Learn the types of cover available and what's right for you
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
In the case of death, the benefit is used to pay out the key persons family for their shares in the company.
How does key person insurance work?
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.
Consider the cost of losing 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
People who are typically classified as key people include:
- Business partners
- Talented salespeople
- Essential technicians
- Those with lots of connections and business relationships
How to decide who is a key person in your organisation
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
Example of how much a key person will need to contribute
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|
Percentages can vary between different policies. The figures above are not indicative of an all policies and is simple for illustrative purposes.
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?|
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.
- 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.
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|
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.
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