What Is Key Person Insurance? Guide for Business Owners

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As a business owner, you likely have insurance policies that cover your building, inventory, and vehicles. But what happens if you lose one of your most valuable assets—an employee who drives your revenue, manages your operations, and holds your company’s institutional memory? For many businesses, the sudden loss of a key individual can be far more devastating than a fire or a lawsuit. 

If a top salesperson, a visionary founder, or a senior executive dies unexpectedly, the impact can paralyze a company’s operations. Sudden drops in revenue, stalled projects, and the loss of critical client relationships can create financial instability that lasts for months or years. 

Key person insurance provides a financial cushion and facilitates business continuity after the death of a nearly irreplaceable employee. Policies are often structured to pay out five to 10 times the employee’s annual salary, injecting tax-free cash into the business when it’s needed most. Learn how a key person policy works, who qualifies for one, and how to choose the right coverage for your business.

What is key person insurance?

Key person insurance is a form of business life insurance. It’s a policy purchased by a company for the life of an employee. With personal life insurance, an individual buys a policy to provide a financial safety net for their family should something happen to them. Key person insurance follows the same concept, but is structured for businesses rather than households.

In this arrangement, the business itself owns the policy, pays the premiums, and is the designated beneficiary. If the key person dies, the company receives the resulting death benefit. 

These funds are designed to help keep the business afloat while that employee’s position is replaced. The money provides the liquidity needed to cover operating expenses, offset lost income, and cover the expense of recruiting and training a replacement.

Key person insurance can also include disability coverage. By adding a disability rider, the company receives funds if the employee is incapacitated by a severe illness or accident. A disabling injury that prevents a key player from working can be just as financially draining as a death, making this an important consideration.

Who is considered a key person?

A key person is anyone whose absence would cause a major disruption to the company’s financial health. There is no strict job title requirement; it depends on the employee’s contribution to the company’s sales revenue or their possession of specialized, hard-to-replace knowledge.

Common examples of key people include:

• A senior executive. This person could be a decision-maker whose leadership is essential to the company’s strategic direction.

• A top salesperson. An employee who brings in a substantial amount of revenue or one who holds strong relationships with major clients can qualify for this type of coverage.

• A lead engineer or developer. This employee could be someone with proprietary knowledge of a business project or product that no one else understands.

Although there is no legal limit on the number of key person policies a business can hold, they are generally reserved for the staff who drive the most value. Most insurers will only approve coverage if the company can demonstrate a clear “insurable interest,” meaning the business would suffer a proven financial loss if that specific employee were gone.

How does a key person insurance policy work?

A key person insurance policy operates differently from the group life insurance often found in benefits packages. These policies do not protect against voluntary turnover—if the employee quits, retires, or is fired, the insurance doesn’t pay out. In these scenarios, the company typically cancels the policy, and any premiums paid up to that point are considered a sunk cost unless the policy has accumulated cash value.

Here’s an overview of the process:

• Identification. The company identifies one or more key employees and determines how their absence would impact the business financially.

• Consent. The employee must provide consent to be insured. You cannot take out a policy on an employee without their knowledge and permission.

• Underwriting. Underwriting is the process of evaluating and assessing risk before providing a financial product or service. The insurance company will evaluate the employee's health and lifestyle, much like a personal policy.

• Approval. After reviewing the medical exam and records, the insurer makes a decision. They can approve the policy as requested, offer it at a higher premium if health issues are found, or decline coverage entirely if the risk is too high.

• Ownership. The company pays the premiums and owns the policy. If the company buys a term policy, the premiums are recorded as a business expense. If it buys a permanent policy, the accumulating cash value can be recorded as an asset on the company’s balance sheet. Premiums typically range from $500 to $5,000 annually per $100,000 of coverage, depending on the employee’s age, health, and whether the company chooses term or permanent insurance. 

• Payout. If the key person dies, the death benefit is paid directly to the company.

The funds can be used at the company’s discretion. Common uses include:

• Offsetting lost income during the transition period after a key employee dies

• Recruiting and training a new person for the role

• Paying off debts to avoid financial strain (The death benefit is unrestricted, meaning the company can use the cash to settle any outstanding loans or lines of credit, even if they are unrelated to the specific workload the insured employee handled.)

• Buying out the deceased partner’s partnership interests from their family members, often structured alongside a buy-sell agreement

Beyond internal stability, banks may require key person insurance on the business owner or key employees before guaranteeing business loans. Investors may also require it to protect their own financial interests.

How much key person insurance does a business need?

Determining the amount of coverage your business needs is more art than science. Unlike insuring a building, where you can calculate replacement costs based on square footage, placing value on a human life in a business context involves the projection of future losses.

While every business is different, coverage amounts usually fall into specific ranges based on the company’s size and the employee’s role. 

• Small businesses. Policies often range from $100,000 to $500,000 to cover immediate debts and finding a replacement.

• Established companies. For key executives or top salespeople, policies typically range from $1 million to $5 million.

• High-growth startups. Investors may require coverage limits of $10 million or more for founders whose personal reputation drives the company’s valuation.

The goal is to provide a financial cushion that lets the remaining leadership make calm, strategic decisions instead of panicked financial ones. Businesses generally draw from three methods to arrive at a number:

1. Multiple of income. The rule of thumb is to insure the key person for 5 to 10 times their annual compensation. This assumes it may take several years to find and train a replacement who can perform at the same level.

2. Replacement cost. This calculates the hard costs of replacing the employee. It includes recruiter fees, signing bonuses, training costs, and the estimated lost sales or errors that will occur while the new hire gets up to speed. This calculation is also useful when determining disability coverage, as the business may need only enough funds to cover the temporary costs of an interim replacement while the key employee recovers.

3. Contribution to earnings. For a salesperson or business owner, you could estimate the percentage of the company’s profit they are directly responsible for and then multiply that by the number of years it would take to recover that momentum.

Insurers do limit the coverage amount. They will only approve the amount that can be financially justified. To get approved for a multimillion-dollar policy, the business must prove that the financial loss caused by the employee’s death would actually equal that amount.

Term life insurance vs. permanent life insurance

When purchasing coverage, you will generally choose between two types of insurance policies. The best choice for your company will depend on your cash flow and the intended duration of the need.

Term life insurance

Term life is the most common choice for key person insurance. This type of policy provides coverage for a specific period—usually 10, 15, or 20 years. If the key person dies, the policy pays a tax-free lump sum directly to the company. If the policy includes a disability rider, benefits are typically paid in monthly installments to cover costs while the employee recovers, though some policies offer a lump sum for permanent disabilities.

• Pro. It offers the best price, allowing you to buy a high death benefit for a relatively low premium. This is because term insurance is “pure” protection with no investment component. You're paying strictly for the death benefit, not for building up cash value. It is ideal for covering temporary needs, such as a business loan or protecting a business project until completion. Without this coverage, the death of a key revenue-generator could leave the company with significant monthly debt payments without the income stream needed to cover them.

• Con. It has no cash value, so if the key person outlives the term, the policy expires, and the business receives none of the money it put toward paying the policy.

Note: To address a common fear, no, a business cannot profit from foul play. Under the slayer rule, if a beneficiary is involved in the death of an insured employee, the insurance company will legally deny the payout. Additionally, employees must consent to the policy in writing; a company cannot take out secret life insurance on its staff.

Permanent life insurance

Permanent life insurance (such as whole life or universal life) has no expiration date. Unlike a term policy that ends after a set number of years, this policy remains active indefinitely, guaranteeing a payout whenever the employee eventually dies, as long as premiums are paid.

• Pro. These policies build cash value over time. The business can treat this cash value as an asset on the balance sheet, potentially borrowing against it for working capital. It can also serve as a powerful retention tool. By offering to transfer the policy to the employee only upon retirement, the company incentivizes key talent to stay, turning a necessary insurance cost into a valuable recruiting perk. 

• Con. Premiums are significantly higher than term life insurance—often 10 to 15 times the cost for the same death benefit. For example, a healthy executive might be insurable for $1,000 a year with a term policy, while a permanent policy for the same coverage could cost upward of $12,000 to $15,000 annually. For most companies, specifically startups or cash-strapped small businesses, tying up that much capital in insurance premiums is often impossible when those funds are needed for immediate growth.

How is key person insurance taxed?

Because the business owns the policy and is the sole beneficiary, the IRS views these payments as an investment in a business asset rather than a tax-deductible employee benefit like group life insurance. Here’s how it impacts your business taxes:

Premiums

In almost all cases, the premiums paid for key person insurance are not tax-deductible as a business expense. This is so that the business cannot “double dip” by deducting the cost of the policy and then receiving the payout tax-free.

Payout

Although the premiums are not deductible, the death benefit that the company receives is generally income-tax-free. If the key employee dies and the company receives a $1 million payout, that $1 million adds to the company’s liquidity without triggering a massive income tax bill.

The benefit can become fully taxable if the company fails to follow specific IRS rules, most notably the Pension Protection Act of 2006. If the business does not obtain written consent from the employee before the policy is issued, the payout loses its tax-free status and is taxed as ordinary income.

Note: Tax laws are complex and subject to change. Always consult with a CPA or tax professional regarding your specific business situation.