What it means
The purpose is corporate, not personal. If a founder, lead engineer or top salesperson dies or becomes critically ill, revenue can fall and lenders can grow nervous at exactly the moment the company has extra costs.
The policy buys time and cash so the business can recruit, reassure customers and keep its banking arrangements intact. Cover is normally written as term life assurance, sometimes with critical illness added, on a named individual with the company as both owner and beneficiary.
Because the company pays and the company collects, the arrangement is different from a death-in-service benefit, which pays the employee's family. Both can exist side by side and cover different risks.
Setting the sum insured is where most of the thinking happens. Common approaches are a multiple of the person's contribution to gross profit, the amount of debt personally connected to them, the cost of finding and settling a replacement, or a straight multiple of salary.
Insurers will usually ask for justification, since they will not write cover far beyond a defensible business need. Lenders often ask for it directly.
Where a loan or an investment depends on one individual, a facility agreement may require cover assigned to the lender for the term of the debt. That requirement alone accounts for a large share of the policies written.
The tax and accounting treatment varies by country and by policy purpose, so it deserves a specific conversation with an accountant. As a general rule, premiums may be deductible when the cover is purely to protect trading profits over a short term, while cover linked to a capital purpose such as repaying a loan or buying shares is treated differently.
Never assume the treatment without checking the local rules.
In practice
Real-world examples
Example 1
A craft distillery borrows $900,000 to build a new still, and the lender makes the facility conditional on $900,000 of key person cover on the founder, assigned to the bank for the loan term.
Example 2
A three-partner architecture practice takes cross-cover on each partner so that if one dies, the payout funds the purchase of that partner's shares from the estate. The arrangement sits alongside a shareholders' agreement setting the valuation method.
Example 3
A logistics software firm insures its chief technology officer for $1,200,000, the estimated cost of an 18-month delay to its product roadmap. When she is diagnosed with a serious illness, the critical illness element funds two senior contract developers.
Think of it
Key person insurance is like the emergency oxygen mask on an aeroplane. You hope you never need it, but if the pressure drops unexpectedly, it provides the vital support required to keep you breathing until stability returns.
Formula
Calculation
A common sizing method is: sum insured = gross profit attributable to the key person x number of years needed to recover. Annual premium = sum insured / 1,000 x rate per $1,000 of cover.
A specialist recruitment firm makes $1,500,000 of gross profit a year, and the board judges that 40% of it depends on the managing partner's client relationships. Attributable gross profit = 40% x $1,500,000 = $600,000.
The board estimates a three-year recovery period to rebuild those relationships, so sum insured = $600,000 x 3 = $1,800,000.
The insurer quotes a rate of $2.40 per $1,000 of cover for a healthy 45-year-old over a ten-year term. Annual premium = $1,800,000 / 1,000 x $2.40 = 1,800 x $2.40 = $4,320, which is $360 a month. Against $600,000 of gross profit at risk each year, that premium is 0.72% of the exposure it protects.Case study
Seen in the real world
This is an illustrative and fictional example. Brightwater Analytics, a 25-person data consultancy, generated $4,000,000 of revenue and $1,600,000 of gross profit, with roughly half of that traced to work won by its co-founder Ana.
The board sized cover at 50% x $1,600,000 = $800,000 a year of attributable gross profit, and chose a two-year recovery period for a sum insured of $1,600,000. The premium came to $5,120 a year at a quoted rate of $3.20 per $1,000 of cover.
When Ana suffered a stroke and stepped back for a year, the critical illness payout covered an interim managing director at $190,000, a business development hire at $145,000 and roughly $700,000 of revenue that lapsed while relationships were rebuilt. In this fictional account the firm survived a year that would otherwise have forced redundancies, at a cumulative premium cost of about $20,000 over four years.
Watch out
Common mistakes
- Assuming the payout goes to the individual's family, when the company owns the policy and receives the proceeds.
- Sizing the cover from salary alone, which usually understates the profit and relationships genuinely at risk.
- Setting the policy up once and never revisiting it, so the sum insured no longer matches a business that has doubled in size.
Questions
People also ask
Is key person insurance the same as death-in-service cover?
No, death-in-service pays the employee's dependants, while key person cover pays the business to absorb the commercial damage.
Are the premiums tax deductible?
It depends on the purpose and on local rules, with short-term trading protection more likely to be deductible than cover linked to loan repayment or share purchase.
Who should be insured?
Anyone whose absence would materially reduce profit or breach a loan condition, which in most small companies is one to three named people.