Here's something most small business owners don't think about until it's too late: what happens to your company if your star employee—the one who lands all the big clients, or runs operations, or built your entire product from scratch—suddenly dies? It's uncomfortable to consider, but the statistics are sobering. Roughly 60% of small businesses that lose a key employee close within six months if they don't have financial protection in place. That's where key person insurance comes in.
Think of key person insurance as a financial safety net for your business. It's a life insurance policy your company buys on a critical employee—someone whose death would seriously hurt your bottom line. You pay the premiums, you own the policy, and if something happens to that person, your business gets the payout. Simple concept, but it can mean the difference between surviving a crisis and shutting your doors.
What Is Key Person Insurance and Who Needs It?
Key person insurance (sometimes called key employee insurance or key man insurance) is a type of life insurance policy that protects businesses from the financial fallout of losing someone essential to operations. The "key person" could be a founder, CEO, top salesperson, lead engineer, or anyone whose expertise, relationships, or leadership directly drives revenue and keeps the business running.
This insurance is especially critical for small and medium-sized businesses. When you're a startup or small company with just a handful of employees, losing one person can be devastating. If your chief technology officer is the only one who understands your proprietary software, or your sales director maintains all the client relationships, their sudden death could tank your revenue overnight. Key person insurance gives you the financial breathing room to find a replacement, cover lost income, and keep operations stable during what would otherwise be a catastrophic transition.
Many investors and lenders actually require key person insurance before they'll fund your business. They want assurance that their investment won't evaporate if something happens to the people making the company successful. Industries like technology, healthcare, and finance are the biggest users of this coverage, but any business that depends heavily on specific individuals should consider it.
How Key Person Insurance Actually Works
The mechanics are straightforward. Your business purchases a life insurance policy on your key employee—with their written consent, of course. The company pays the premiums, owns the policy, and is named as the beneficiary. If that employee dies while the policy is active, your business receives the death benefit payout, typically ranging from $1 million to $5 million depending on how much coverage you purchased.
You'll need to decide between term or permanent coverage. Term policies are the most common choice for key person insurance—they last for a specific period (usually 10, 20, or 30 years) with level premiums and provide a death benefit if the employee dies during that term. They're cheaper and simpler. Permanent policies cost more but build cash value that your business can borrow against and last for the employee's entire life, which might make sense if you're insuring a founder who plans to stay with the company long-term.
Many businesses also add disability coverage, which pays out 40-70% of the key person's salary if they become disabled and can't work. This addresses a more common risk—disability is actually more likely than death for people in their working years, and losing a key person to a serious injury or illness can be just as damaging as losing them permanently.
What You Can Use the Money For
One of the best things about key person insurance is the flexibility. The death benefit isn't restricted to specific uses—you can deploy it however your business needs it most. Common uses include covering lost revenue while you search for a replacement, paying recruiting fees and headhunter costs to find someone with similar expertise, hiring temporary workers or consultants to fill the gap, covering ongoing operational expenses like payroll and rent during the transition, paying off business loans or lines of credit that the key person guaranteed, or funding a buyout of the deceased person's ownership stake if they were a partner or shareholder.
In worst-case scenarios, some businesses use the payout to wind down operations gracefully—paying final expenses, settling debts, and distributing remaining assets to owners rather than declaring bankruptcy. That's not ideal, but it's better than leaving vendors, employees, and creditors in the lurch.
How Much Coverage Costs and How to Calculate It
Key person insurance typically runs $50 to $500 per month for every $1 million in coverage. That's a wide range because premiums depend heavily on the insured person's age, health, gender, and lifestyle. A healthy 35-year-old non-smoker will cost far less to insure than a 55-year-old with high blood pressure and diabetes. The coverage amount you choose also matters—more coverage means higher premiums.
So how much should you buy? The rule of thumb is to calculate 5-10 times the person's annual compensation, or estimate the financial impact of losing them. Ask yourself: How much revenue would we lose in the first year without this person? What would it cost to recruit and train a replacement? How much operational disruption would we face? Some businesses use more sophisticated formulas that factor in the person's contribution to profit margins, their role in client retention, or the value of intellectual property they've created.
For context, most small businesses purchase between $1 million and $5 million per key person. A tech startup might insure their lead developer for $3 million. A consulting firm might carry $2 million on each of their three managing partners. It sounds like a lot, but when you consider that losing a top performer could cost you hundreds of thousands in lost contracts and months of scrambling to replace them, the premiums start to look reasonable.
Tax Implications You Should Know
Here's the deal with taxes: the premiums you pay for key person insurance are not tax-deductible as a business expense. The IRS treats them like personal life insurance premiums from a deductibility standpoint. That's the bad news. The good news? The death benefit your business receives is generally tax-free, as long as you set everything up correctly from the start.
To keep the death benefit tax-free, you must get written consent from the key person before purchasing the policy, and you need to file IRS Form 8925 to notify the government about the policy. These are simple steps, but skipping them can result in the payout being taxable, which would significantly reduce its value when you need it most. Work with your accountant or tax advisor to make sure you handle the paperwork properly.
How to Get Started with Key Person Insurance
If you're thinking your business might need this coverage, start by identifying who your true key people are. Look for employees whose death would cause immediate financial hardship—people who generate significant revenue, hold irreplaceable expertise, maintain critical client relationships, or whose leadership keeps everything running smoothly. For many small businesses, that's the founder and maybe one or two other people.
Next, talk to a business insurance agent or financial advisor who specializes in this type of coverage. They can help you calculate appropriate coverage amounts, compare term versus permanent options, and find competitive quotes from multiple insurers. The key person will need to undergo a medical exam and health questionnaire—their health status will determine both whether they're insurable and what the premiums will be.
The global key person insurance market has grown to over $15 billion in 2024 and is projected to reach $26 billion by 2033, reflecting how many businesses now recognize this as essential protection rather than optional coverage. Don't wait until you're trying to secure financing or until a health scare makes you realize how vulnerable you are. The best time to get key person insurance is when everyone's healthy and your business is stable—that's when you'll get the best rates and the smoothest approval process.
Key person insurance isn't about being morbid or pessimistic—it's about being realistic and prepared. Your business worked hard to build what you have. A single unexpected loss shouldn't be able to destroy it. For a few hundred dollars a month, you can protect your company, your employees' jobs, and your own livelihood. That's not just smart business—it's essential risk management.
