What is key man insurance?

The purpose of key person insurance is to provide a payout if a key individual passes away and their death is expected to cause financial harm to the business. Examples of qualifying key employees include a founder, c-suite executive, top salesperson, or specialist.

With key man insurance, an employee from the business takes out a policy on a critical employee. The business pays the premiums and is the beneficiary of the policy. Key person insurance helps cover two things:

• Losses from the death of the insured party
• Lost revenue and other damages if the insured party is unable to work due to illness or another covered claim

If the insured individual passes away, the policy pays a death benefit to the company. The money can be spent on anything, but it’s intended to save the business from declaring bankruptcy or shutting down.

It’s also important to understand what keyman insurance doesn’t cover. This policy only covers your financial losses when the person named in the policy dies or becomes ill. It won't cover other situations that cause a business to slow down or suddenly lose sources of revenue.

However, there are other small business insurance policies that can cover these losses.

Not every business needs a life insurance policy to protect its founder, CEO, or specialist personnel.

Here are a few examples where this insurance is useful:

• The founder of your microbrewery is an inextricable part of the business. He's worked for years as a beer distributor and knows every liquor store and bar owner in the area. Plus, he's an expert in beer brewing. Without him, the company would be at a loss. As a board member, you might suggest that your business take out a life insurance policy on the founder. This will help ensure that the company can continue with or without him.
• You work at a hybrid car R&D company. The head of the company's research department has been studying hybrid drivetrains for 30 years and is considered a leader in the field. If she became ill or passed away, the company would lose one of its biggest assets. Key man insurance could be the factor that allows your company to keep moving despite that loss.

For companies and startups that have personnel who are irreplaceable because their loss would make it extremely difficult for the business to continue, a key person insurance policy offers important protection.

Most key man insurance policies include two types of coverage for a critical employee: life insurance and disability insurance.

Here’s how the two insurance solutions differ:

• Life insurance: Life insurance provides a death benefit to the business if the key person dies. The death benefit is typically paid in a lump sum and can be used for any purpose.
• Disability insurance: Disability coverage provides a payout if the key person becomes disabled and is unable to work. The benefits are usually paid at monthly intervals.

If you’re thinking about purchasing key person insurance on an executive or other irreplaceable team member, you’ll need to figure out the right amount of coverage to get. Here are three ways to determine an appropriate coverage limit:

• Key person's salary: Take the worker’s annual salary and multiply it by 10. For example, if the key person’s salary is $250,000 per year, a $2,500,000 coverage limit might be sufficient to keep the business afloat.
• Cost of replacing them: You can calculate a coverage limit based on the cost of replacing the individual. For this method, add the estimated cost of hiring and training a replacement. Then, add the revenue loss you would expect from losing the key person.
• Potential loss of revenue: Think about how much revenue the business could lose if the key person passed away and multiply that figure by the number of years it would take to replace them with a new person. For instance, if the key person brings in $1 million in sales per year, and you think it would take five years to replace them, you could choose a $5 million coverage limit.

Key man insurance coverage is a specialty type of policy. It might make sense for your small business, or it might not. It depends on the type of business and the personnel you work with.

As you think about this coverage, it's important to consider what other types of business insurance you might need as part of your risk management strategy. Some common policies include:

• General liability insurance: General liability insurance pays for legal costs if your business gets sued for bodily injury, property damage, or advertising injury.
• Workers' compensation insurance: Workers’ compensation pays for an employee’s medical bills and partial lost wages if they get sick or injured at work. It’s required for small businesses in most states.
• Business interruption insurance: Business interruption insurance covers necessary expenses if your business is forced to temporarily close after a catastrophic event, like a fire or natural disaster.
• Professional liability insurance: Professional liability insurance, also called errors & omissions insurance, covers lawsuits related to professional errors, negligence, contract breaches, and unsatisfactory work.

If you want to insure a key employee, another thing you might consider is a buy-sell agreement. With a buy-sell agreement, a life insurance policy is used to transfer funds from one co-owner to another if one person passes away or leaves the company. The money is typically used to buy out the deceased business owner’s share of the company.

Most small business insurance providers offer key man insurance policies. Here are the general steps you should follow to purchase this type of coverage:

• Identify key employees: Decide which employees you want to insure. Typically, these are people who are responsible for the success of the company or provide significant financial contributions.
• Choose the right insurance amount: Figure out how much coverage will meet the needs of the business. This can be based on the employee’s salary, the cost of replacing them, or the potential loss of revenue.
• Compare policies from different insurers: Before you choose a key man insurance policy, it’s a good idea to compare policies from a few different insurers. Make sure to choose a company that meets your needs and preferences.
• Apply for a policy: Contact the insurance company and request an application. If you have questions about the policy or the insurance cost, consider speaking to an agent or getting quotes before you apply.
• Complete medical underwriting (if required): Some insurers require the insured employee to undergo a short medical exam for underwriting. The exam often includes a blood and urine sample, height and weight measurement, blood pressure reading, and an in-depth review of the person’s medical history.
• Purchase the policy and name the business as the beneficiary: Once underwriting is complete (usually in several weeks), you can purchase the policy. Name the business as the beneficiary to receive the death benefit. The coverage will go into effect when you pay the initial premium.  

Purchase the policy and name the business as the beneficiary: Once underwriting is complete (usually in several weeks), you can purchase the policy. Name the business as the beneficiary to receive the death benefit. The coverage will go into effect when you pay the initial premium.