Contents

• What Is Key Person Life Insurance?
• Features of Key Person Insurance
• How is Key Person Insurance Taxed in Business
• Do You Need Key Person Insurance
• How Much Key Person Insurance is Enough
• How To Apply for Key Person Insurance

Key person insurance is when a business will 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 and in the case of that employee’s death, the company is the beneficiary of the insurance policy. Key person insurance is an important business strategy to follow and even though this type of insurance is relatively new, its benefits to your business shouldn’t be discounted.

Most life insurance companies will 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, in the case of key person insurance that benefit is paid to your company or employer. 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.

What Is Key Person Life Insurance?

Key person insurance is also known as key man insurance and is a life insurance policy taken out by a company on one of their employees. The insured employee is someone who is key to the success of the business and could be an executive, a principal shareholder, a senior scientist or a highly effective salesperson. Small businesses can take out key person insurance too and in this instance the insured is usually the owner of the business or a founding partner.

However, as important as key person insurance is to the ongoing success and running of your business despite a personnel disaster, less than half of all Australian business owners have heard of key person insurance and only 7% have taken out a policy for their business. Losing a key member of staff would be devastating for your business and remaining employees financially, but would also mean the loss of expertise and additional costs to replace the skill base and experience of your employee. To avoid a negative effect on business productivity, sales, profit, capital value and credit rating, an insurance benefit payment should be in place.

Features of Key Person Insurance

When a company takes out a life insurance policy on a key employee, the business pays the premiums and is the beneficiary in the event of that employee’s death. Having insurance in case of the death of a key member of a company can help avert the death of the company itself without the input and expertise of that person. The benefits of a key person insurance policy can be used for:

• The expense of temporarily filling a tem member’s place until a permanent replacement can be found.
• Purchasing shares from the family of the deceased,
• Paying off debts, distributing money to investors and paying severance to employees so the business can be closed down in a proper and professional way.

Having key person insurance gives a company a range of options when a key staff member dies, rather than having to immediately settle for bankruptcy. At the same time, remember that key person insurance is for the benefit of a business, and no payout from the policy goes to the insured’s dependents. So if, for example you are self employed and run a solo business, the features of key person insurance are not as beneficial and you could be better off with personal life insurance to look after your spouse and children if you die.

Key person life insurance insures a business against losses including:

• Those due to an extended period where the key person is unable to work and temporary personnel are required. This can include the recruitment and training costs of a replacement.
• Loss of profits as key person insurance can offset the lost income from lost sales, losses due to the delay or cancellation of business projects, the loss of the opportunity to expand the business and the loss of specialist skills and knowledge.
• 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 as those guarantors are insured where the value of the insurance coverage matches the value of the guarantee.

How is Key Person Insurance Taxed in Business

The best way to structure key person insurance is to have the policy owned by the business or employer of the insured. Then, any insurance benefit in the event of the loss of the key person is paid directly to the business, as the policy owner.

The benefit paid to a business with key person insurance is to cover the revenue and/or capital contribution made by the lost employee. The proceeds of the revenue portion of the policy are tax assessable, and that portion of the insurance premium is tax deductible. However, the proceeds of the policy which are attributable to the capital portion of the policy are generally not tax assessable meaning that portion of the premiums is usually not tax deductible.

Key person insurance needs to be attributed to:

• A revenue purpose. For example, replacing lost income, and compensation for lost profits.
• 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 and benefits paid are assessed for Term, Total and Permanent Disability and Trauma Insurance. 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.

Benefits paid for Term insurance are not assessable, but capital gains tax will apply to Trauma and TPD benefits which are paid directly to the business. Trauma and TPD proceeds do not receive the capital gains tax concession which normally applies to life insurance benefits because they are paid to a party other than an insured or their family.

Do You Need Key Person Insurance

To decide whether you 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, and then determine who those people are. In a small business for example, the key person may be you, the owner, because you are the one who manages every aspect of the company from the accounts, to the employees, to the customers.

A key person must be directly associated with the business and their loss must be seen to cause financial difficulties for the business. This means a key person to insure 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. In some businesses, the entire management team may be integral to success and in this case a key person insurance policy can be purchased for each member of the team, or each owner in a business partnership. Also consider insuring lower level employees who may have built up relationships with important distributors or clients, without whom you could lose those connections.

How Much Key Person Insurance is Enough

When choosing an insurance amount, 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 key person insurance for between $500,000 and $10 million and while they may seem like exorbitant amounts, 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. When choosing a cover amount it is important you strike a balance between what your business budget can afford now, and the amount you will need to short term cash flow in case of a death in the company.

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 contingency plan in place to repay your debts even if the worst does happen because in paying the key person insurance premiums, your business lists the lender as a beneficiary. This allows the bank to collect on some, if not all, of their funds. In addition to compulsory key person insurance, you can extend the cover to list your business as a beneficiary too.

The structure of the business will also determine the amount of key person insurance 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. Also consider any additions you may want to include in your key person insurance policy including disability insurance to help a business manage if a key employee is lost for a short period of time while rehabilitating from an illness or injury.

Also make sure the coverage of a key person insurance policy 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.

How To Apply for Key Person Insurance

In some cases an insurance company will 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 also 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. To help with your calculations, consider the value of projects which 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 loads 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. Putting key person insurance in place is just part of the process of insuring your business against a loss. Make sure you create a plan which 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.