What is key person insurance and how can it protect your business?

By: Updated: November 5, 2021

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In many organizations, one person is vital to its success – and perhaps even survival. It could be the business owner or the CEO. Or it might be a development expert, such as a software engineer who is working on a major revenue-producing product.

If this individual is disabled or dies, key person protection can play an important role in helping the business to stay afloat. Read on to learn more about this valuable risk management tool.

 

What is the purpose of key person insurance?

Key person insurance is similar to life or disability insurance. However, there is one important difference. In the event that of an insurance payout, the business receives the money – not the family of the key person.

This insurance has several purposes, all of which relate to allowing the business to continue even if the key person is no longer there. The funds can:

  • Help cover the cost of recruiting and replacing the individual
  • Pay off debts to put the company in a stronger financial position
  • Ease the fears of lenders, customers, investors and employees about the future of the business

 

Who needs key person insurance?

Any business or organization that depends on one or two people for its success can benefit from key person insurance. For example, a sole proprietor may want to have insurance to cover the cost of selling or winding down the business in the event of his or her death.

All organizations need a risk management strategy. Part of that plan is having a succession plan of “leaders in waiting” who can take over the business in the event that the CEO dies or can’t continue. Key person insurance is a type of risk insurance that supports that strategy by providing funds to help bridge the gap during the change of command.

 

What does it cover?

There are three different types of key person insurance:

  1. Life insurance: Pays a lump sum to the business in the event of the death of the insured individual, such as the business owner or CEO.
  2. Disability insurance: Provides ongoing payments in the event of “total disability” from injury or illness of the insured. This means that the individual would not be able to perform his or her duties.
  3. Critical illness insurance: This policy provides a single payment in the event that the key person is struck by a critical illness and is unable to work at the previous level of productivity. The policy will specify which critical illnesses are covered – it may include a stroke or heart attack.

 

How is it calculated?

The cost of key person insurance depends on a number of factors:

  • The benefits: A life insurance payout could range from a few thousand dollars to $1 million or more. Ongoing payments for disability insurance at RBC Insurance, for example, can run from $2,500 to $15,000 per month for a period of 12 months.
  • The individual: Like regular life insurance, the cost will depend on the individual’s health, lifestyle habits and age.
  • The restrictions: Most policies will have limitations. For example, RBC will provide life insurance for key people aged between 18 and 55. The policy will be valid until the individual reaches age 62 or leaves the company. In the case of disability insurance, before paying out there may be a waiting period of 60 to 90 days after complete disability.

Therefore, with all of these variables, it’s best to check with your insurance specialist to see what type of policy fits your need and budget.

 

Is key person insurance tax deductible

When you purchase key person insurance, the business usually pays the premiums. However, these are not deductible as a business expense. If there is a payout due to death or disability, it is not usually considered taxable income for the corporation.

 

Key man insurance vs. life insurance

Back in the old days, this insurance was known as “key man” insurance. Of course, now the key person in an organization could be a man or a woman. That’s why it’s now known as key person insurance.

This insurance is similar to life insurance in that there is a payout in the event of the insured’s death. With life insurance, the beneficiary is normally the spouse or family members. For key person insurance, the payment goes directly to the business.

 

The process of key person insurance

Taking out key person insurance requires a similar process to getting a life insurance policy. The steps are:

  1. You complete the application on behalf of the business, identifying the key person to be insured.
  2. The key person will undergo a mini physical with a medical representative of the insurance company. This may include blood and urine samples, stepping on the weigh scales, a blood pressure check, and perhaps an EKG. The representative will collect the person’s medical history.
  3. The underwriter at the insurance company will review the application and medical results. He or she will decide whether to offer an insurance policy and at what price.
  4. With the proposed policy and pricing in hand, the business managers can decide whether to accept it or turn it down.
  5. Once management receives the policy, they should review it carefully to ensure that it is accurate and covers what is expected.

Your insurance company may have slightly different requirements but hopefully this gives you a general idea of the process.

 

Documents required for key man insurance

The insurance company may ask the business to provide background information on the business. This could include:

  • The most recent balance sheet
  • Income statements for the past three years
  • A board resolution declaring the type and amount of key person insurance they wish to purchase.

Again, the documents required may vary between insurance companies. Check with your insurance provider to see what they will need.

 

Does your business need key person insurance?

Key person insurance can play a role in an overall strategy to minimize risk and ensure the continuity of the business. You may wish to consider it for your company if the death or disability of one or two vital team members would threaten the future of the business.

 

Are you incorporated in Canada?

Small business owners and incorporated individuals in Canada can use a Health Spending Account (HSA) to save up to 40% of their medical expenses.  An HSA has no premiums and it is a cost effective alternative to traditional health insurance.  The plan covers a wide variety of health and dental expenses.  An HSA takes only a few minutes to set up.  Learn more by downloading one of our guides.

 

Learn more about a Health Spending Account by downloading a free guide:

Download the HSA Guide for Incorporated Individuals Download the HSA Guide for a Business with Staff

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