Key Person Disability Insurance – Income Replacement Part 4

Jun 24, 2024 | AEB Insights, Employee Benefits

Key Person Disability Insurance

“Key person disability insurance, sometimes referred to as key man disability insurance or key person replacement coverage”, [1] is a type of insurance that provides financial protection to a business in case a key employee, executive, or business owner suffers a disabling accident, injury, or illness and is unable to work. This type of insurance is designed to help businesses cover the costs associated with losing a key team member. Lost revenue, increased operational expenses, or even the cost of finding and training a replacement. With key person disability insurance in place, businesses can help ensure their financial stability and survival in the event of an unexpected loss.

The insurance pays a cash benefit to the business to help cope with the loss of a significant revenue producer or the short-term loss of a critical talent (someone with a unique skillset).

Key Person: Yes or No?

Not everyone is eligible for Key Person Disability insurance. Policies require that the insured meet a specific Occupation Class (3A, 4A, 5A). But most businesses do have at least one person who impacts the organization in such a manner that even a temporary disability threatens the company’s existence. Most key persons are unique contributors with specialized skill sets or business acumen and can be employers or employees alike.

About This Income Replacement Insights Series:

This is the fourth in a 5-part series of Insight articles to provide more specifics than addressed in our initial Disability Insurance Overview and previous articles in Part 2 about Short Term Disability Insurance and Part 3 on Long Term Disability Insurance.  We will continue with our last in the series in Parts 5.  “Income Replacement” is considered synonymous with “Disability Insurance” but may also be present in some life insurance policies. For the purpose of this Insights series, our focus is on Disability Insurance.  These are the series topics:

  • Disability Insurance Overview – Income Replacement Part 1
  • STD (Short-Term Disability) Insurance – Income Replacement Part 2
  • LTD (Long-Term Disability) Insurance – Income Replacement Part 3
  • Key Person Disability Insurance – Income Replacement Part 4 – you are here
  • Overhead Expense Disability Insurance – Income Replacement Part 5

Can include:

  • Shareholders or Equity Partners
  • Board Members
  • Senior Level Executives
  • Technical and Creative Experts
  • Inventors
  • Software Developers
  • Top Sales Professionals
  • Niche Experts: Architects, Engineers, Physicians/Healthcare Specialists, or Attorneys
  • Business Owners

Cannot include:

  • Contractors, freelance workers, or other nonemployees your business utilizes in its operation (e.g., 1099 recipients)
  • Owners, partners, previous shareholders, or employees who leave the company due to retirement or termination
  • Employees that are not crucial to a business’s operation or revenue
Key Person Disability Insurance - AEB Insights Income Replacement Part 4 - Lady Boss desk 2

How does it work?

  1. A business purchases insurance coverage for a key person, referred to as the “insured.”
  2. The business pays all the premiums.
  3. The business owns the policy.
  4. Should the insured become disabled, the business owns the policy and, on filing an eligible claim, is the recipient of the benefits (versus the insured).

Note: The “insured” Key Person could likely receive independent coverage with STD Insurance (followed by LTD Insurance for a longer disability period).  In this case, the insured would receive all benefits paid by the claim.

Defining disability

Key Person disability insurance benefits are paid based on policy terms but generally require “total disability” to be considered eligible for the claim.

Total Disability is decided solely as due to injury or sickness with all of the following rules:

  1. The Insured, or key person, is unable to perform the substantial and material duties of their job;
  2. The Insured is not working in any other occupation that is comparable by duties and earnings for the Owner;
  3. The requirements of the Claim are satisfied.

Further, many policies require that even with reasonable job or worksite modifications, the insured will still be unable to fulfil their work role. [2]

What determines the coverage amount?

Various factors are considered when deciding on the coverage amount for key person insurance. These include the key person’s income, the costs of finding and training a replacement, and their contribution to the company’s profits. Additionally, the cost of the insurance policy will depend on the elimination period or the waiting period, which starts when the individual becomes disabled. Elimination periods can range from 30 to 365 days; the shorter the period, the more expensive the policy.

How can the benefits be used?

  • Costs of hiring and training a replacement – even if temporary
  • Pay staff overtime for their added workload
  • Business operating expenses, e.g., rent, utilities, or insurance. Many of these expenses could also be covered with Business Overhead Expense coverage (look to Part 5 of this series to learn more).
  • Accounts Payable
  • With a decision to sell or close the business, funding to keep it operational during an interim period.

The benefits received from Key Person disability coverage are usually not considered income to the company, and the premiums paid for the insurance are generally not tax-deductible.

Due to its niche nature, Key Person disability insurance has limited options. The number of carriers that underwrite these policies is limited in comparison to many other forms of insurance. Some businesses and individuals may also explore additional options such as Life Insurance, including Term Life and Permanent Life Insurance policies, to protect their key personnel.

Benefit period

The benefit period refers to the period during which the proceeds are payable under a covered disability. Key-person disability insurance policies cover short-term situations, allowing companies to “buy time” to adjust to contingencies. The benefit period for monthly benefits plans is usually at least six months. Different benefit period options are available depending on the insurance provider. The maximum benefit period for Key Person disability insurance plans, if available by the carrier, is two years. However, the number of providers is quite limited, so there are not as many options available as in other, more competitive types of insurance.

Are there any other options to protect Business Key Persons?

Key Person Disability Insurance has few options because of its niche and limited number of providers. Some businesses or individuals might also explore Life Insurance with two other options: Term Life and Permanent Life Insurance policies.

Conclusion

Key Person Disability Insurance is a type of insurance designed to provide financial protection to businesses in case a key employee, executive, or business owner suffers a disabling accident, injury, or illness and is unable to work. The insurance pays a cash benefit to the business to help cope with the loss of a significant revenue producer or the short-term loss of a critical talent. The above text explains who is eligible for this insurance and how it works, including the definition of disability and what determines the coverage amount. It also details how the benefits can be used and provides information on the benefit period and other options to protect business key persons.


Reference Sources¹

Cited references with some as direct quotes.

  1. What Is Key Person Disability Insurance? | AdvisorSmith.
  2. Know More About Disability Insurance | Key Person Insurance. 

Othe interesting references:


 

Review the following relevant AEB content:

Other Posts in this series as they are published:

  • Disability Insurance Overview – Income Replacement Part 1
  • STD (Short-Term Disability) Insurance – Income Replacement Part 2
  • LTD (Long-Term Disability) Insurance – Income Replacement Part 3
  • Overhead Expense Insurance – Income Replacement Part 5

¹Outbound links all open in a new browser window or tab

Data accuracy effective:  24 June 2024 (laws and statistics can change, and we will endeavor to update when they do)

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