Key Person Life Insurance for Business Owners and Executives

Key person life insurance is a policy a business owns on an individual whose death would cause the company a financial loss. The business applies for it, pays for it and is named as the beneficiary, so the proceeds arrive as company money that can be used to absorb the disruption. It is often called key man insurance, which is the older term for the same general arrangement.

4J Insurance Brokerage is an independent commercial and employee benefits brokerage in Frisco, Texas. Key person coverage is one of three exposures in our business life insurance practice. This page covers what the coverage does, how it is structured, how the amount is reasoned out, and the consent and tax requirements that have to be handled before a contract is issued rather than after.

What is key person life insurance?

Key person life insurance is life insurance owned by a business on an owner, partner or employee whose contribution is difficult to replace. The company is the policy owner, the premium payer and the beneficiary. If the insured dies, the death benefit is paid to the business, which can apply it to lost revenue, recruiting costs, loan obligations or whatever the disruption creates.

Some businesses carry concentration risk in a person the same way others carry it in a customer or a single facility. A firm where one principal holds the technical licences, or one salesperson controls most of the pipeline, or one founder is the reason the bank extended the line, has an exposure that appears nowhere on the balance sheet. Key person coverage converts part of it into a funded, contractual outcome.

"Key man insurance" and "key person insurance" are the same idea

Key man insurance is the traditional industry and search term. Key person life insurance is the modern and more accurate description, since the individual is frequently neither a man nor an owner. Carriers, applications and older policy forms may still use the key man wording. If you have been quoted key man insurance and are reading about key person insurance, you are looking at the same coverage.

Who qualifies as a key person?

Insurable interest is the starting point. A business generally has to show it would suffer a genuine economic loss if the individual died. The people who meet that test fall into recognisable groups.

• Owners and partners whose personal involvement drives the operation rather than merely governing it.
• Executives whose judgment, licences or approvals the business cannot operate without.
• Producers who hold the relationships behind a disproportionate share of revenue.
• Technical specialists whose knowledge is undocumented and slow to rebuild, which is common in manufacturing, engineering and specialty trades.
• Named individuals in a loan or bond arrangement, where a lender or surety has conditioned terms on that person's continued involvement.

A practical test: if this person died tonight, would revenue, borrowing capacity or the ability to deliver contracts change materially within ninety days? If yes, that is a key person. If the work would simply be redistributed and absorbed, it probably is not.

Who owns the policy and who receives the death benefit?

In a standard key person arrangement the business occupies three of the four roles.

That last row is the point most often misunderstood. A key person policy is not a benefit for the insured's household. If the individual also needs personal coverage, that is a separate policy with separate ownership. One contract asked to serve both purposes usually serves neither well.

How the proceeds are typically used

Nothing inside the policy dictates how a business spends the death benefit. In practice it tends to go to the same short list.

• Replacing lost gross profit while revenue recovers.
• Recruiting and onboarding a replacement, including search fees, a premium above market to attract the right candidate, and the period before that person is productive.
• Reassuring lenders, sureties and major customers that the business is capitalised through the transition.
• Retiring or servicing debt the key person's activity was supporting.
• Funding a purchase of the deceased owner's interest, although that is better handled through a funded buy-sell agreement than by informal intention.

How much coverage a business might consider

There is no formula that a carrier will simply accept. Underwriters generally expect a business to justify the amount with a rationale they can follow. Four approaches are commonly used, often in combination.

Where a lender requires coverage as a condition of financing, that requirement often decides the amount before the other methods are reached.

What influences cost

Premium is driven mainly by the insured rather than by the business. Age and health are the largest factors, followed by the amount and duration of coverage and the type of policy. Term coverage for a defined period is generally the least expensive way to cover a defined exposure, which is why it is common where the need has an identifiable horizon such as a loan term. Permanent coverage costs more and is usually considered where the need is expected to outlast any fixed period. Tobacco use, occupation and travel can affect the offer, and larger amounts trigger fuller underwriting and financial justification.

Is medical underwriting involved?

Usually yes. Key person coverage is individually underwritten, which typically means a health questionnaire and, depending on age and amount, an examination, laboratory work and access to medical records. Financial underwriting runs alongside it, since the carrier will want the amount supported by the stated rationale. Consent is not optional: the insured signs the application and, for an employer-owned contract, must receive notice and give written consent before the policy is issued.

How it differs from personal life insurance and from group life

Group life is an employee benefits decision, not an owner protection decision. See dental, vision, life and disability benefits.

Can it be used on an owner?

Yes, and owners are among the most common insureds. Separate the two jobs coverage on an owner can be asked to do. Key person coverage compensates the business for the disruption of losing that person. Buy-sell funding gives the surviving owners or the entity cash to purchase the deceased owner's interest. A business with more than one owner frequently needs both, usually as separate arrangements with different ownership and beneficiary designations. See life insurance to fund a buy-sell agreement.

What happens if the key person leaves?

The business continues to own the policy. It can keep it in force where it still has a reason to hold the contract, stop paying and let it lapse or surrender it for any accrued cash value, or transfer it to the departing individual. That last option carries tax consequences worth reviewing first, because transferring a policy for value can affect how the death benefit is treated under Internal Revenue Code section 101(a)(2).

Employer-owned contracts add a further point: the section 101(j) exceptions turn partly on the insured's status relative to the time of death, so a policy retained long after someone has left does not necessarily behave the way it would have while they were employed. That is a conversation for the point of departure, not years later.

Is key person life insurance tax deductible?

Premiums are generally not deductible where the business is directly or indirectly a beneficiary. Internal Revenue Code section 264(a)(1) denies a deduction for premiums paid on any life insurance policy covering an officer, employee, or any person financially interested in the taxpayer's trade or business, when the taxpayer is directly or indirectly a beneficiary under the policy. In a standard key person arrangement the business is the beneficiary, so that provision is squarely in play.

Death benefits are addressed separately. Section 101(a) provides the general rule that amounts received under a life insurance contract by reason of the insured's death are excluded from gross income. For employer-owned life insurance contracts, section 101(j) limits that exclusion unless the notice and consent requirements were met before the contract was issued and an applicable exception is satisfied, with annual reporting on IRS Form 8925, Report of Employer-Owned Life Insurance Contracts. Statutory text is available at 26 U.S.C. 101 and 26 U.S.C. 264.

Tax treatment depends on the policy structure, ownership, beneficiary designation and applicable law, and business owners should coordinate with qualified tax and legal advisers before relying on any particular outcome. What a broker can do is make sure the notice and consent step happens at the right point, because it cannot be repaired retroactively.

Key person life insurance FAQ

What is key man insurance?

Key man insurance is the traditional term for key person life insurance: a policy a business owns on an individual whose death would cause the company a financial loss, with the business as owner, payer and beneficiary. The terminology has largely shifted to key person, but the arrangement being described is the same.

How much does key person insurance cost?

Cost is driven mainly by the insured's age and health, then by the coverage amount, the coverage period and the policy type. Term coverage for a defined period is generally the least expensive structure for a defined exposure. Because pricing is individually underwritten, a meaningful figure requires an actual quote rather than an average.

Who owns a key person life insurance policy?

The business. It applies for the policy, holds the contract rights including the right to name and change the beneficiary, and pays the premium. The insured must consent, and for an employer-owned contract that consent has to be obtained before the policy is issued.

Who receives the death benefit?

The business, as named beneficiary. The proceeds are company funds and the insured's family has no claim on them under the policy. Personal protection for the insured's household is a separate policy with separate ownership.

What happens to key person insurance if the employee leaves?

The business still owns it and can keep it, surrender it or transfer it to the individual. Each option carries different consequences, and a transfer for value can change how the death benefit is treated, so it is worth reviewing with a tax adviser at the time of departure.

Does a business need the employee's permission?

Yes. The insured signs the application, and where the contract is an employer-owned life insurance contract, section 101(j) requires that the insured be notified and give written consent before the contract is issued. That step is not something that can be completed afterwards.