Succession & Estate

Key-person Insurance as a Deal Mechanism

Use key person coverage the way lenders, buyers and appraisers use it — as collateral, as a valuation offset, and as the thing that keeps a deal alive when the person the deal depends on is gone.

  • Advanced
  • 9 min total
  • 12 chapters

What decision this helps you make: Who to insure, for how much, on what basis, and how to deploy the coverage inside a loan, a sale, or a succession rather than filing the policy and forgetting it.

What this topic is

Key person insurance is a policy owned by and payable to the business on the life — or the continued health — of an individual whose loss would materially damage it. It is distinct from buy-sell funding, which buys out an ownership interest. Key person coverage compensates the enterprise for lost earnings, funds a search and a transition, and reassures the parties whose money is exposed to that person: lenders, buyers, minority investors, and bonding companies.

Why it matters

In most closely held businesses the value is concentrated in one or two people, and every sophisticated counterparty prices that. Lenders write it into covenants and take collateral assignments. Buyers discount for it or hold back escrow. Appraisers apply a key person discount to the valuation itself. Coverage is the mechanism that converts an unpriceable risk into a funded one — and it is routinely sized by a rule of thumb that bears no relationship to the loss it is meant to cover.

Who should learn it

Owners of businesses that depend on one or two people, chief financial officers negotiating credit facilities, buyers and sellers pricing key-person risk in a transaction, and advisers sizing and structuring coverage.

What you will understand

  • Four defensible ways to size the coverage, and why the multiple-of-salary shortcut usually understates the loss
  • The tax mechanics: nondeductible premiums, an excludable death benefit, and the pre-issuance requirements that can destroy the exclusion
  • How lenders, buyers, and bonding companies actually use the policy in documents
  • Why the key person discount in a valuation is offset by coverage — and why the proceeds themselves now add to estate value

Prerequisites

Common misconception

"We have key person insurance — ten times his salary, that should cover it." A multiple of compensation measures what you paid the person, not what their absence costs. If a chief executive personally holds three relationships worth $9M of annual revenue at 18% contribution margin, and replacing them takes two years and a $400,000 search, the loss is not ten times a $300,000 salary. It is the present value of a multi-year earnings gap plus the cost of the transition, and the two numbers routinely differ by a factor of three.