Why Businesses Buy Key Person Life Insurance

Which of the following is not a reason for a business to buy key person life insurance? The answer is the choice that does not protect the business itself. A pension deficiency if the key employee dies is not a business reason to buy key person life insurance.

This page explains why. It also gives you a simple test you can use on any answer choice. It is written for business owners, partners, HR and finance managers, and students. It is general education, not advice on your specific situation.

What Key Person Life Insurance Is

Key person life insurance is a life insurance policy a business buys on the life of an owner, director, officer, partner, manager, or key employee, if that person consents in writing before the insurance is purchased. The Insurance Information Institute explains that this coverage compensates a business for financial losses caused by the death or disability of a key employee.

A key person is someone the business would struggle to replace. That might be a person with unique skills, a key client relationship, or the authority to make major decisions. Owners and senior officers often fit this description.

The business owns the policy, pays the premiums, and is the beneficiary. When the insured person dies, the death benefit goes to the business. It does not go to the employee’s family.

That is the main difference from a personal policy. An employee who buys life insurance for a spouse or children owns that policy and names family as beneficiaries. A key person policy protects the company’s finances.

Common Reasons a Business Buys Key Person Coverage

A business buys key person coverage to protect its own finances after a critical person is lost. The common reasons all point back to the company.

• Cash flow disruption. Revenue can drop while the business finds new leaders or wins back clients. The death benefit can help cover payroll, rent, and other bills during that gap.
• Lost sales and profits. A top salesperson may take client relationships with them. The policy can help offset revenue that falls away.
• Recruiting and training. Hiring and training a replacement costs money and time. The proceeds can help pay for that search and the learning curve.
• Lender concerns. When a loan or credit line depends on the business staying stable, a lender may ask how the company would respond to losing a key person.

A good reason answers one question. What does the company lose, and what does it need to keep running?

Spotting the Option That Is Not a Reason

A pension deficiency if the key employee dies is the choice that is not a business reason. Use one test on every answer choice. Does the business own the policy, pay the premium, receive the benefit, and bear the loss?

A pension deficiency is a shortfall between what a pension plan owes and what the plan holds. Funding that shortfall is the plan’s obligation. It is not a loss the company suffers because a key worker has died. So this choice fails the test.

Compare it with a reduction in sales after a key employee dies. The business loses that revenue directly. The business receives the death benefit and bears the loss. That choice passes.

Any answer that makes the employee’s family the purpose of the policy also fails. So does any choice that gives a personal benefit to the employee. Those are personal-policy ideas, not business reasons.

Read every answer choice in full in your course or test materials. Similar options often differ by only a few words, and those words usually decide the answer.

How Employee Death Affects the Business

Losing a key employee hurts the business first. The loss shows up in revenue, specialized knowledge, and relationships.

Work the employee handled may stop or slow down. Orders, projects, or vendor deals can pause while the team regroups.

The employee may also hold knowledge no one else in the company has. Replacing that knowledge takes time, and time costs money.

Customers, suppliers, and lenders often deal with one specific person. When that person is gone, the business has to rebuild trust.

The business bears much of this operational loss. The employee’s family does not run the company. That is why the death benefit goes to the business.

Cash on hand may need to cover payroll and bills while the business stabilizes. How the company uses the death benefit is its own decision.

Who Owns the Key Person Insurance Policy

The business typically owns the policy, pays the premiums, and names itself as beneficiary. The company holds all three roles. That is the structure the exam question tests.

Ownership also matters for federal estate tax purposes. Under 26 U.S.C. § 2042, insurance receivable by beneficiaries other than the executor can count in the gross estate when the decedent held certain incidents of ownership at death. Who holds those rights is a question to review with the facts of your business and family.

Florida adds its own rules. The business may not retaliate against someone who refuses consent.

For the full structure, see our key person insurance guide.

What Affects the Amount and Cost of Coverage

Cost depends on the facts of each case. Insurers review factors such as the insured person’s age, health history, and the amount of coverage requested.

Health questions are part of underwriting. Issue may depend on insurability, so the health review can shape whether and how a policy is issued.

This page does not quote premiums. Actual cost is set through underwriting for the specific person and business.

The coverage amount should reflect the business’s financial impact. Estimate what the company would lose and how long it would need to recover. Using only the employee’s salary can miss lost revenue and replacement costs.

Tax and Cash Flow Questions to Raise Before Buying

Tax treatment depends on the facts of your business. Three rules are worth knowing.

First, for employer-owned life insurance contracts, the tax-free amount generally cannot exceed the premiums and other amounts the business paid.

Second, a business that owns employer-owned contracts must file a yearly return. Under 26 U.S.C. § 6039I, a policyholder that owns one or more employer-owned life insurance contracts issued after the section was enacted must file a return for each year it owns them. The return must show the number of the applicable policyholder’s employees at the end of the year, the number of those employees insured under the contracts at the end of the year, the total amount of insurance in force at the end of the year under the contracts, the name, address, and taxpayer identification number of the applicable policyholder and the type of business in which the policyholder is engaged, and that the applicable policyholder has a valid consent for each insured employee (or, if all such consents are not obtained, the number of insured employees for whom such consent was not obtained) (IRC § 6039I). The business must also keep records to support that filing.

Third, interest on money borrowed to fund premiums can face limits.

Premiums are an ongoing expense. Plan them into the budget alongside payroll and loan payments.

Talk With Nischay Rawal About Your Business’s Situation

You may be reading this because a key employee has died or is seriously ill. A partner’s health may have changed, or a lender may want to see a plan. Those situations are hard, and questions pile up quickly.

Nischay Rawal is a licensed insurance agent in Florida. Under Fla. Stat. § 626.112, no one may act as an insurance agent unless licensed and appointed. Fla. Stat. § 626.112 reads: “(1)(a) No person may be, act as, or advertise or hold himself or herself out to be an insurance agent, insurance adjuster, or customer representative unless he or she is currently licensed by the department and appointed by an appropriate appointing entity or person.” Under Fla. Stat. § 626.9531, when soliciting or selling insurance products, agents must clearly tell prospective insureds that they are acting as insurance agents with regard to the identified insurers, or other risk bearing entities authorized under this code and approved by the office to do business in this state.

Insurance is offered by the licensed agent, separately from the accounting practice. If a commission applies, the firm discloses it in writing, as Fla. Stat. § 473.3205 requires.

To ask about a coverage review for your business, reach out through our contact page.

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