Key Person Insurance: How Businesses Insure Against Losing Their Most Important People

Key person insurance, traditionally called key man insurance, is insurance that a business buys on the life or health of someone whose loss would seriously damage it. If that person dies, or in some policies becomes critically ill or disabled, the insurer pays the business a sum of money. The business can use the money to hire and train a replacement, cover lost profits, reassure lenders and customers, repay debts, or buy out the person's ownership stake.

The core idea is simple: some businesses depend heavily on one or a few individuals. A small engineering firm might rely on the founder who holds the client relationships. A software start-up might rely on the one developer who understands the core code. A family restaurant might rely on the chef whose name is on the door. If such a person is suddenly gone, the business may lose revenue, credibility and momentum at precisely the moment it has to spend money on recovery. Key person insurance is a way of converting that risk into a predictable premium.

This article explains how key person insurance works, who counts as a key person, how cover is commonly sized, how it differs from related forms of business insurance, how it is taxed in the United States and the United Kingdom based on official sources, and what its limits and common pitfalls are.

Important note: This article is for general education. It is not financial, legal, insurance or tax advice. Tax rules change and depend on individual circumstances. Anyone considering a policy should consult a qualified adviser in their own jurisdiction.

What key person insurance is

Wikipedia describes key person insurance as insurance taken out by a business to compensate it for financial losses arising from the death or extended incapacity of an important member of the business. It also notes some characteristics that distinguish it from ordinary personal life insurance:

• There is no single legal definition. "Key person insurance" is a description of a purpose, not a special category of policy in law. In practice it is usually an ordinary life insurance policy, or a critical illness, trauma or disability policy, owned and used by a business.
• The business is usually the owner and beneficiary. The company applies for the policy, pays the premiums and receives the payout. The insured person does not receive the money directly.
• It pays a fixed sum. Unlike indemnity insurance (for example, property insurance, which pays the actual cost of the damage), key person life cover pays an agreed amount, regardless of the actual loss the business suffers. This makes sizing the cover at the outset important.
• It is often tied to the person's useful period. The term of a key person policy is commonly set so that it does not extend beyond the period during which the person is expected to be valuable to the business. As discussed below, this matters for tax treatment in the United Kingdom.

A brief note on the name

The older term "key man insurance" is still widely used, especially in the UK and in older literature. The gender-neutral "key person insurance" has become the standard term in much of the industry. The two mean the same thing.

Why businesses buy it

The economic problem

Businesses invest in their people, and some people become far more valuable to a firm than their salary reflects. They may hold relationships, knowledge, reputation, licences or skills that would take years to rebuild. A sudden loss can affect the business in several ways:

• Sales may fall if customers followed the person, not the firm.
• Projects may be delayed or abandoned.
• Lenders may reconsider credit lines if they had relied on the person's management.
• Investors may lose confidence.
• The firm must spend money on recruitment, temporary cover and training.

A 2021 Forbes Technology Council article cited on Wikipedia discussed "key person dependency" in relation to information: when one person holds critical knowledge that is not documented or shared, the firm faces a concentrated risk if that person leaves or is lost.

What the research says about the value of key people

There is evidence that the loss of a senior executive can affect a company's value. In a 1985 study in the Journal of Accounting and Economics (volume 7, pages 151–174), Johnson, Magee, Nagarajan and Newman examined stock market reactions to 53 sudden deaths of senior executives in events between 1971 and 1982. They found little systematic effect on average share returns, but considerable variation from case to case. The direction and size of the reaction were related to factors such as whether the executive was a founder, measures of the executive's talent and decision-making responsibility, and the costs of renegotiating or terminating employment arrangements. In other words, markets did not treat every executive death as bad news; it depended on who the person was and what they did.

That nuance matters for key person insurance. The loss of a well-run company's chief executive may have little long-term effect if there is a strong succession plan. The loss of a founder whose personal relationships drive the business can be devastating. Insurance is most valuable where the dependency is real and concentrated.

The four main uses

Wikipedia groups the uses of key person insurance into four broad categories:

Strictly speaking, some practitioners treat the third use, funding ownership buyouts, as a separate product called shareholder protection, partnership protection or buy-sell funding, and the fourth as business loan protection. All of them use the same basic tool, life or health insurance owned for a business purpose, but they differ in who owns the policy, who receives the money and, importantly, how they are taxed.

Who counts as a key person?

There is no formal test. A key person is anyone whose absence would cause the business significant financial harm. Wikipedia gives examples including company directors, sales directors, IT specialists, managing directors and heads of product development. More generally, a person may be "key" because they:

• Generate a large share of revenue, for example through personal client relationships.
• Hold unique technical knowledge or intellectual property that is not easily transferred.
• Are the public face of the business, so that its brand or reputation depends on them.
• Hold licences, accreditations or qualifications that the business needs to operate.
• Have personally guaranteed significant business debts.
• Are central to the confidence of investors or lenders.

A key person need not be an owner or a senior executive. A highly specialised technician can be more critical to a small firm than its finance director.

Questions businesses commonly ask

Insurers and advisers commonly encourage businesses to think through questions such as:

• If this person were gone tomorrow, what would happen to revenue over the next one to two years?
• How long would it take to find and train a replacement, and what would it cost?
• Are there loans, leases or guarantees tied to this person?
• Would customers, suppliers or employees leave?
• Is there a documented succession plan, and is the knowledge this person holds written down anywhere?

Types of policy

Key person insurance is not a single product. It can be built from several kinds of cover.

Term life insurance

The most common form. The policy pays out if the insured dies within a fixed term, for example five or ten years, and pays nothing if they survive the term. Term cover is relatively inexpensive and matches the logic of key person insurance well: the business needs protection while the person is important to it, not forever. In the UK, term cover with no investment element is also the form most likely to receive favourable tax treatment, as explained below.

Permanent (whole life or universal life) insurance

Permanent policies last for the insured's whole life and usually build up a cash value. Wikipedia notes that one claimed advantage of some key person policies is that the business may be able to borrow against them, which is not possible with term plans. Permanent policies are more expensive, and in the UK, premiums on whole life or endowment policies are treated as capital expenditure and are not deductible.

Critical illness and trauma cover

These policies pay a lump sum if the insured is diagnosed with a listed serious illness, such as certain cancers, heart attack or stroke. Since a key person may survive a serious illness but be unable to work for a long time, critical illness cover can address a risk that life cover does not.

Disability and income protection cover

Some policies pay a regular amount if the key person cannot work because of illness or injury. These help a business manage long absences rather than permanent losses.

Combined policies

Policies may combine life cover with critical illness cover. Wikipedia notes that in the UK, adding critical illness cover where the key person is also a significant shareholder may make it more likely that the policy will be seen as serving the person's personal interests rather than purely the business, which can affect tax treatment. That particular point is flagged as needing a citation on Wikipedia, so it should be checked with an adviser.

How the arrangement typically works

A typical key person arrangement looks like this:

1. The business identifies the key person and estimates the financial impact of losing them.
2. The business applies for the policy. The key person must normally consent and take part in underwriting, which may include health questionnaires and medical examinations. Insurers require the business to have an insurable interest in the person's life, meaning a genuine financial interest in their continued life and health.
3. The business owns the policy and pays the premiums. It is usually named as the beneficiary.
4. If a claim arises, the insurer pays the business the agreed sum.
5. The business uses the money for whatever purpose it needs: replacing the person, covering losses or repaying debts.

Wikipedia notes that there is no legal requirement that the business own the policy, and that sometimes the insured person or another individual owns it for tax or continuity reasons. Ownership and beneficiary arrangements affect taxation, so they should be chosen deliberately.

What happens if the person leaves?

A key person policy is linked to a business purpose. If the key person resigns or retires, the business may cancel the policy, keep it (if allowed and if it still serves a purpose), or in some cases transfer it to the individual. Each option may have tax consequences. Wikipedia notes, for example, that surrendering a policy may make an amount taxable to the key person as profit in lieu of salary in some circumstances.

Sizing the cover

Because key person life cover pays a fixed amount, the business must decide in advance how much is enough. Wikipedia's article recommends considering lost profits, replacement costs and debts that would need to be repaid. Insurers and advisers use several approaches. None is mandated by law, and insurers apply their own limits during underwriting.

Common approaches

Many businesses combine approaches. For example, a firm might insure enough to repay a business loan plus an estimate of lost profits during a recovery period.

A worked example (hypothetical)

The following figures are hypothetical and are intended only to illustrate the reasoning. They are not a recommendation.

A small architecture practice has annual gross profit of £800,000. The founding partner personally brings in most of the major clients. The other partners estimate that if she died suddenly:

• About half of gross profit, £400,000 a year, would be at risk because clients have relationships with her personally.
• It would take roughly 18 months to rebuild relationships or win replacement clients.
• Recruiting a senior architect to take on her design role would cost around £40,000 in fees, and there would be an extended handover period.
• The practice has a £150,000 bank loan, which the bank granted partly on the strength of her involvement.

A profit-based estimate might be £400,000 × 1.5 years = £600,000. Adding recruitment costs of £40,000 and the £150,000 loan gives roughly £790,000. The practice might decide to seek cover in that region, subject to the insurer's underwriting and to the practice's view of whether it can afford the premiums.

Two caveats apply. First, the figures depend heavily on assumptions, especially the share of profit attributed to the founder and the recovery period. Second, insurers may limit the amount they will cover based on their own assessment. The example illustrates the logic of sizing, not what any insurer would actually offer.

Key person insurance compared with related products

Several products are often confused with key person insurance.

The distinctions matter. A key person policy pays the business; it does not provide for the key person's family. A family that assumes a key person policy will support them may be surprised. Conversely, a business that assumes a group life scheme will cover its losses may find that the money goes to employees' families, as it is supposed to.

Tax treatment in the United States

US tax treatment of key person life insurance involves two questions: whether premiums are deductible, and whether the death benefit is taxable.

Premiums are generally not deductible

Section 264(a)(1) of the Internal Revenue Code disallows a deduction for premiums paid on any life insurance policy, endowment or annuity contract when the taxpayer is directly or indirectly a beneficiary under the policy. Since a business that owns a key person policy is usually its beneficiary, its premiums are generally not deductible. Wikipedia's article reflects this, citing section 264(a), although it also contains a conflicting statement in its list of advantages that appears to refer to Indian tax law rather than US law; the US position based on the statute is non-deductibility.

Section 264(a) also contains related limits on deducting interest on debt used to buy or carry life insurance. One provision, section 264(a)(4) together with subsection (e), generally disallows interest on debt with respect to life insurance policies covering any individual, with an exception allowing interest on up to $50,000 of borrowing per "key person," subject to further conditions in the statute.

Death benefits: the general rule and the employer-owned contract rules

Normally, under section 101(a) of the Code, life insurance proceeds paid because of the insured's death are excluded from the recipient's gross income. That is why personal life insurance payouts are generally tax-free in the US.

However, the Pension Protection Act of 2006 added section 101(j), which restricts that exclusion for employer-owned life insurance contracts. According to the statute:

• An employer-owned life insurance contract is one owned by a person engaged in a trade or business, under which that person (or a related person) is directly or indirectly a beneficiary, and which covers the life of someone who was an employee of that business when the contract was issued.
• For such contracts, the amount excluded from income is limited to the total premiums and other amounts paid by the policyholder. Anything above that is taxable income.
• The rule applies to contracts issued after August 17, 2006. Older contracts are generally grandfathered, but a material change, such as an increase in the death benefit, can cause a contract to be treated as newly issued.

The commentary in The Tax Adviser (December 2009) and the statute itself use the term "employer-owned life insurance" (EOLI). This regime is often discussed alongside the term "company-owned life insurance" (COLI). Wikipedia notes that the rules were enacted through provisions sometimes referred to as the COLI Best Practices Act within the Pension Protection Act of 2006.

The exceptions and the notice-and-consent requirement

The full death benefit can still be excluded if certain conditions are met. Section 101(j) provides exceptions, but only if notice and consent requirements are satisfied before the policy is issued. The employee must:

1. Be notified in writing that the employer intends to insure their life, and of the maximum face amount for which they could be insured.
2. Give written consent to being insured and to the coverage continuing after they leave employment.
3. Be informed in writing that the employer will be a beneficiary of the death proceeds.

If notice and consent are satisfied, the exclusion is preserved where, among other things:

• The insured was an employee at any time during the 12 months before death; or
• At the time the contract was issued, the insured was a director, a highly compensated employee (as defined in section 414(q)), or a highly compensated individual (under section 105(h)(5), with the statute substituting 35 percent for 25 percent in the relevant test); or
• The proceeds are paid to the insured's family members, estate, a trust for them, or a designated beneficiary other than the policyholder, or are used to buy an ownership interest in the business from such persons.

Many key persons, such as directors and senior executives, fall within the "highly compensated" or "director" categories, but the exceptions only help if notice and consent were completed correctly and on time.

IRS guidance: Notice 2009-48

In 2009 the IRS issued Notice 2009-48, a question-and-answer guide to section 101(j). According to the summary in The Tax Adviser, it addresses definitions of employer-owned contracts and employees, how to satisfy notice and consent, transition rules and section 1035 exchanges. It provides limited relief for inadvertent failures to meet notice and consent: where the policyholder made a good-faith effort, including having a formal system for obtaining notice and consent, and the failure is discovered and corrected no later than the due date of the tax return for the year the policy was issued. Consent cannot be corrected after the insured has died.

Annual reporting: Form 8925

Section 6039I, also enacted in 2006, requires reporting. Policyholders that own employer-owned life insurance contracts issued after August 17, 2006 generally must file Form 8925, Report of Employer-Owned Life Insurance Contracts, with their income tax return for each year they own such contracts. According to The Tax Adviser, the form reports items including the number of employees insured, the number insured under contracts issued after August 17, 2006, the total amount of insurance in force, and whether valid consent was obtained for each covered employee. Businesses should check the current IRS form and instructions, as forms are periodically revised.

Practical summary for the US

US tax law has other provisions, for example concerning corporate alternative minimum tax or state taxes, that may affect specific cases. These are beyond the scope of this article.

Tax treatment in the United Kingdom

UK treatment focuses mainly on whether premiums are a deductible trading expense and, linked to that, whether the payout is taxable as a trading receipt.

The Anderson rules (1944)

The traditional starting point is a statement made in 1944 by the then Chancellor of the Exchequer, Sir John Anderson, in response to a parliamentary question about premiums paid by companies on insurance for employees and directors. As summarised by Wikipedia and by tax commentators, the so-called Anderson rules indicate that premiums are normally treated as deductible and proceeds as trading receipts when:

1. The sole relationship between the business and the insured is that of employer and employee;
2. The insurance is intended to meet loss of profit resulting from the loss of the employee's services; and
3. The policy is an annual or short-term insurance.

Cases where companies insure the lives of directors were said to be dealt with on similar lines. Commentators differ on how much weight the 1944 statement carries today, given later legislation and case law, but it remains a frequently cited reference point.

HMRC's current guidance (BIM45525)

HM Revenue and Customs sets out its view in its Business Income Manual at page BIM45525, "Specific deductions: insurance: employees and other key persons." Based on that page, premiums on a policy taken out by an employer in its own favour to cover the loss of profits from the death, illness, accident or injury of an employee, director or other key person are deductible only if:

• The sole purpose of taking out the insurance is the trade purpose of meeting a possible loss of trading income, not a capital loss; and
• For life policies, the cover is term insurance only, with no other benefits, and the term does not extend beyond the period of the person's usefulness to the company.

The page further states that premiums on whole life or endowment policies, and on critical illness or accident policies that have an investment element, are capital expenditure and not deductible, citing the 1919 case Earl Howe v CIR.

Receipts follow premiums (usually)

According to BIM45525:

• If both conditions are met, the premiums are deductible, and the policy proceeds are treated as trading income: under section 106 of the Income Tax (Trading and Other Income) Act 2005 for unincorporated businesses and section 103 of the Corporation Tax Act 2009 for companies.
• If either condition is not met, the premiums are not deductible and the proceeds are generally not taxed as trading income. However, HMRC notes that whether a receipt is trading income is a separate legal question, so no assurance can be given that it will be excluded. The page cites cases including Simpson v John Reynolds & Co and McGowan v Brown & Cousins.

In other words, UK businesses face a trade-off: claiming a deduction on premiums generally means the payout is taxed; not claiming it generally (though not certainly) means the payout is not taxed as trading income.

Shareholders and personal benefit

A recurring issue in UK practice is the key person who is also a substantial shareholder. Because the "sole purpose" test requires the insurance to be for the trade, commentators and Wikipedia note that if the insured person owns a significant part of the company, the policy may be viewed as partly serving their personal interests, for example by protecting the value of their shares or their family's position. That can put deductibility at risk. Businesses in this position typically seek advice, and some approach their tax office for a view.

Practical summary for the UK

Other countries

Wikipedia briefly notes that in Australia premiums are generally not deductible unless the policy is used specifically for revenue protection, and that proceeds may be taxable and may involve capital gains tax depending on ownership. Treatment varies widely across countries, and local advice is essential.

Lenders and key person cover

Lenders sometimes require life insurance on key people as a condition of a loan, typically taking a collateral assignment of the policy so that the lender is repaid first from any proceeds. In the United States, for example, the Small Business Administration's lending rules for its loan programs have included requirements for life insurance on key individuals in certain situations, and these requirements have changed across successive versions of the SBA's standard operating procedures. Borrowers should check the current requirements with their lender rather than relying on older summaries.

A policy assigned to a lender serves the loan protection purpose. It may not leave the business with any funds to deal with the wider disruption of losing the person, so businesses sometimes hold separate cover for the two purposes.

Advantages and disadvantages

Potential advantages

Drawing on Wikipedia's list and the logic above:

• Liquidity at a critical moment. The business receives cash when it is most likely to need it.
• Confidence for lenders, investors and customers. Knowing the business can survive the loss of a key person may support credit and relationships.
• Time to plan succession. Funds can bridge the gap while the business recruits or restructures.
• Possible tax advantages in some jurisdictions and structures, as discussed above, though these vary and are not available everywhere.
• Possible policy loans on permanent policies that build cash value.
• Support for retention. Some arrangements, particularly where the policy may eventually transfer to the individual, can be used as part of a retention package.

Potential disadvantages

• Cost. Premiums are an ongoing expense and may be high for older or less healthy key people.
• Underwriting limits. Insurers may decline cover, add exclusions or charge more based on health.
• Fixed payout. The sum may not match the actual loss, which may turn out to be larger or smaller.
• Tax complexity. As shown above, the rules depend on details of policy type, ownership, purpose and paperwork. Mistakes, such as failing to obtain US notice and consent before issue, can make proceeds partly taxable.
• No substitute for planning. Insurance provides money, not a successor. Without succession planning, documentation and cross-training, a payout may not save the business.
• Exit issues. If the key person leaves, the business must decide what to do with the policy, and transfers or surrenders may have tax consequences.

Common misconceptions

"Key person insurance protects the key person's family." Generally no. The business owns the policy and receives the money. The key person's family needs separate personal cover or a death-in-service benefit.

"Only very large companies need it." Often the reverse. Large companies typically have deeper management benches and more resources to absorb a loss. Small and medium-sized firms are frequently more dependent on one or two individuals.

"Premiums are always tax-deductible as a business expense." Not in the US, where section 264(a)(1) generally disallows the deduction when the business is a beneficiary. In the UK, deductibility depends on meeting HMRC's conditions, and claiming the deduction generally makes the payout taxable.

"Life insurance payouts are always tax-free." In the US, the general exclusion is limited for employer-owned contracts issued after August 17, 2006 unless specific notice, consent and exception requirements are met. In the UK, key person proceeds can be taxable trading receipts.

"Any policy can be called key person insurance and treated the same way." Policy type matters. In the UK, for example, term-only cover may qualify for deductible treatment, while whole life or investment-linked policies are capital.

"Key person cover and shareholder protection are the same." They overlap in using life insurance, but serve different purposes, pay different parties and are usually taxed differently.

"Once the policy is in place, the job is done." Policies need review. A person's importance changes over time, the business grows or shrinks, and loans are repaid. Cover that was right five years ago may be too high or too low now.

Practical checklist (general education)

The following points summarise the issues discussed above. They are general questions to raise with an adviser, not a recommendation to buy any product.

1. Identify dependency. Who, if lost, would cause significant financial harm, and why?
2. Reduce the dependency where possible. Document processes, share client relationships, cross-train staff and maintain a succession plan.
3. Estimate the financial impact. Consider lost profits, replacement costs and linked debts.
4. Choose the type of cover. Life, critical illness, disability or a combination, and term versus permanent.
5. Decide ownership and beneficiary arrangements deliberately, with tax advice.
6. In the US, complete notice and consent before the policy is issued, and plan for annual Form 8925 reporting where it applies.
7. In the UK, decide on the tax treatment of premiums, bearing in mind HMRC's conditions and the link between deductible premiums and taxable proceeds.
8. Coordinate with other arrangements, such as shareholder agreements, buy-sell funding, loan covenants and employee benefits.
9. Review periodically, especially after changes in the business, the key person's role or applicable law.

Frequently asked questions

Does the key person have to agree to be insured? In practice, yes. Insurers require the insured person's participation in underwriting, and in the US, section 101(j) requires written notice and consent before an employer-owned policy is issued if the business wants to preserve the full tax exclusion for proceeds.

Can a business insure an owner who is not an employee? Often, yes, provided the business has an insurable interest. The tax treatment, however, depends on the relationship and the jurisdiction. In the UK, the Anderson rules and HMRC guidance focus on employer–employee relationships and on whether the insurance has a sole trade purpose, so owner-directors require careful analysis.

What can the business spend the payout on? Generally whatever it needs. The money is not restricted by the insurer. Typical uses include recruiting a replacement, covering lost profits, repaying loans and reassuring creditors. Tax treatment, however, may depend on the original purpose of the policy.

How much does key person insurance cost? It depends on the insured's age, health, smoking status, the amount and type of cover, and the term. There is no standard price. Businesses typically obtain quotes through brokers or insurers.

Can key person insurance cover illness as well as death? Yes. Critical illness, trauma and disability policies are commonly used alongside or instead of life cover, because a key person may survive a serious illness but be unable to work for an extended period.

What happens to the policy if the key person retires or leaves? The business may cancel it, keep it or, in some cases, transfer it to the individual. Each option may have tax consequences that should be checked in advance.

Is key person insurance the same as "COLI" in the US? Key person insurance is one use of company-owned or employer-owned life insurance. The US rules in section 101(j) apply broadly to employer-owned contracts, not only to those described as key person policies.

Is key person insurance legally required? Generally not as a matter of law. However, a lender, investor or contract may require it as a condition of financing or investment.

Summary

Key person insurance addresses a real and often overlooked risk: that a business depends on particular people whose sudden loss would cause financial harm. It works by having the business own a life, critical illness or disability policy on that person and receive the payout. Its value depends on the depth of the dependency, the adequacy of the sum insured and how well the policy is coordinated with succession planning, ownership arrangements and lending.

Tax treatment is a central and complex part of the picture. In the United States, premiums are generally not deductible, and the tax-free status of proceeds from employer-owned policies issued after August 17, 2006 depends on meeting the notice, consent and exception rules of section 101(j). In the United Kingdom, HMRC's guidance links the deductibility of premiums to the taxability of proceeds and confines favourable treatment to term-only cover taken out solely for trade purposes. Elsewhere the rules differ again. For that reason, key person insurance is best approached as part of broader business continuity planning, with professional advice on the specific circumstances.

Sources

• Key person insurance (Wikipedia)
• 26 U.S. Code § 101, Certain death benefits (Cornell LII)
• 26 U.S. Code § 264, Certain amounts paid in connection with insurance contracts (Cornell LII)
• The Tax Adviser (December 2009): Taxability of employer-owned life insurance contracts
• HMRC Business Income Manual BIM45525: Specific deductions: insurance: employees and other key persons
• Johnson, Magee, Nagarajan & Newman (1985). An analysis of the stock price reaction to sudden executive deaths. Journal of Accounting and Economics 7
• University of Michigan Deep Blue record for Johnson et al. (1985)
• Forbes Technology Council (2021): The Risk Of Key Person Dependency For Information
• Coleman Report: Life Insurance Requirements for SBA Loans