Definition: Life insurance on a key employee, partner or proprietor on whom the
continued successful operation of a business depends. The business
is the beneficiary under the policy.
Key person insurance is simply life insurance on the key person
in a business. In a small business, this is usually the owner, the
founders or perhaps a key employee or two. These are the people who
are crucial to a business--the ones whose absence would sink the
company. You definitely need to consider key person insurance on
those people.
Here's how key person insurance works: A company purchases a
life insurance policy on its key employee(s), pays the premiums and
is the beneficiary of the policy. If that person unexpectedly dies,
the company receives the insurance payoff. The reason this coverage
is important is because the death of a key person in a small
company can cause the immediate death of that company. The purpose
of key person insurance is to help the company survive the blow of
losing the person who makes the business work.
The company can use the insurance proceeds for expenses until it
can find a replacement person, or, if necessary, pay off debts,
distribute money to investors, pay severance to employees and close
the business down in an orderly manner. In a tragic situation, key
person insurance gives the company some options other than
immediate bankruptcy.
If the company is a sole proprietorship and employs just you and
no other employees or has no other people who depend on it, then
key person insurance isn't as necessary. You'll notice we didn't
mention your family--don't confuse key person insurance with
personal life insurance. If you have a spouse and/or children who
depend on your income, then you should have personal life insurance
for that purpose.
How do you determine who needs this insurance? Look at your
business and think about who is irreplaceable in the short term. In
many small businesses, it's the owner who holds the company
together--he may keep the books, manage the employees, handle the
key customers and so on. If that person is gone, the business
pretty much stops.
How much key person insurance do you need? That depends on your
business, but in general, you should get as much as you can afford.
Shop around and get rates from several different agents; most life
insurance agents will sell you a key person policy. Be sure to ask
for term insurance--many agents will push whole or variable life,
which have much higher premiums and commissions but are unnecessary
for a key man policy. Ask for quotes on $100,000, $250,000,
$500,000, $750,000 and $1 million, and compare the costs of each.
Then think of how much money your business would need to survive
until it could replace the key person, come up to speed and get the
business back on its feet. Buy a policy that fits into your budget
and will address your short-term cash needs in case of tragedy.