Key business partners discussing work

Key Person Insurance Definition

What is key person insurance? Get a clearer understanding of this less known, but very useful form of life cover and compare quotes.

Key person insurance is a life, trauma and disability insurance policy taken out on the key person in a business. It pays benefits to the company for losses resulting from the death or disability of an important employee. This can be:

  • Disability resulting from accident or illness
  • Inability to work
  • The untimely death of the key person

The loss of a key person can irreparably disrupt a business. Their particular talents or connections might be essential to your company, or their position might be critical and needs to be filled as soon as possible to keep things running.

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How does key person insurance work?

When a company takes out a life insurance policy on its key persons, they pay the premium and are the beneficiary of the policy. If something happens to the key person, key person insurance pays out to the business only, and is for business purposes only. The key person doesn’t personally receive any of the money.

It is also not unusual for business partners to take out key person insurance on each other when starting a venture, as can be seen in the example below which demonstrates how key person insurance can allow a business to continue operating if they lose a vital employee.

CASE STUDY: HOW KEY PERSON INSURANCE SAVED MICHAEL AND PHIL'S BUSINESS FOLLOWING A TRAGIC EVENT

Who is commonly insured as a key person?

People who are typically classified as key people include:

  • Directors
  • CEOs
  • Business partners
  • Talented salespeople
  • Essential technicians
  • Those with lots of connections and business relationships

However, the definition of a key person can often transcend their official titles, and be more related to any employee that the business can't do without, regardless of what their position is.

How do I determine who is a key person in my business?

If you are a business owner trying to decide who to include on a key person insurance policy, some advice would be to:

  • Identify key people by working out what proportion of company profits they are directly responsible for, or would not be possible without them.
  • Ask yourself which employees are missed most when they go on vacation or are sick, whether there’s a single person who deals with most or all of your clients or if there is someone whom you can’t deliver products or services without.
  • Consider the amount of time it would take to find a replacement for vital employees.
  • Think about which employees have skills that are hard to come by or that are in high demand on the current job market (either through education or through experience)?

Why should I consider key person insurance for my business?

Key person insurance proceeds can be used in many ways depending on how your business plans to recover from the loss of the key person.

  • It can be used to pay off debts, particularly secured business loans where the company stands to lose important assets if they go unpaid.
  • If the business cannot continue without the key person, then the benefits can fund employee severance and liquidation procedures.
  • The insurance proceeds are often used to fund the recruitment, training and salary of a replacement. It can even fund extra incentives and employee transfers to help you find a top calibre replacement.
  • If a key person passes away, their partner will often inherit equity or their share of the company. To get it back inside the business you will need to buy it off them, usually at market price. This is an essential use of key person insurance when applicable.
  • If the provision of your company’s goods or services has been disrupted, key person insurance benefits can be spent on giving your customers discounts or incentives to compensate them in the hope they will stay with you through the transition period.

Key person insurance is a way for your business to regain its footing and navigate hard times if it loses an important employee.

What are buy/sell agreements in key person insurance?

A buy/sell agreement is a legal contract that automatically determines what happens to someone’s share of a company if something occurs. Essentially it’s an agreement which lists different conditions that might impact a shareholder, such as illness, disability, death, disappearance, insanity and anything else, and then says what happens to their equity if that condition does eventuate.

Consider the example of a company that is equally owned by three directors when one of them dies. Depending on whether or not a buy/sell agreement was in place results in two very different outcomes:

Is a buy/sell agreement in place? What happens?What's the outcome?
  • Yes
  • When executing the estate, lawyers discover a buy/sell agreement which dictates that if a director dies their shares are automatically bought by the company at 75% of market value.
  • They execute this, and the two surviving board members now have complete ownership in an effortless and cost-effective way.
  • The key person insurance policy covers this with plenty left over.
  • Because the buy/sell agreement was in place before they took out the key person insurance policy they could even plan for its cost and find a policy to suit.
  • No
  • The deceased’s family, named as beneficiaries of all assets in the will, divides the shares amongst themselves.
  • To keep ownership within the company the two surviving directors have to negotiate individually with each family member to buy back the shares.
  • They end up spending a lot of time on it and paying well above market price for the shares.
  • This in turn eats up most of the key person insurance payout.

If you are considering a buy/sell agreement keep these points in mind:

  • All shareholders involved in a buy/sell agreement must unanimously agree to its terms for it to apply.
  • A buy/sell agreement is not legally required, but is strongly recommended as part of business continuity planning.
  • You should consider the merits of a buy/sell agreement when taking out a key person insurance policy as the terms of such an agreement can have an impact on which policy is ideal for you.

How do I choose a key person insurance policy?

  • Identify a key person by working out what proportion of the company revenue would be impossible without them. Certain policies might require a key person to meet certain requirements, such as being directly responsible for more than 20% of a company’s revenue, but there are no official across-the-board requirements.
  • Have a plan for the money in the event of a payout. This plan should detail what the money will be spent on, and will be different depending on who the key person is and what they do. This is a legal requirement because there are different tax implications depending on whether the money is used for revenue purposes or for capital purposes.
  • Compare policies according to their limits, exclusions, premiums, benefits payable and other conditions. As a policy that pays in the event of death or serious health events, you can expect key person insurance to have higher premiums for smokers, hazardous occupations, pre-existing conditions and similar risk factors.
  • Using an insurance broker, accountant and/or financial adviser is highly recommended for key person insurance policies. They can help you navigate related tax issues.

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