What exactly is key person insurance?
Key person insurance (also known as keyman insurance) can be used by a business to insure itself against the loss of key personnel including managers, owners or employees who are integral to the success and profitability of the company. Any company can take out key person insurance on one of their employees. If that employee passes away or is unable to work, the company will receive a benefit from the keyman policy.
Why should businesses consider key person insurance?
With modern business becoming more and more competitive and fast paced, the loss of a key member of staff could be devastating for your business, but to help you recover sooner and remain competitive, key person life insurance is able to fill the void.
Why do life insurance brands offer key person cover?
Most life insurance companies offer a form of key person insurance, as the two policies are very similar. In the case of life insurance a benefit is paid to your dependents or partner if you pass away. In the case of key person insurance, that benefit is paid to your company or employer.
Why should I get key person insurance for my business?
Key person insurance can provide invaluable protection in covering run-off expenses that a business may face following the loss of a worker.
Cost of loosing a key person
- Loss of revenue generated by the key person.
- The cost of sourcing and training new employees
- Disruptions to the management structure.
- The existing business debts of the key person
- Loosing important clients, suppliers and contacts from the key person
What can key person insurance provide?
- Cash flow to replace lost revenue
- Pay for recruitment and training
- Fund the cost of transferring ownership
- Help pay of existing business debts and loans
- Help off-set the loss of key clients, suppliers and contacts
- Business security
What are the other benefits of taking out key person insurance?
- A small business expense: Key person insurance policies can be very affordable. Premiums are also generally tax deductible, or can be paid from a term insurance policy, and the benefits are paid tax-free too.
- Flexibility: You can choose which of your employees you insure as key persons, and cover is generally easy for any company to apply for, often without having to show any financials.
- Good will to keep employees: Since you know your employees are your most important business asset, you want to be doing everything you can to keep them. Therefore, you can use your key person cover as an employee benefit to keep your employees loyal, and reduce the risk of them leaving you for your competitors.
Click to read the case study
Dave, the lead engineer
Elijah was the CEO of AstroRocket Software, a successful company that made customised software for businesses. Elijah worked closely with Dave, his lead engineer and the brains behind all the products, and quickly realised that Dave was a critical a part of every project, and that without him AstroRocket Software would loose the majority of its capability. Elijah considered several keyman insurance policies, and eventually settled on one that pays benefits in the event of Dave’s death, permanent disability or inability to work.
To determine the monthly benefits that would be paid out to AstroRocket Software if Dave wasn’t there, Elijah considered the value of business that would be lost and what it would take to keep things running. He settled on a figure of $40,000 per month if Dave couldn’t work, and a lump sum benefit of ten time Dave’s annual salary in the event of his death or total and permanent disability.
Unfortunately, it wasn’t long before the policy paid out. Dave was injured in a car crash and rushed to hospital. Doctors agreed he wouldn’t be able to work for a three months, and the keyman insurance policy paid out $90,000 in total across those three months. As Dave’s disability was not permanent, this was largely spent on hiring temps and outsourcing to stand-in consultants, and a series of business lunches with disgruntled clients. Dave got back to work after two months, and the benefits stopped, having paid for what they needed to and made sure the business kept on running.
If Dave had passed away in the car crash, then the keyman insurance policy would have paid out the full lump sum of ten times Dave’s annual salary instead of monthly payments, and this money would have been spent on recruiting and training suitable replacements and permanently adjusting to the loss of their key engineer. Fortunately this wasn’t the case, and thanks to keyman insurance AstroRocket Software didn’t go down in flames when its lead engineer did.
To decide whether you may need a key person insurance policy in your business you will need to determine whether there are members of the team without whom the company could not function. Key person's typically include
- The owner of the business. In a small business the key person may be you, the owner, because you are the one who manages all aspect of the company.
- High level employees. In a larger company it could be the director of the company, a partner, a key salesperson, a project manager or anyone with skills or knowledge specific to the operation of the business, and of specific value.
- Some lower level employees. You also might consider insuring lower level employees who may have built up relationships with important distributors or clients, without whom you could lose those connections.
Additionally insurers will require a key person to be:
- A direct associate. A key person must be directly associated with the business.
- A key contributor. Their loss must be seen to cause financial difficulties for the business e.g. how much profit do they contribute to?
What types of criteria need to be met in order to insure a key person?
It's up to both the business and the key person to meet criteria set out by an insurer. Here's an example of what an insurer's eligibility criteria can look like:
|Who?||Criteria for a capital|
|The business entity|
|The key person|
*For a key person who is insured for a revenue purpose
How much must a key person contribute to a business?
Most policies will have a certain level of contribution to the business that key person must make. Depending on whether the key person is an employee or a business owner, contribution is typically in the form of either:
- Gross annual profit
Below is an example of the contribution that could be required with a keyman policy:
|Type of key person||Contribution to gross annual profit||Ownership|
|Business owner||20% to 80%||20 to 80%|
|Employee||20% to 100%||Not required|
Can vary between different policies
Is key person insurance tax-deductible?
This will depend on the purpose of the key person insurance:
- A revenue purpose. For example, replacing lost income, and compensation for lost profits.
- A capital purpose. For example, repaying debts, discharging security over a guarantor's property or compensating for the loss of goodwill.
|Type||Are premiums tax deductible?||Are insurance benefits taxed?||Are the insurance benefits subject to capital gains tax?|
|Conditions||Only for business taxes||Only for business taxes||Benefits are subject to capital gains tax if the recipient is not business, and is not a relative of the key person|
What if the policy is for both revenue and capital purposes
- The capital portion of the policy is generally not tax assessable, meaning that portion of the premium is usually not tax-deductible.
- The revenue portion of the policy is tax assessable, and that portion of the insurance premium is tax-deductible.When a business is audited following a key person insurance claim, the ATO will look at both the stated purpose for the insurance in company records, and how the proceeds of the payout have been put to use. Where the main purpose of key person insurance is to provide revenue in case of a lost staff member, the premiums paid are tax deductible. However, if a company takes out key person insurance to protect against capital losses (to back a loan for example) the premiums are not tax deductible.
The benefit paid to a business with key person insurance is in place to cover the revenue and/or capital contributions that will no longer be made by the lost employee. Purpose is determined by what types of business losses will be incurred from loosing the key person.
|Lost revenue||The lead manager on a project is injured and the project is not completed. Service fees are refunded to the client.|
|Recruiting and training||Key person is permanently disabled and needs to be replaced in the interim and long term.|
|Growth||The cost of securing loans to expand the business after a key person is no longer with the business.|
|Lost good will||A key person has developed relationships with clients. Insurance can help pay for free services to help continue relationship with clients|
|Existing debts of the key person||A director has taken out a loan in the businesses name to expand it's warehouse.|
|Ownership transfer||If a key person owns a portion of the business, their ownership can also be bought out.|
When is it determined?
This is done during the application purpose. Key person insurance policies will a section where applicant indicates:
- The purpose
- The amount of cover
- Details of the key person
The owner of the actual policy will depend on the nature of the business and the life insured.
- If the Key Person is a Sole Trader the policy owner would be their spouse or self. Sole traders would need to consider their own policy as the business technically ceases on the death of the sole trader. This is similarly the case for partners.
- If the Key Person is a principal in a one-man company they will be insured by their spouse or by their own policy.
- If the Key Person is an employee of a company (may include director of a company) the policy will be owned by the employer (can include sole trader, partnership, company or trust).
Before you apply for a key person policy
- An insurance company may require a board of directors to pass a resolution, which affirms the purpose of the key person insurance policy.
- The key employee who is being insured must be notified about the policy and agree to the insurance on their life.
- The business then owns the policy, pays the premiums and is the beneficiary in the case of the key person's death.
Before you purchase key person insurance for your business and employees, make sure you:
- Know the value of key persons. It can be difficult to put a price on your own head or that of someone important to the company, but you will need to estimate their value to determine the level of cover you want to apply for. Consider the value of projects that could be lost without that person, the amount of sales generated by that person and the costs associated with replacing them.
- Know whether you need key person insurance. Your business may already have credit insurance which covers outstanding loans and debt amounts. If this is the case, your business may not need the additional protection of key person insurance.
- Know how your business will recover from a loss. Make sure you create a plan that details how your business would continue to operate after a trauma or loss. This will also help you determine whether you need the coverage of a key person insurance policy, and this business continuation plan may be required as part of your insurance application.
How much key person insurance do I need?
- Size of business and cost to replace worker: You should consider the size and financial situation of your business operations, but in most cases it is best to insure your key persons for as much as you can afford. In Australia you can take out cover for between $500,000 and $10 million.They may seem like exorbitant amounts, but think about how much your business would realistically need to survive until a key person could be replaced, and how much would need to be spent on training and orientation.
- Structure of business: The structure of the business will also determine the amount of cover required as you may need to buy back shares in the company from family members of the deceased to ensure you remain in control of the business.
- Review cover frequently: Make sure the level of coverage is regularly reassessed to ensure the benefit will be enough to cover all the costs during the loss of a team member, especially if you plan to use the benefit to buy back shares from an estate.
Is cover required?
- In some cases you will be required to take out key person insurance on those members of your team who are most important to the business before you can be approved for a business loan. In this instance you are showing your lender you have a contingency plan in place to repay your debts even if the worst does happen. In paying the key person insurance premiums, your business lists the lender as a beneficiary, which allows the bank to collect on some, if not all, of their funds.
Still unsure if your business needs key person insurance?
An employee is generally recognised as a key person if the loss of them would result in a significant reduction in the profits of the business during the period following the loss of the insured person. Some things to consider when assessing if your business actually needs cover include:
- Duration of time it would take for the business to have the same profitability that it enjoyed prior to the loss
- Remuneration that would be required to pay for the replacement worker
- The reduction in profit that the business would be likely to experience following the event
- Loss of customers to competitors following the loss
- Training resources required to train the replacement to a level that they would be effective
- Reduction in production while the new replacement is trained
- Loss of loyal customers and brand credibility if orders could not be met
- Loans taken out that may have to be covered following the loss of the person
Frequently asked questions our users have
Q. What can keyman insurance benefits be spent on?
A. Key person insurance benefits are intended to fill the gap left by the absence of your key person. This can take many different forms, including training a replacement or maintaining client goodwill until they return. In the event of a key person’s death, the proceeds can be used to retain ownership of the business and buy the key person’s share of the company from their descendants.
Q. Should I get a policy for each key person, or can I cover them all with one?
A. Both are viable options with their own benefits and downsides and neither is inherently better. It depends on your own needs and circumstances, but the implications may be complex and dependent on the specifics of your business so it is recommended that you contact a key person insurance broker or your business financial adviser before proceeding. Generally you will pay more for an individual policy for everyone, but will have more tailored cover if something happens to one or more of them.
Q. Do keyman insurance policies need medical tests?
A. Typically yes, but not necessarily. Potentially high payouts mean insurers prefer to conduct medical tests for a better understanding of the health risks faced by your key employees, but depending on the nature of your policy this may not always be applicable.
Q. What’s a buy sell agreement and what does it mean for keyman insurance?
A. A buy sell agreement is an arrangement among the board members of a company which determines what will happen to everyone’s share of the company should they pass away, and at what price their shares will be valued at. It automatically ensures appropriate succession procedures are followed, and as a legally binding agreement which must be unanimously passed by all involved board members, it can save a lot of time, money and legal hassle by settling potential disputes before they begin. Without it, the proceeds of a keyman insurance policy may need to be put towards buying the shares back at a negotiable price rather than those dictated by the buy sell agreement.
Q. What’s the difference between capital purposes and revenue purposes?
A. When you take out a keyman insurance policy you will need to earmark revenue for either revenue purposes or capital purposes. Revenue purposes are for when the loss of your keyman has revenue implications such as loss of customers, while capital purposes are for replacing lost business capital value resulting from the loss of the key person, such as buying back their share of the company. You are required to earmark funds for these purposes ahead of time for tax reasons, but if and when the time comes you are able to spend the benefits on either as needed.
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