How Does Key Person Insurance Work?

Have you heard of taking out life insurance on a key employee or partner, or on yourself as the proprietor of your business? The continued successful operation of your company may depend on it. If you have key people whom you see as crucial to your firm — workers whose absence would sink the company — you may want to consider taking out key person insurance on them.

Here's how it works: You purchase a life insurance policy on a key employee and pay the premiums. Your company is the beneficiary. If that employee dies, your firm will receive the insurance payoff. 

What about the disability of a key executive? Key person disability insurance offers benefits payable monthly or as a lump sum after a specified waiting period — 30 or 60 days for monthly payments and 12 or 18 months for a lump-sum payment.

You should consider purchasing key person coverage if your business:

• Is highly dependent on one or more individuals who have special skills and who would be difficult to replace.
• Relies on a key individual for a major portion of its revenues.
• Has a debt that would be difficult to pay without that key person.
• Plans to seek a loan or investors: You could be refused unless you have key person coverage in place.
• Plans to merge or go public. You may find that to proceed, you'd need key person coverage for top executives.

You can use the proceeds from the insurance for expenses until you find a replacement and train him or her. You could use the money to pay off debts, or you may want to distribute the funds to investors. Other uses may be to pay severance to employees and close the business in an orderly fashion. In a tragic situation, key person insurance gives the company options so you don't have to face bankruptcy.

Do you feel that there's an employee whom you consider irreplaceable in the short term? This person — maybe a partner — keeps the books, manages the employees and handles key clients. If that person is gone, the business pretty much stops.

What factors should you consider?

• Shop around and get rates from several different agents.
• Term insurance may be a better bargain for key person needs than a whole or variable life policy. 
• Permanent key person insurance is an asset that can be used as collateral for a loan. Also, it can be transferred to the insured at the worker's retirement or if the firm no longer needs the coverage.
• Think of how much money your business would need to survive until you'd be able to replace that key person and get up to speed.
• You should shop for policies that fit into your budget and are aligned with your cash needs in the event of death.

Your firm may have more than one key person — maybe all five executive officers are essential to the company's success. To save money, your firm could purchase a key person life insurance policy that includes a first-to-die provision. The policy will pay a death benefit to the company if any officer dies and then continue to cover the remaining officers. 
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The point is, for the health of your company, and your estate plan, you should consider key person insurance.