As the death or a major accident of a key person will bring a firm with disastrous losses, key person insurance has attracted increasing attention worldwide. But key person insurance is a double-edged sword because it has both positive and negative effects on a firm’s performance. Different from prior papers, this study proposes to capture the two opposite effects of key person insurance by using a microeconomic analysis. The novel contribution of this paper is that besides risk-reducing effects of key person insurance, we find that key person insurance reduces the salaries of employees, output and excepted profit of the firm. More importantly, we illustrate that strong ability of the key person will promote the efficiency of employees. So this paper offers a full evaluation of firms’ purchase behavior of key person insurance and also develops the theory of key person insurance.

Introduction

Key person insurance, also called key man insurance, is an important form of business insurance. It is an insurance policy taken out by a business to protect from financial losses that would arise from the death or extended incapacity of a crucial member of the business. Key person insurance is necessary if the sudden loss of a key executive could have a significant negative effect on a company’s operations. In recent years an increasing number of insurance companies have started to offer key person insurance policies. Key persons have significant effects on a firm’s performance in the short-term. For example, in the case of Baidu.com Inc., owner of China’s most popular internet search site, the company’s shares fell sharply following the death of its chief financial officer (CFO), Shawn Wang, on Dec. 27, 2008. In the two days following his death, the share price fell 4.7%. In another case, when Steve Jobs, the co-founder, chairman and chief executive officer (CEO) of Apple, resigned from the company on Aug. 24, 2011, and then passed away on Oct. 5, 2011, there was a huge shock to the company’s stock (the share price fell 6% on the day after his death), which greatly affected the interests of investors. As we know, these sudden events have considerable effects on firms’ profits, and key person insurance can protect firms’ losses because these losses will be covered by the insurers. Therefore, key person insurance attracts attention from both firms and insurance companies because the risk for the key persons can be eliminated. Very few papers on key person insurance have been published. However, there is a vast literature on the effects of insurance on economic activities in industries and on the economy. For example, in microeconomics, Wang et al. (2017) and Pieper et al. (2015) addressed the effects of insurance on firms’ innovation in improving environmental quality. In industrial economics, competitive relationships between insurance companies and hospitals are discussed by Wang and Nie (2016), and the factors that affect the insurance industry have been confirmed by Biener et al. (2016). In macroeconomics, existing literature focuses on economic growth under insurance (Lee et al., 2016; Courbage and Rey, 2016; Nie, 2007; Eling and Schaper, 2017; Nie et al., 2016; Wang and Nie, 2018). Lee, Chang, Arouri & Lee (2016) recently examined the negative relationship between insurance and growth. Also, Bertrand & Prigent (2016) argued that insurance significantly impacts the equilibrium in portfolios, and they showed that the equilibrium risk-neutral density is equal to the product of a factor corresponding to the total risk tolerance with exogenous insurance constraint. Because life insurance relates to almost everyone, most of the literature highlights the effects of life insurance on human capital (Israelsen and Yonker, 2017; Nie, 2014; Dineen and Allen, 2016). Below we briefly introduce the related research about the effects of life insurance on human capital.