Protect your business financially from the loss of key personnel or employees with 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, whether they be managers, owners or another employee who is 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.
The Best Bits
- Provides cover for the loss of key employees in a business.
- Flexible options and easy application.
- Premiums are generally tax-deductible.
What business expenses can it cover?
Key person insurance can provide invaluable protection in covering run-off expenses that a business may face following the loss of a worker. Such expenses may include:
- Sourcing new employees: The benefit payout can be used to fund the recruitment and training of new staff to replace the key worker who was lost.
- Looking after company finances: Having a lump sum benefit paid to the business means the money can be used to settle loans or other bills and expenses of the company. This means you protect the business' credit rating. You can also use the funds to secure new loans for the business, to help future growth.
- Funding transition: The benefit pay out can be used to help transition a company to new owners, or be used to purchase stock from the family or beneficiaries of the deceased person. The funds can also be used to offer salary continuation for the spouse of the deceased person.
- Business security: As much as you put business systems and practices in place, there is knowledge and expertise, which can only come from the carefully selected and dedicated team members themselves. Without certain team members a business can quickly suffer, but with key person insurance you know your business is protected.
- 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.
- Benefits 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.
Additional expenses that may be covered
- Shareholder and partnership interests where key person insurance allows shareholdings or partnership interests to be purchased by remaining shareholders or partners.
- Guaranteeing business loans or banking facilities.
- Purchasing shares from the family of the deceased.
Who is a key person?
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.
- A key person must be directly associated with the business.
- Their loss must be seen to cause financial difficulties for 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.
- 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.
- 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.
Do I need key person insurance for my business?
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
Who owns and manages key person insurance policies?
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).
What you need to know before you apply for key person insurance
- 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.
Is this kind of insurance 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, so key person insurance needs to be attributed to:
- A revenue purpose (for example, replacing lost income, and compensation for lost profits); and/or
- A capital purpose (for example, repaying debts, discharging security over a guarantor's property or compensating for the loss of goodwill).
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 revenue portion of the policy is tax assessable, and that portion of the insurance premium is tax-deductible.
- The capital portion of the policy is generally not tax assessable, meaning that portion of the premium is usually not tax-deductible.
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