Key Person Insurance
The aim of key person insurance is to compensate the business for losses and facilitate business continuity. Key person insurance does not indemnify the actual losses incurred but compensates with a fixed monetary sum as specified on the insurance policy.
An employer may take out a key person insurance policy on the life or health of any employee whose knowledge, work, or overall contribution is considered uniquely valuable to the company. The employer does this 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 is likely to suffer in the event of the loss of a key person.
There are four categories of loss for which key person insurance can provide compensation:
- Losses related to the extended period when a key person is unable to work, to provide temporary personnel and, if necessary to finance the recruitment and training of a replacement.
- Insurance to protect profits. For example, offsetting lost income from lost sales, losses resulting from the delay or cancellation of any business project that the key person was involved in, loss of opportunity to expand, loss of specialised skills or knowledge.
- Insurance to protect shareholders or partnership interests. Typically this is insurance to enable shareholdings or partnership interests to be purchased by existing shareholders or partners.
- Insurance for anyone involved in guaranteeing business loans or banking facilities. The value of insurance coverage is arranged to equal the value of the guarantee.
Who can be a key person?
A key person can be anyone directly associated with the business whose loss can cause financial strain to the business. For example, the person could be a director of the company, a partner, a key sales person, key project manager, or someone with specific skills or knowledge which is especially valuable to the company.
Many business operators who carry on business with others may not necessarily appreciate the legal and emotional difficulties that will arise when partnerships end or cannot continue because of death or disability. In most cases no agreement exists to buy-out or sell-out to the remaining partners in the event of death or disability.
Partnership agreements are not comprehensive enough to cover all the needs and requirements of a partnership whether it is individuals, companies, trusts, or unit trusts.
Buy-sell agreements ensure that business operators can effectively transfer ownership of the business in the event of death or disability and these agreements have insurances in place like life, trauma, and total and permanent disability. If a partner dies or suffers, a trauma or disability the buy-sell agreement provides for the business to pass to the remaining partner on pre-arranged terms. Buy-sell agreements provide certainty over how to deal with the business assets, by specifying who will acquire the interest and the price formula for that transaction.
An effective buy-sell agreement will deliver the most tax effective payment to the appropriate person when it becomes necessary. However, the tax effectiveness of the outcome can depend heavily on the ownership structure for the insurance. Partners should consider a range of ownership options, including:
- Joint ownership
- Entity-business ownership
- Insurance trust
Where the insured owns the policy, the estate receives the policy proceeds in exchange for the share of the business with the proceeds being generally tax-free.
Problems can arise if the agreement does not the transfer the business. The estate could end up with both the insurance proceeds and the business interest possibly triggering Capital Gains.
As always, you should seek personalised advice from a specialist as no two businesses are the same.