Key person insurance helps protect the business you've worked to build.

Things to know:

• Key person insurance helps protect a business's interests if an owner or critical employee dies.
• The business owns the policy and gets the death benefit. Key person insurance doesn't replace the need for an individual life insurance policy.
• Key person insurance can be purchased as either term life or permanent life, just like personal life insurance.

What's a key person insurance policy?

A key person life insurance policy, sometimes called key man insurance, can help protect a business in the event of an essential employee's death.

The business is the policy's owner and beneficiary and pays the premiums. Small businesses often buy key person insurance for an owner or senior executive.

Who's a key employee?

A key employee can be anyone critical to the success of the business. The employee might have specialized training or knowledge, be responsible for a significant portion of the company's revenue, or have a reputation in the industry that's seemingly impossible to replace. 

Essentially, if the death of this person would cause major financial harm to the business, key person insurance may be worth considering.

Types of key person insurance

Like personal life policies, key person insurance can be purchased as a permanent life policy or as term life insurance.

Permanent life insurance doesn't have a set term and remains in place if premiums are paid. It generally has higher premiums than term life but may build cash value over time. This cash value can be borrowed against or received by the company if the key employee leaves. Whole life insurance and universal life insurance are both types of permanent life insurance.

Term life insurance provides a fixed benefit with a set premium for a certain number of years, usually 10, 20 or 30. After this initial term, the policy renews — but at an increased cost. It generally has lower premiums than permanent life insurance.

What does key person insurance cover?

Key person insurance helps cover costs associated with the death of a pivotal employee. Here are some examples:

Hiring and training a replacement

Recruiting and the hiring process can be time-consuming and costly. Training a new person will also take time and money. If the business pursues these options, the benefit from key person insurance can help.

Operating expenses and lost income

When the key person handles sales, their death may impact revenue. The funds from key person insurance can offset this.

Funding to buy out the financial interests of a deceased partner

If the company is a partnership, the surviving partner or partners may want to purchase the part of the company owned by the deceased. The death benefit from key person insurance can pay for this. Legal arrangements between co-owners, called cross-sell, buy-sell or purchase agreements, are often created with key person life policies as their funding sources.

Closing costs if the business is shutting down

If the company is going to close, key person insurance can help with shutdown costs, including severance pay for employees, payments to investors and help paying off debts.

How much does key person insurance cost?

It depends. Costs depend on the type of policy purchased and other factors like the age, overall health and lifestyle of the insured.

Permanent life insurance generally has higher premiums. Since it may build cash value, it costs more monthly, but the cash value can be borrowed against or received by the company if the key employee leaves.

Term life insurance usually has lower premiums. Term life provides a fixed benefit with a set payment for a certain number of years. With that term ends, the policy will renew at a higher cost or can be canceled.

Is key person insurance tax deductible?

Premiums for key person insurance are paid with after-tax dollars and usually aren't tax deductible. Like other life insurance policies, though, if the key employee dies, the death benefit is usually free from taxation. A tax attorney or accountant with knowledge of the business should be consulted.