What is Key Person Insurance?

If your business would lose significant revenues due to the loss of a particular employee, that individual is likely a key person (or a “key man”) for your business.

You can also identify whether an employee is a key person by considering the cost of finding a replacement. If your business would need to hire a headhunting company to find a replacement, the individual in question is likely a “key person.”

The key person (or key man) might be the Marketing Director, the CEO, the President, or any other employee responsible for a large part of your company’s revenue or who cannot be easily replaced.

What is your current income?

Your current income is crucial in determining your retirement goals and key person insurance needs. Consider your annual salary, bonuses, and any other sources of income. This will help you understand how much you need to save for retirement and how much key person insurance coverage you require.

Additionally, consider the following factors when assessing your finances:

• Expenses: What are your monthly expenses, including housing, food, transportation, and entertainment?
• Debt: Do you have any outstanding debts, such as mortgages, car loans, or credit card debt?
• Savings: How much have you saved for retirement, and what are your savings goals?
• Investments: Do you have any investments, such as stocks, bonds, or real estate?

By understanding your finances and retirement goals, you can make informed decisions about your key person insurance needs and create a comprehensive plan for your future.

How Key Person Life Insurance works

Key person insurance works the same way as any other life insurance policy. The contract involves three key parties:

• the insured (the person whose life is covered by the insurance policy)
• the policy owner (the person or entity that pays the premiums and has the right to make changes to the insurance policy)
• the beneficiary (the person or entity that receives the death benefit).

The key person insurance premiums are typically paid by the business to protect against the financial impact of losing a key employee, and while these premiums are not tax-deductible, the death benefit is generally tax-free.

The term "key employee" refers to an individual whose expertise, knowledge, or connections are crucial to a company's success. This employee is often indispensable due to their specialized skills, experience, or business network, which significantly contribute to the company's revenue or operations. In the event of their departure, the business could face notable disruptions and financial setbacks.

Additionally, a key employee may be anyone who has an impact on the organization that is difficult or costly to replace. This could include roles such as senior executives, top salespeople, or individuals whose personal brand is tightly linked to the company's reputation. For such critical roles, companies often consider key person insurance to safeguard against the financial risks associated with losing a key employee.

With key employee insurance, typically, the business is the policy owner and the beneficiary. The premiums of this insurance are generally not tax deductible, but the death benefit is tax-free. The beneficiary is free to use the payout however they like.

Types of key person insurance

Three types of key person insurance are available. These are:

Key person life insurance

Life insurance provides a death benefit upon the person’s death. When you shop for key person life insurance, you will have the following options:

• Term life key person insurance

A permanent life insurance policy is a viable option for businesses that need long-term coverage beyond a specified period, offering benefits that term policies do not.

Term life policies are cheaper than other types of life insurance plans. A term life key person insurance policy has a predefined expiration date, which can be as short as one year or as long as 35 years. Depending on your policy, you may be able to renew it until the insured reaches a certain age. If you do not renew the coverage, the insurance policy will lapse. The insurer only benefits your business if the insured passes away during the policy term.

• Whole life key person insurance

Whole life insurance provides lifelong protection, provided you have your premiums paid. In addition, it bundles as an investment tool. A part of each premium payment goes into an investment account, which grows tax-deferred at a fixed rate. The insurance policy owner can withdraw the money from this account at any time by taking out a policy loan.

Upon the insured’s death, the insurer typically pays the beneficiary (in the case of key person insurance is usually the business owner) only the death benefit amount. Any unspent cash value stays with the insurance company.

• Variable life key person insurance

Similar to whole life insurance, variable life insurance offers lifelong protection and accumulates cash value. Unlike whole life insurance, variable life insurance may allow you to change the premium and the death benefit amount over time. In addition, the cash value is tied to sub-accounts selected by you and grows at a variable rate. If the sub-accounts you choose perform well, you can receive handsome returns. However, your cash value can also get wiped out if the market underperforms. 

Key person disability insurance

You can purchase a key person disability insurance policy, also known as key employee insurance. For the disability insurance, life insurance companies will pay a monthly benefit if the insured is unable to work due to illness or injury.

Critical illness key person insurance

Key person critical illness insurance helps you protect your business against the financial loss it will likely suffer if the insured develops a critical illness. The insurance carrier will pay a lump sum if the insured is diagnosed with a covered health condition.

Benefits of Key Person Insurance

Key person insurance can help your business:  

• offset lost income due to the death of a key employee
• cover the cost of finding and training a replacement
• buy out the shares of the deceased  
• provide financial assistance to the deceased's family.

Key Person Insurance Cost

How much you will pay for key person insurance depends on several things. These factors include:

• The type of coverage

Life insurance policies are either term or permanent. Term life insurance is cheaper and lasts for a specific duration. Generally, you can buy a policy for a term of up to 35 years and renew the policy up to a predetermined age. Term life insurance is 10 to 15 times more affordable than permanent life insurance.

Permanent life insurance does not have an expiry date. The coverage remains in force as long as you pay the premiums. Your policy also includes an investment component called cash value. The cash value earns interest or capital gains and grows tax-deferred. You can tap into it whenever you want by withdrawing money or taking a business loan against it.

While key person insurance is crucial for protecting the business, personal life insurance offers additional benefits for individuals, especially those who run their business independently and may not require key person coverage.

• ‍The amount of coverage

The greater the death benefit amount, the costlier the coverage, all other things being equal.

• ‍Age

The younger the insured, the lower the premium. That is because the cost of insurance increases with age.

• ‍Health

How much you pay for coverage depends on the insured’s life expectancy. The longer the insured is expected to live, the lower the premium rate.

Most life insurance policies involve medical underwriting. The insured provides information about their current health and medical history as part of the application process. They will likely undergo a medical examination similar to an annual physical. The insurance carrier will assign the insured a risk class based on their test results, determining the premium rate.

• ‍Smoking status

People who smoke or use tobacco in any form have a lower life expectancy than those who do not smoke. As such, they receive higher life insurance rates. On average, smoking can increase the insurance cost by three to five times.

Conclusion

Key person insurance is designed for businesses that are dependent on the expertise of one or a few key people/employees. By taking out a life insurance policy on a key employee; a business can ensure that it does not lose its financial footing, should that key person pass away.

The business is the policy owner and beneficiary with key man insurance. Upon the insured’s death, the business receives the proceeds of the policy, which it is free to spend as it deems fit.

Considering if key person insurance is right for you? Talk to a Dundas Life licensed insurance advisor today.

Frequently Asked Questions (FAQs)

What kind of employee would be a key person?

A key person is a key woman or a man who is an employee or a business partner whose skills and intellectual capital are so valuable that your business would suffer substantial financial losses due to that person's death or inability to work. This person has knowledge, skills, or talent that few others can duplicate. The industry he or she works in, or the nature of the work, maybe so specialized (such as research or design) that there are few others with the skills needed.

In addition, the unique skills held by a key person may not have been acquired through education or experience but through their own creativity, talents, and interests.

Is key person insurance so important?

Key person insurance can provide your business with the working capital it needs to keep operating. You can use life insurance proceeds to fund the recruitment and training of a replacement should a key person pass away or become totally disabled. In this case, the insurance could compensate you for a key person's contribution (or your other business owners) for lost income should your business have to close.

How long does key person insurance cover you for?

This depends on the type of life insurance plan you choose for the policy. For example, term life insurance can provide coverage for 10 or 20 years at a time. However, a permanent life insurance plan like universal life insurance could provide protection for the entire lifetime of the insured person.

How long does key person disability insurance provide coverage?

The plan offers coverage until:

• The insured person reaches the specified age stated in the contract or
• The date the insured ends active full-time employment for any reason other than total disability or
• The date the maximum benefit period has been met for any one period of total disability or
• The date benefits become payable under the replacement expense benefit provision to receive disability insurance coverage.

What is the definition of “total disability”?

Under the key person disability insurance plan, "total disability" means that because of injury or sickness, the insured person is under a physician's regular and personal care. They cannot perform the important duties of their regular occupation.