Here's something most business owners don't think about until it's too late: what happens to your company if your top salesperson, lead developer, or co-founder suddenly passes away? Not just emotionally—financially. The answer for many businesses is key person life insurance, and it could be the difference between weathering a tragedy and closing your doors.
Key person life insurance (sometimes called "key man insurance," though that term is outdated) is business-owned life insurance that protects your company from the financial fallout of losing someone essential to your operations. Think of it as a financial safety net that gives your business breathing room to recover, find a replacement, and stabilize operations after an unexpected loss.
What Makes Someone a Key Person?
Not every employee needs key person insurance. This coverage is specifically for people whose absence would create serious financial problems for your business. That could be your CEO who built all your client relationships, your CTO who's the only one who understands your proprietary technology, or your top salesperson who brings in 40% of your revenue.
In 2024, businesses allocated approximately $4.2 billion toward key person insurance for executives and $3.8 billion for essential employees, reflecting growing recognition of how vulnerable companies are to losing critical talent. Small and mid-sized businesses are especially at risk because they typically don't have the depth of talent to absorb the loss of a key contributor.
Ask yourself: if this person died tomorrow, would your company lose clients, revenue, or operational capability? Would you need to hire someone urgently at a premium? Would your business loan be at risk? If the answer is yes, they're a key person.
How Key Person Insurance Works
The mechanics are straightforward. Your business purchases a life insurance policy on the key employee, pays the premiums, and names itself as the beneficiary. If that person dies while the policy is active, your company receives a death benefit—typically anywhere from $1 million to $5 million or more, depending on the person's value to your organization.
Here's what that money can cover: recruiting and training a replacement (which can cost 6 to 9 months of the person's salary), covering lost revenue while you rebuild, paying off business debts, reassuring investors or lenders, buying out a deceased partner's share of the business, or simply keeping the lights on during a difficult transition period.
Most businesses opt for term life insurance for key person coverage because it's more affordable than permanent life insurance and aligns with business planning horizons. A typical policy might run for 10, 15, or 20 years, covering the period when that person is most critical to your success.
The Tax Question: What You Can and Can't Deduct
Here's where it gets interesting. Under IRS Section 264(a)(1), you cannot deduct key person insurance premiums as a business expense. You're paying those premiums with after-tax dollars. At first, that sounds like bad news. But there's a silver lining: when you receive the death benefit, it's typically income tax-free for your business.
Think of it as a trade-off the IRS gives you. You can't deduct the premiums, but you get something more valuable in return: a potentially multi-million dollar payout that doesn't get reduced by taxes. For a $2 million policy, that tax-free benefit could save your business $400,000 to $700,000 compared to if it were taxable income.
One important note: for policies issued after August 17, 2006, you need to follow specific IRS notice, consent, and reporting requirements to keep that death benefit tax-free. Make sure you work with an insurance agent who understands these compliance requirements, or you could accidentally create a tax liability.
How Much Coverage Do You Actually Need?
Most businesses use a rule of thumb: 5 to 10 times the key person's annual salary. So if your CTO makes $200,000, you'd typically purchase $1 million to $2 million in coverage. In 2024, this is exactly the range most companies choose for critical executive roles.
But salary is just one factor. You should also consider their contribution to revenue, the cost to replace them, and any business loans that depend on their involvement. Here are three common calculation methods insurance companies use:
The replacement cost method adds up salary, recruiting fees, training costs, and the time it takes to get someone up to speed. For a senior executive, this could easily exceed $500,000 before they're fully productive.
The contributions to earnings method looks at how much profit that person generates. If your top salesperson personally brings in $3 million in annual revenue with a 20% profit margin, they're contributing $600,000 to your bottom line each year. Losing them for even two years could mean $1.2 million in lost profits.
A simple formula many businesses use: add the person's salary to their direct financial contribution, then multiply by at least 5. This gives you a buffer that accounts for multiple years of transition and lost productivity.
What Key Person Insurance Actually Costs
The average cost of key person insurance is about $816 per year, or $68 per month, though this varies widely based on the coverage amount and the insured person's age and health. A healthy 35-year-old might pay $50 to $70 monthly for $1 million in coverage, while a 50-year-old would pay $150 to $200 monthly for the same amount.
Here's how to think about that cost: if you're paying $2,000 a year to protect against a $1 million loss, that's a 0.2% annual cost for substantial protection. Most businesses spend more than that on office snacks. The key person insurance market reached $9.61 billion in 2024 and is expected to grow to $14.3 billion by 2032, showing that more and more businesses see this as a worthwhile investment.
You can typically purchase coverage in increments of $100,000, $250,000, $500,000, or $750,000 up to $1 million, and then in $1 million increments beyond that. This flexibility lets you right-size your coverage as your business and key people's roles evolve.
Getting Started with Key Person Insurance
The process is simpler than you might expect. Start by identifying which employees are truly essential to your business operations. Then calculate how much coverage makes sense using the methods we discussed. The key person will need to undergo a medical exam and consent to the coverage, just like with any life insurance policy.
Work with an insurance agent who specializes in business insurance and understands the compliance requirements for key person policies. They can help you navigate the IRS notice and consent rules, choose between term and permanent life insurance, and structure the policy correctly so the death benefit remains tax-free.
Many business owners put this off because they're busy or uncomfortable talking about death. But here's the reality: you're already taking risks by not having this coverage. If your business couldn't survive losing a key person, you owe it to yourself, your employees, and your family to protect against that risk. The policy is there when you need it most, giving your business a chance to survive a tragedy that would otherwise be financially devastating.
