Key Person Insurance: Individual Benefits

Key person insurance is a life insurance policy that a business takes out on an employee whose skills, knowledge, or relationships are critical to its success. The business owns the policy, pays the premiums, and is the beneficiary of coverage on a key employee as well as a key person. If a key person dies, the death benefit is paid to the company to help replace lost revenue after an employee's death, so the business receives money that can help protect operations.

There is no exact formula for determining how much coverage to carry for key person insurance. A common starting point is to multiply the key person's annual salary by five to seven, but a business owner should also weigh that person's contribution to the company's bottom line. Many businesses also consider the individual's contribution to the company's profits, since losing top talent can have a much larger impact than their salary alone suggests.

The payout gives the business flexibility during a difficult transition and can help keep the business running after a key employee dies. It can replace lost revenue after a key employee dies, help cover immediate cost pressures, offset temporary drops in cash flow, cover the costs of recruiting and training a replacement, and pay ongoing business expenses while operations stabilize. It can also help the business meet obligations to creditors if the loss creates financial strain.

Death benefits from key person insurance are generally received tax-free by the business, as long as certain IRS requirements are met. These typically include notifying the employee and obtaining their written consent before the policy is issued. Tax treatment can vary, so consult a qualified tax professional for guidance based on your situation. If the policy is classified as a Modified Endowment Contract, withdrawals or policy loans may be taxed differently, and taxable gain on distributions or surrender is generally measured against the policy’s cost basis. A tax advisor can confirm that your policy is set up correctly.

Yes. Lenders often want assurance that a loan will be repaid even if a founder or top executive passes away, and some require key person coverage as a condition of financing. The coverage also reassures investors, business partners, and other stakeholders that the business can withstand the loss of a critical team member. For example, it can help fund continuity if one owner dies and the surviving business owner needs liquidity tied to a buy-sell plan.

It depends on your goals. Term life insurance provides coverage for a specific period, which works well for protecting a loan or covering a key person until retirement. Permanent life insurance, such as whole life insurance, provides lifelong coverage and builds accumulated cash value over time; some policy cash value may be available for the business to access later, depending on the policy. Your advisor can help you decide which structure fits your business plan.

A buy-sell agreement sets the terms for how an owner's or business partner's share of the business will be transferred if they pass away. Life insurance policies on each owner provide the cash needed to buy out the deceased owner's interest or purchase a deceased partner's share from their estate, helping family members avoid ownership conflicts while the remaining owners keep control without draining company funds. Many partnerships pair buy-sell funding with key person coverage for more complete protection.

An executive bonus plan is a popular option, where the business pays a bonus that the executive uses to fund a personal life insurance policy. In some designs, the executive owns the policy and may build policy cash that can be used to supplement retirement income or provide retirement income later. Non-qualified deferred compensation plans let executives defer part of their pay, and some plans allow deferral of up to 100% of compensation. These executive benefits and executive benefit programs are often offered to a select group of highly compensated employees as part of broader executive benefit plans. Some executive benefit plans use a more generous formula for retirement benefits, and distributions may begin at a later date. Executive disability insurance is another valuable benefit that supplements group coverage and protects a larger share of a high earner's income, and about 30% of companies provide it to senior executives. A restricted endorsement bonus arrangement can limit early access to accumulated cash while improving retention.