What is key person insurance?

When it comes to your business, there are some people that feel irreplaceable—they keep the engine running. They understand your business and what it takes to be successful. Those people that are vital to your business are called “key persons.” Maybe it’s your CEO, a founder, or the lead of your most profitable team. Maybe it’s even you! 

But what if something happens to one of your business’s key people? On top of the emotional turmoil of loss, your business now needs to find a replacement for someone who was invaluable. They were integral to your business’s success. Recruiting and hiring a replacement takes time and money, and those important relationships the key person had with clients and other stakeholders have been altered. Without key person insurance, potential revenue loss and hiring costs can perhaps be detrimental to the viability of the business.

What is key person insurance?

Key person insurance is an insurance policy that a business can take out on an employee who is considered essential for the successful ongoing operations of the business (known as a key person). In the event of the death, critical illness, or disability of a key person, the business is paid a tax-free benefit. Key person insurance can be used to protect against a variety of monetary losses that can occur when an important employee or owner passes away. This benefit can help the company recoup some losses or reduce expenses or cover the cost of the job search to replace the key person. It may also be used to supplement some of the lost revenue caused by the major disruption of the loss of a key person. 

Who is considered a key person?

A key person is someone considered as an invaluable resource to the business because they ensure your business continues to operate. They would be hard to replace due to their recognition, specific skills, connections, or resources. If the success of your business is tied directly to a specific person, you have a key person. Your business might even have more than one key person. A key person could be a CEO, but they could also be a lead designer or a top salesperson. In order to be recognized as a key person by an insurance provider, you will have to submit substantiated proof that the person you want to insure is vital to your business.

The following are some examples where an individual may be viewed as a key person:

• The company’s brand awareness and business performance are tied to a particular employee’s name or reputation
• The company’s execution of its strategic projects, current or ongoing, are reliant on utilizing the employee’s unique skills
• The loss of the employee could trigger a reduction in revenue
• The replacement of the employee could lead to significant operating expenses
• The loss of the employee would affect the company’s access to credit and loans
• The absence of the employee can cause creditors to seek repayment of loans

How does key person life insurance work?

Businesses can own and purchase insurance on the lives of their key employees that are considered vital to the business. If one of these key persons passes away, the business receives a tax-free payment. The proceeds can then be used to meet expenses, repay debts, or hire replacements. The money can also be used as a reserve against the drop in revenue that may occur while the company goes through a period of transition. Additionally, the money can be used to pay the costs of replacing the lost skills. The death benefit gets added to the capital dividend account from where it can be paid tax-free to the owners in the future, if the insurance is no longer required. 

What does key person insurance cover?

Key person insurance provides financial coverage in the case of unexpected death, illness, or disability of a key person that results in that key person being unable to work. The policy can be used to cover loss of profit or any debts incurred due to the loss of a key person. It can also be designed to cover the cost of hiring and training a replacement. According to The Society for Human Resource Management it can cost between 90% and 200% of an employee’s annual salary to find a replacement. So, having a policy that alleviates some of that cost is a huge benefit to businesses. 

Key person insurance can also be used to:

• Cover the reduced profit from any lost revenue
• Cover recruiting costs to find a replacement employee
• Pay off any business loans that may be outstanding or tied to the key person’s continue involvement
• Provide capital to buy the departing employee’s share of the business
• Provide benefit to the family of the key employee
• To attract and reward key employees
• Allow active shareholders and partners to buy out and monetize the shares of the key person

What does key person insurance exclude?

There is usually a contestability period during the first two years of any life insurance policy. This means if a claim is made on the policy during the first two years, the insurance company conducts an investigation to ensure that no fraudulent claims were made and that no information was deliberately withheld. During these first two years, suicide is also not covered by key person insurance. 

Read more about how suicide affects life insurance coverage. 

How much key man life insurance is required?

To determine the value of death benefit for key man insurance, you will have to calculate how much this person is worth to the business. This is usually done using their income or salary and multiplying that number by 5-10x. However, there are also other methods to determine this value such as calculating replacement cost (how much it would take to rehire and retrain a replacement)  and contributions earnings (how much money this key employee brings into the company).  

Cost of key person insurance

The cost of key person insurance can vary depending on a few factors. These factors include the type of policy and coverage that you choose; the benefit amount; the gender, age, and health of the key person; the size and structure of the business; and the industry your business operates in. It’s also important to note that if your key person leaves your business, you can end the policy with no downside risk. The cost will be different for every business, so it is best to contact one of our advisors to determine the price of a policy for your business. 

Types of key person insurance

There are a few types of key person insurance—life insurance, disability insurance, and critical illness insurance. While your business needs may vary from other businesses, it’s important to talk to one of our advisors to figure out the type(s) of insurance that will leave you and your business feeling the most comfortable. Also note that there are two main types of life insurance, term and whole. These types also apply to key person life insurance.

Term life insurance

Term life insurance is the most affordable and most popular type of key person insurance. As the name suggests, the policy only lasts for a certain term or period of time. Your business pays monthly or yearly premiums on the policy. For the duration of the policy, whether that be five years or thirty-five years, your business is covered if something happens to your insured key person. When the policy expires, you can renew it or obtain a new term policy. This type of policy is appropriate if your key person is an employee who can leave to join a different employer or competitor. This policy can also be cancelled at a relatively lower cost, should the key person leave the business. 

Whole life insurance

Whole life insurance is a type of permanent life insurance that does not have an expiry date. Whole life insurance can be significantly more expensive than term insurance. However, it has the added benefit of dividend accumulation that can allow it to grow in value alongside the growth in the business contributed by the key person. Whole life insurance is ideal for key people that you anticipate will be with your company longer than a typical term policy. A whole life policy can be cancelled and its cash value can be retained by the business, should the key employee leave the company. It can also be used to retain key persons by transferring the ownership of the policy to the employee in the future.

Disability insurance

Separate from your key person life insurance policy, you can also add disability insurance coverage. The company can own the disability insurance on a key person. This policy will pay a tax-free benefit to a business if the key person is injured or disabled and unable to work, which happens more often than you think. In fact, 33% of workers between 30-64 years old will experience a disability greater than 90 days in their career. With that stat in mind, key person disability coverage is a good idea to secure your business’s future success.

Critical illness insurance

Similar to disability insurance, you can also purchase key person critical illness insurance. Critical illness insurance provides a benefit payment if your key person is diagnosed with or experiences a critical illness such as cancer, stroke, or heart attack. As critical illnesses such as cancer become more prevalent, occurring in one in two people, key person critical illness insurance is also a great addition to your policy.

As always, we recommend speaking with one of our advisors to determine which type or types of key person insurance is best for your business and key people.

Is key person insurance tax-deductible?

The premiums paid for the purpose of key person life insurance are not tax-deductible by the business as an expense. However the life insurance proceeds received from the payout are tax-exempt. These proceeds can also be paid out as tax-free dividends to the owners, once the business has recovered. Additionally, the corporation can transfer the ownership of the life insurance policy to the key person so their own beneficiaries can benefit from the estate. However in such cases, depending on the type of the policy, it may be seen as a disposition and create a taxable event for the employee.

Disability insurance proceeds may also be tax-free depending on how the premiums were paid (either before or after-tax). Premiums for the business-owned key person disability insurance are a non-deductible expenditure by the corporation. Any proceeds received and any return of premium benefits are non-taxable to the corporation.

The premium for a business-owned critical illness insurance is similarly non-deductible as an expense by the corporation. The insurance proceeds and any return of premium benefits are however non-taxable to the corporation. 

If the corporation pays the cash proceeds of the critical illness or disability benefit to the employee or shareholder, depending upon the purpose of the payment, the amount may be included in the income of the employee or shareholder and become taxable.

Learn more

Business-owned insurance products can vary depending on the needs of your business. An independent broker like PolicyAdvisor can help you sort through your options, find you a quote, and advise if your insurance needs are growing beyond that of a personal broker. We can also collaborate with tax lawyers to ensure that your business will be passed down in a tax-efficient manner. Reach out to our experienced advisors below and they can get you started down the right path for covering yourself and the business you’ve built.