What actually is Key Person Insurance?
In simplistic terms Key Person insurance can best be described as an insurance policy taken out by a business to compensate that business for financial losses that would arise as a result of the death or extended incapacity of a key person involved in the key operations of the business.
Key Person insurance includes a variety of optional benefits such as;
- high degree of certainty to the future;
- business succession planning;
- certainty of equity value;
- agreed funding to purchase the equity;
- continuity of equity value for the surviving spouse;
- funding of re-payments of any capital loans or personal guarantees in the event of a major illness, injury or death of a Key Person or business partner;
- provides funds for recruitment & training of a suitably qualified replacement employee;
- meeting business expenses while the business goes through this transition;
- meeting requirements for bank business loans;
- salary packaging benefits; [dependent on the persons own taxation affairs]
In most cases, Key Person insurance is tax deductable.
Key Person insurance will not usually indemnify a business for actual losses incurred; rather the aim is to compensate the business for losses and facilitate the business’s continuity by putting funds into the hands of the business.
Thus, insuring a key person’s key contribution to a business is the best way to ensure the business’s ongoing viability in the event of that key person’s death or permanent/temporary disablement; in addition, having Key Person insurance provides partners and equity holders a high degree of certainty for succession planning and helps maintain the value of their holdings in the business.
Who is a Key Person?
A key person might be;
- a business’s owner;
- a partner in the business;
- a partner of a professional practice;
- a chief executive officer of a corporation;
- a senior executive of a corporation;
- senior management of a business;
infact; there is no legal definition of "key person" but, for insurance purposes a key person is generally someone in a business whose knowledge, work, or overall contribution is considered uniquely valuable to the company.
i.e; a legal practice’s Principal Partner who is the driving force behind the practice’s ongoing success; which, in the case of that person’s death or incapacity that prevented them from continuing in that role, would cause a material loss to the practice’s income; or
a key person could be a company’s software programmer who has a significant intellectual knowledge that the business relies upon.
In small business especially; it might usually be the case that the key people in the business are the business owners, however, it’s not always the owner of the business that is the only key person/people, for instance it could be a qualified baker in bakery franchise.
Indeed, a drop in revenue is inevitable when a key person is no longer there; think about it –
- who is missed most when on holiday? –
- how long would it take to replace them if they weren’t with you anymore? and,
- how could that be funded?
- what sort of losses would the business suffer meanwhile?
What triggers a Key Person insurance claim?
Essentially, there are two [2] ‘types of loss’ which trigger a Key Person insurance claim; they being,
- the death of the Key Person; and/or
- the incapacity of the Key Person rendering them unable to work in the ‘key’ role insured.
How is a business compensated?
In the event of such a loss [depending on the terms of the Key Person insurance product purchased] most policies will include cover which:-
- pays a previously agreed sum to the remaining business partner(s) to enable them with certainty to purchase the Key Person’s equity/share in the business so as to maintain the business’s continuity and preserve its value;
- pays a sum up to a previously agreed limit directly to the business; to cover the costs of employing temporary personnel, including the costs of their recruitment and training to undertake the Key Person’s role while they remain unable to work; and/or in the event of the Key Person’s death, replace them;
- pays a sum up to a previously agreed limit directly to the business to offset lost income from lost sales and business opportunities; and includes payment for losses resulting from the delay or cancellation of any business project that the Key Person was involved in or directly linked to where as a result of their death or incapacity could not proceed because their particular specialised skills or knowledge were paramount to the project’s success;
- pays a previously agreed sum to a bank or similar financial institution in order to repay any loans for anyone involved in guaranteeing business loans or banking facilities. The value of insurance coverage is arranged to equal the value of the guarantee.
Basically; the cover will not usually extend beyond the period of the key person’s usefulness to the business.
Who can take out Key Person insurance?
Key Person insurance is usually taken out by the key person’s employer which can be a partnership, company or other type of entity that employs or contracts the key person in the key role.
Remember, Key Person insurance compensates the business; it’s not designed to compensate the key person directly because the key person will ordinarily have the option of being covered under other types of insurance including;
- income protection insurance;
- trauma & critical illness cover;
- life insurance; and,
- workers compensation [ie, statutory employee cover]
As mentioned, the employer/partnership takes out Key Person insurance to offset the costs [such as hiring temporary help or recruiting a successor] and losses (such as a decreased ability to transact business until successors are trained) which the employer/partnership is likely to suffer in the event of the loss of a key person being a person whose knowledge, work, or overall contribution to the business/partnership is considered uniquely valuable.
A business can have more than one key person; for instance each partner in a professional practice can be a key person to the practices.
How much Key Person cover is required?
This will be dependant upon the particular business/partnership’s needs and is an area where advice is best sought from a specialist insurance broker such as RGIB who has the experience and product knowledge to ensure clients get the right Key Person cover for their needs.
As an indication, there are a variety of methods including the:
- ‘replacement cost method’ (what the cost is to replace the key person);
- ‘contributions to earnings method’ (percentage of earnings to company revenue);
- ‘multiples of income method’ (current salary multiplied to determine value);
Each business and partnership is different and requires specific consideration prior to determining a suitable amount of cover. Thus, it is not unusual for us to work with a client’s accountant to determine what the best solutions for our client is.
Valuing a Key Employee
In many cases it is hard to put an exact monetary value on how important a key person is to a given business. Most of the requests we receive are based on the amount of funds being borrowed by the company via loan or some other arbitrary amount that was determined by an investor.
The goal when valuing a key person for life and disability insurance is to get the correct amount of coverage based on the specific needs of the business but that also corresponds to the realistic loss associated with the death or disability of the key employee from the insurance company’s viewpoint. For more information about valuing a key employee please click here
Do I need a specialist Insurance Broker to help me take out Key Person insurance?
Yes, you do; because Key Person insurance is a sophisticated product that requires skill and intuity to tailor the cover necessary to meet your objectives.
Most suburban mum and dad type insurance brokers will, if at all, have access to only one or two insurance companies that offer ‘off the shelf’ products aimed at the middle ground so to speak – chances are you’ll pay for cover you won’t need and at the same time won’t get the right level of cover you actually do need.
Some of the things included in our services are;
- analaysing your ‘Key Person insurance requirements;
- calculating the level of cover to suit;
- helping to establish acceptable cover limits for key people;
- liaising with your accountant to get the figures right;
- helping to establish a value on the business/practice;
- helping to formulate Buy/Sell agreements for succession planning;
- negotiating with underwriters to tailor the best insurance cover at the most affordable premium;
- obtaining insurance premium funding;
- helping manage the ongoing Key Person insurance program – annual level reviews as well as at a time of claim to help ensure that the money goes to the right people at the right time.
It’s imperative to have an insurance broker such as RGIB arrange your Key Person insurance so as avoid any unnecessary complications at benefit payment time.
RGIB is Australia's most innovative insurance broker arranging more than AUD$5.5 Billion cover for over 6,000 business, liability & indemnity SME clients.
Specialising in business, public liability and indemnity insurance with Australian and International insurance companies ensuring clients a professional, efficient & fast service at the best available terms.
Is it true Key Person insurance premiums are tax deductible?
Yes, in most countries, premiums paid for Key Person insurance are tax deductable because the cover relates to a business’s risk management. It’s a business purposes insurance cover.
Depending on the Key Person’s and/or the Business’s taxation arrangements, there is the potential to structure the cover for salary packaging benefits; [dependent on the persons own taxation affairs however, this is a matter for an accountant or tax advisor]
Is it true Key Person insurance is a good way of succession planning for a family business?
Family businesses by their very nature are businesses that operate on ‘trust’ between family members.
It is not uncommon for a business to have been established over generations however, as each generation branches off into their own family groups, so too does the equity as the business’s ownership splits and dilutes amongst family members.
Inevitably, some family have a higher degree of expertise in running the business while others sometimes shift off to silent partnerships or perform lower ‘key’ duties within the business.
A lot of people know that splitting up the family’s estate, especially where there are assets with significant ongoing values such as in a business, that the process can be painful, drawn out and result in expensive litigation without the desired result.
By having Key Person insurance, each key person in the business can be identified and valued accordingly; that way, if a key person passes away, the business will be compensated to allow the family members to pay out the deceased partner’s family for their equity share and maintain control of the family business in the simplest and smoothest way.
Are Agreements between business owners and partners important to have?
Absolutely yes - if you have a business partner, and you do not have a written agreement covering succession plans for your business, then quite simply your partnership and equity in the business is at risk.
Without certainty no business can thrive; especially if there is no guarantee of succession and partnership equity transition when the whole business’s worth could be tied up in long drawn out estate claims and settlements.
That’s why it’s vitally important for any business to have in place written agreements to specify how a partner’s equity/shareholding would be transferred, sold and paid for by the surviving partner(s) if a partner dies or is disabled and can no longer work.
Key Person insurance is a key factor in helping the surviving partner(s) pay for the deceased partner’s equity and maintaining control over the business they had built up.
However, if there is no written agreement, then it’s highly likely that the estate of the deceased will automatically receive the shareholding in the business that your partner had. There are past scenarios whereby the estate representatives may seek an immediate payment for the shareholding in the business or they may seek to sell the equity or indeed, wind up the business ultimately taking away from you everything you and your former partner created. For more information about Agreements please click here
How would such an agreement be reached and how does it work?
For the reasons mentioned above a written buy-sell agreement between business partners is crucial.
You will most likely need to engage an accountant to assist in providing a valuation of each partner’s equity; and an ongoing methodology of revaluing the worth of equity as the business worth grows and or other partners come in etc’
Then, you will most likely need to engage a solicitor to assist in drawing up such an agreement; incorporating an ongoing methodology of catering for new partners coming in etc’
Having a written buy-sell agreement incorporated into your Key Person insurance where covering the partnership offers the following benefits:
- fund a Buy/Sell agreement documenting an agreed price
- guarantees the orderly, equitable and certain transfer of ownership
- maintains control of the business for the future
- protects their entitlement to profits and the value of the business; and
- ensures the exiting owner receives fair value for their interest
RGIB’ can help you keep the costs down in drawing these types of agreements because we work with a panel of lawyers and accountants experienced in providing these services at much reduced costs as compared with having it down by a solicitor who is not up on how Key Person insurance works.
Does the business partner buy-sell agreement have to be reviewed annually?
We would suggest that annual reviews would be ideal for any business as it may be the case that the key person’s &/or the partners circumstances have changed. This may include the levels of debt being increased or decreased, the profitability of the business has altered from last year or new key people have been added to the cover.
Is it true Key Person insurance premiums are tax deductible?
One of the initial requirements of effective business succession planning is to obtain an accurate value for the company. Once the value of the business is established, the proper measures to protect the company and its owner’s and shareholders can be identified.
Some of the things taken into consideration when valuing a business are:-
- Some of the typical factors to consider when valuing a business
- general operations of the business
- comparing the business to other similar businesses
- what is the business’s economic outlook?
- what is the business’s earning capacity?
- what is the ‘book value’ of the stock?
- goodwill and other intangible values
To read more about valuing a business for the purposes of considering Key Person insurance please click here Valuing a Business
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