Key Person Insurance: Protecting Against the Loss of Critical People

What Is Key Person Insurance?

Key person insurance is a life insurance or disability insurance policy that a business purchases on the life of an essential individual — typically a founder, owner, top salesperson, or someone with irreplaceable skills, relationships, or knowledge.

The business is the policy owner and beneficiary. If the key person dies or becomes permanently disabled, the business receives the insurance payout. That money helps the business survive the disruption — covering lost revenue, recruiting a replacement, paying off debts, or even facilitating an orderly shutdown if necessary.

This is not a personal life insurance policy. It is a business asset designed to protect the company from the financial shock of losing someone critical.

Why Small Businesses Are Especially Vulnerable

In a large corporation, no single person is irreplaceable. In a small business, one person often holds the primary client relationships, the technical expertise, the business vision, or the financial guarantees. Lose that person, and you lose:

• Revenue — If the key person generates a significant percentage of sales, revenue drops immediately
• Client relationships — Clients may leave when their trusted contact is gone
• Institutional knowledge — Years of industry knowledge, supplier relationships, and operational know-how
• Credit and financing — Banks and lenders may call loans or refuse renewals if the person who personally guaranteed them is gone
• Team morale — Employees may lose confidence in the company's future

Key person insurance does not replace the individual. It buys the business time and resources to stabilize.

Who Should Be Covered?

Ask yourself: if this person disappeared tomorrow, would the business survive? Common candidates include:

• Founders and owners — Especially in businesses where the owner is the business
• Top revenue generators — The salesperson who brings in 40% of revenue
• Technical experts — The engineer or developer whose skills cannot be quickly replaced
• Managers with deep client relationships — The project manager every client trusts
• Partners — In partnerships, key person insurance can fund a buy-sell agreement

You do not need to insure every employee. Focus on the people whose absence would cause immediate, measurable financial harm.

How Much Coverage Do You Need?

There are several methods to determine the right coverage amount:

Multiple of Compensation

A common starting point is 5 to 10 times the key person's annual compensation. If your top salesperson earns $150,000, you would insure them for $750,000 to $1,500,000.

Revenue Impact

Calculate how much revenue the key person directly generates or enables. If they are responsible for $2 million in annual revenue and it would take two years to rebuild those relationships, you need $4 million in coverage.

Replacement Cost

Estimate the cost to recruit, hire, and train a replacement. Include executive recruiter fees (typically 25-33% of first-year salary), signing bonuses, onboarding time, and the productivity gap during the transition.

Debt Coverage

If the key person personally guarantees business loans, the coverage should be enough to pay off those obligations.

Most small businesses purchase key person policies between $250,000 and $5 million, depending on the individual's role and the business's size.

Types of Key Person Insurance

Term life insurance — The most common and affordable option. Provides coverage for a set period (10, 20, or 30 years). No cash value accumulation. Pure protection.

Whole life insurance — More expensive, but builds cash value over time. The cash value is a business asset that can be borrowed against. Makes sense when you want the policy to serve as both protection and a long-term financial instrument.

Disability insurance — Key person disability coverage pays the business if the individual becomes disabled and cannot work. Disability is statistically more likely than death during working years, yet most businesses overlook this.

Tax Treatment

Key person insurance has favorable tax treatment:

• Premiums are not tax-deductible — The business pays premiums with after-tax dollars
• Death benefits are generally tax-free — Under IRC Section 101, life insurance proceeds received by the beneficiary (the business) are typically income-tax-free
• Cash value growth is tax-deferred — For whole life policies, the cash value grows without annual taxation

Consult your accountant for your specific situation, as tax rules have nuances around employer-owned life insurance (EOLI) notice and consent requirements under IRC Section 101(j).

How to Set Up Key Person Insurance

1. Identify your key people — Use the criteria above to determine who is critical
2. Calculate coverage amounts — Use multiple methods and settle on a defensible number
3. Get the individual's consent — The insured person must consent to the policy and typically undergo a medical exam
4. Choose the policy type — Term for pure protection, whole life if you want cash value
5. Name the business as owner and beneficiary — This is a business-owned policy, not a personal one
6. Review regularly — As the person's role, compensation, or the business's financial position changes, adjust coverage accordingly

Common Mistakes

Not having any key person coverage. Most small businesses skip this entirely and only realize the gap when it is too late.

Underinsuring. A $250,000 policy on a person responsible for $3 million in annual revenue is inadequate.

Failing to update policies. If a key person's role expands significantly, the original coverage amount may no longer be sufficient.

Ignoring disability. Death gets all the attention, but disability is more likely and can be equally devastating to the business.

The Bottom Line

Key person insurance is one of the simplest and most overlooked risk management tools for small businesses. It costs relatively little compared to the financial devastation of losing a critical team member. Identify your key people, quantify the risk, and put coverage in place before you need it.