United States
Hong KongKey person and buy-sell insurance
Key person insurance is owned by the business on an employee whose loss would cost it money, with the business as beneficiary. A buy-sell agreement funds the purchase of a deceased owner's share, either by the other owners individually in a cross purchase or by the business in an entity purchase.
Two business uses of life insurance, and the exam separates them by asking one question: what is the money for? Replacing what the business loses, or buying something the business needs to buy.
Key person insurance
| Role | Who |
|---|---|
| Applicant and owner | The business |
| Insured | The key employee |
| Premium payer | The business |
| Beneficiary | The business |
| Insurable interest | The financial loss the business would suffer |
Every role except the insured sits with the company. The employee consents and receives nothing, and their family receives nothing either, which surprises people who assume that being the subject of a policy must come with an entitlement under it. It does not. That gap is exactly what a stem will test.
The loss being insured is real: lost sales, the cost of recruiting a replacement, credit that was extended because of one person's reputation. Premiums are not deductible to the business, and the death benefit is generally received free of income tax, which is the opposite of what most people assume about a business expense.
Buy-sell agreements
A buy-sell agreement is a contract between owners setting out that when one dies, the others, or the business, will buy their share, and the estate will sell it. Life insurance funds it. Without the funding the agreement is a promise nobody can afford to keep.
| Cross purchase | Entity purchase (stock redemption) | |
|---|---|---|
| Who owns the policies | Each owner on each other owner | The business |
| Who is beneficiary | The surviving owners | The business |
| Number of policies with three owners | Six | Three |
| Who buys the departed share | The surviving owners personally | The business |
| Best suited to | Few owners | More owners, where cross purchase gets unwieldy |
That third row is the standard calculation question and it is the only arithmetic in this heading. Each owner insures every other owner, so with three owners each holds two policies and there are six in total. Add a fourth owner and it goes to twelve. The number climbing fast is the whole argument for entity purchase.
Four partners want a cross purchase buy-sell agreement funded with life insurance. How many policies are required?
- Four
- Eight
- Twelve
- Sixteen
Insurable interest, again
Both arrangements rest on insurable interest existing at inception. A business has it in an employee whose loss would cost it money. Partners have it in one another, because each would have to find the money to buy out the other's share. That is not a technicality here, it is the reason these arrangements are lawful when a policy on a stranger is not.
A key person policy pays the business. If the employee's family is to be protected too, that is a separate policy the employee owns. Stems that describe a grieving family expecting the key person proceeds are testing whether you know who the beneficiary is, and the answer is the company.
Where it sits
- Section
- IV, retirement and other insurance concepts, 8 questions
- Listed as
- Needs analysis, business insurance needs: key person and buy-sell
- Related
- Insurable interest, in sections III and IX
- Also relevant
- Group life, in the same section
The opinion, and the concession
Learn the policy-count formula, because it is the one thing here a stem can ask that cannot be reasoned out on the spot under time pressure. Everything else in this heading falls out of asking who owns the policy and who receives the money. That pair of questions answers key person, cross purchase and entity purchase without any memorization at all.
The concession: the tax treatment of business-owned life insurance is more complicated than the two sentences above, with federal rules on employer-owned contracts that impose notice and consent requirements. Those are not in the outline and we hold no federal tax source, so this page does not go there. If you sell business insurance after licensing, that is training your carrier will provide.
Common questions
Who receives the death benefit on a key person policy?
The business, which is the owner, the premium payer and the beneficiary. The insured employee consents to the coverage and neither they nor their family receives anything from it. Protecting the family requires a separate policy that the employee owns.
What is the difference between cross purchase and entity purchase?
In a cross purchase each owner buys a policy on every other owner and the survivors purchase the departed share personally. In an entity purchase the business owns one policy on each owner and buys the share itself. Cross purchase becomes unwieldy as owner numbers rise.
How many policies does a cross purchase agreement need?
Each owner insures every other owner, so with three owners there are six policies and with four there are twelve. The number rises quickly, which is the practical argument for an entity purchase where the business holds just one policy per owner.
Are key person insurance premiums deductible?
No. The business cannot deduct the premiums, and in return the death benefit is generally received free of income tax. That combination surprises people who expect a business expense to be deductible, and it is the reason the exam asks about it.