best A- or better)
• Review policy exclusions and contestability provisions

Structure and Documentation

• Establish company ownership of policy
• Name company as beneficiary
• Pass board resolution authorizing coverage and stating business purpose
• Create written plan for use of proceeds
• Store policy documents securely with other corporate records

Ongoing Management

• Review coverage annually against current compensation and value
• Increase coverage as the business grows
• Track premium due dates to prevent lapse
• Update beneficiary if corporate structure changes
• Consider additional coverage for newly essential employees
• Notify insurer of any change in insured's duties or health status