Key Person Insurance: What It Is & How It Works

What Is Key Person Insurance

Key person insurance is a life insurance policy taken out by a business to protect itself from the financial impact of the death or disability of a crucial member of the company. This key person could be any employee whose knowledge, work, or contribution is uniquely valuable to the company. The purpose of the insurance is to compensate the business for the potential financial losses that could occur if the key person is suddenly unable to work.

Also known as key man insurance, this coverage does not extend to minor or short-term illnesses or injuries – just events that could jeopardize the company’s future. It acts as a safety net for the company if the person insured cannot perform their duties over a long time or permanently. The policy helps ensure the company’s revenue isn’t impacted in such adverse circumstances.

How Key Person Insurance Works

Key person insurance operates similarly to a normal life insurance policy, but the business is the beneficiary. The process starts with a company taking out a policy with the key person listed as the insured party. A coverage amount is usually determined by estimating the financial loss the company would suffer if the key person could not fulfill their role. It often includes factors such as the cost to hire and train a suitable replacement, maintain business operations, and cover any loss of profits.

Once a key person insurance policy is purchased, the company pays regular premiums in exchange for a set amount of coverage. Then, in the event of the key person’s death or disability, the insurance policy pays a death benefit or disability payout directly to the company. The company can use this payout to help absorb the financial impact, cover the costs of finding or training a replacement, and stabilize the business during the transition. 

Who Should Use Key Person Insurance

Key person insurance is vital for various organizations, from large corporations to small startups, partnerships, non-profits, and even sole proprietorships. This policy is instrumental in mitigating the risks associated with losing a key person. The following are some of the entities that should consider getting key person insurance:

• Small businesses: Small businesses often rely heavily on one or two key individuals for their success. The loss of such a person could lead to significant financial strain or even the failure of the business. Key person insurance provides a financial cushion, allowing the company to remain operational while finding or training a replacement.
• Startups: In many new companies, the founder or a handful of people possess vital skills or knowledge integral to the business’s growth and survival. Their loss could stall the business’sbusiness’s momentum or even lead to its failure. 
• Partnerships: In professional partnerships, such as law, accounting, or consulting firms, partners often carry a significant amount of responsibility and knowledge. If a key partner suddenly becomes incapacitated, it could disrupt the entire business. 
• Non-profits: Non-profit organizations often lean on key individuals for their vision, leadership, or fundraising. Losing such an individual could impact the organization’s ability to fulfill its mission. 
• Sole proprietorships: In a sole proprietorship, the owner is the business. If they were to pass away or become incapacitated, the company would essentially cease to exist. Key person insurance can provide funds to pay off debts, pay employees, or even sell the business, providing some financial security during an otherwise uncertain time.

By purchasing key person insurance, businesses can protect themselves against the potential loss of a critical team member. It’s an essential investment for any organization, ensuring they can continue to operate even in challenging circumstances.

How to Set Up Key Person Insurance

Setting up a key person insurance policy can seem daunting, but the process is relatively simple. Here’s the general process for how to set up key person insurance:

1. Identify the key person. The first step in setting up key person insurance is identifying who in your business is a key person – if anyone. This could be an individual whose skills, knowledge, or leadership are vital to the company’s success. Generally, this is someone whose loss would cause significant financial strain.
2. Evaluate the financial impact. Once you identify any key people in your operation, you need to evaluate the financial impact their loss would have on your business. This can include potential loss of profits, the cost to hire and train replacements, and any possible disruption to business operations.
3. Determine the coverage amount. The next step is to determine the coverage amount. This should be equivalent to the estimated financial loss your business would experience with the loss of the key employees. If you’re having trouble deciding how much coverage is appropriate, a financial advisor or insurance agent can assist in making this determination.
4. Select an insurance provider. Once you know who you’re insuring and how much coverage you’d like, you need to find an insurer to provide the coverage. You may wish to compare quotes from multiple providers or work with a company like Ethos that can make sure you get the best deal.
5. Complete the application process. After settling on a provider, you must complete an application. This usually involves providing details about your business and the key person. The key person will also need to provide personal information and may need to undergo a medical exam, depending on the provider and amount of coverage.
6. Pay premiums. Once your policy is set up, your business must pay premiums. Depending on the policy, these payments may be monthly, quarterly, or annually.
7. Review the policy regularly. Finally, it’s important to review your key person insurance policy regularly. As your business evolves, you may need to adjust your coverage. Regular reviews ensure your policy continues to provide sufficient protection.

Tips for Using Key Person Insurance

Key person insurance is an important tool for businesses that helps mitigate the risks associated with losing a pivotal team member. However, businesses also need to know how to use this tool appropriately. Here are some important tips for using key person insurance:

• Understand its purposes and benefits. Key person insurance is not a one-size-fits-all solution. It serves specific purposes, like compensating for financial losses, financing the search for a replacement, or even paying off debts and liquidating the business in an orderly fashion. If you’re considering getting key person insurance, ensure it’s to fill an appropriate business purpose.
• Regularly re-evaluate your key people. Businesses evolve, and so do the roles of their key team members. It is crucial to periodically assess who the key people are in your business. As roles and responsibilities shift, you may find that different individuals have become more critical to your operations than the one you initially insured.
• Consider multiple policies for several key people. If your business has more than one key person, having separate policies for each might be beneficial. This way, your business is protected from the loss of any one key person and multiple key individuals.
• Ensure adequate coverage. Regularly review your policy and adjust the coverage as necessary to fit the changing dynamics of your business and the evolving value of your key people to your operation.
• Keep the policy up to date. Keep the policy information current, including the key person’s health status, age, and other variables that might affect the policy. Inaccurate information can lead to complications in the event of a claim.