Key Person Insurance
Key person insurance is a life or disability insurance policy purchased by a business on the life or earning capacity of an employee whose skills, relationships, or expertise are critical to the company's operations, with the business named as the policy beneficiary.
Many businesses depend heavily on specific individuals — a founder, a top sales producer, a chief scientist, or a master craftsperson — whose loss would materially disrupt operations, revenue, or the company's ability to service its debt. Key person insurance (also called key man insurance) is the mechanism businesses use to hedge that risk.
The mechanics are straightforward: the company applies for and owns the policy, pays the premiums, and receives the death benefit or disability proceeds if the covered individual dies or becomes disabled. The insured individual is the employee whose loss is being protected against. The insured's consent is generally required, and in many states the business must have an insurable interest in the employee, which is typically established by demonstrating that the employee's loss would cause a quantifiable financial harm to the company.
The death benefit received by the business is generally income-tax-free under federal law. However, businesses that own life insurance policies on employees may be subject to alternative minimum tax treatment for life insurance proceeds under certain circumstances, and premiums paid for key person life insurance are generally not deductible by the business.
Lenders, particularly those providing Small Business Administration loans or commercial credit facilities, frequently require key person insurance as a condition of financing. The lender may require the business to assign a portion of the death benefit to the lender as collateral.
Key person insurance can be structured as term life, whole life, or universal life, depending on the business's budget, the anticipated duration of the key person's indispensability, and whether the policy is also intended to fund a buy-sell agreement or provide long-term cash value accumulation.