KEY PERSON INSURANCE IN UNCERTAIN TIMES - Beverley Subban
South Africa becomes a new and different place for businesses already challenged by the ongoing pandemic. The recent unrest and looting of businesses has presented a tipping point for many businesses as to whether they remain sustainably successful or not. Having business continuity plans and implementing best practice in all aspects of the business amid unrelenting change has been a struggle for business owners. They had to rethink the new risks facing their key employees who are integral to the running of their business. Being cognisant of the fact that should these key employees be unable to perform their tasks due to a pandemic related illness, disability or untimely death, the entire business and its employees become at risk of shutting down. Business owners have to now review their insurance portfolios to include Key Person Insurance.
WHAT IS KEY PERSON INSURANCE?
Key Person Insurance also known as Key Man, Key Woman or Key Individual Insurance is a life insurance policy purchased by the business for key employees/persons whom the business’s success depends on- they could be the founder or owner in small businesses or top sales executives and decision makers like directors, managers and business partners in larger ones. If the business is reliant on key employees whose absence will directly affect it’s revenue and inevitably place the remaining employees jobs at risk, then key person insurance becomes a must have.
To establish whether your business would require Key Person Insurance, business owners would have to answer affirmatively to the following:-
- Are the business’s performance, daily tasks and ongoing projects tied to a key employee’s unique skills?
- Would the loss of that key employee trigger a slow down of new or existing business?
- Would the loss of the key employee have an impact on the company brand or reputation?
- Does this key employee bring in the majority of the business and revenue of the business?
- Would this key employee’s loss affect the creditworthiness of the business or lead to a business loan being due?
WHY IS KEY PERSON INSURANCE NEEDED ?
The loss of a key person will constitute a risk for any size of business with the resultant financial pressure that has the trajectory to impact both the welfare of the business and it’s employees.
- There would be loss of income due to specific and specialised knowledge being lost.
- There would be costs incurred to recruit and train a replacement.
- Loss of goodwill as clients will be reluctant to do business with the replacement and venture off to the competition.
- Protects the estate of the key employee- should the key employee have signed surety on credit facilities, the banks are likely to come after the key employee’s estate in the event of death due to the amount of liquidity in the estate and their ability to recover.
- Potential investors insist on Key Person Insurance as a prerequisite.
Key Person Insurance provides a business with the much needed financial security and certainty when a key employee suffers from a critical illness, becomes disabled or dies prematurely.
THE POLICY STRUCTURE OF KEY PERSON INSURANCE
Like with any life insurance policy, Key Person Insurance includes the three generic insurance roles:-
- Owner of the policy- is the business or entity that purchases the policy and pays the premium, also has the right to transfer/sell or change the terms of the policy.
- The Insured- is the key employee whose life is insured and the policy’s death benefit would respond to.
- Beneficiary- is the business or entity that would receive the death benefit in the event of the insured passing on during the period of insurance coverage. This policy is in stark contrast to other life insurance policies in that the business is both the owner and the beneficiary of the policy. The insured key employee is relatively passive in the process but has to be informed of the intent to purchase the insurance coverage and provided with details of the policy. Written consent from the insured is also mandatory before the insurance purchase.
The policy can be structured as follows:-
- Term Life Insurance – this type is used where the business wants to purchase a policy for a fixed number of years, eg. Twenty year period – that is generally tied to a specific date which could be the insured key employee’s retirement date or the time it would take to double the protected skillset. It’s the most cost effective option.
- Permanent or Whole Life Insurance – this type never expires provided the business continues to pay the premiums. It comes with a cash saving value which can be accessed by the business provided the reason falls within the terms of the policy eg. used as collateral to access a loan.
- Disability Insurance – as death is not the only misfortune that can rob the business of the valuable input of a key employee, there is more likelihood of a disability occurring - given the pandemic exposure, the high prevalence of automobile accidents and so forth.
It should be noted that if the business is a solo operation and there are no other employees, key person insurance is not necessary, however a personal life insurance policy becomes essential if there are dependant family members.
Extensions to the Policy
- The option of a salary benefit becoming payable to family members for a predetermined period in the event of the key employee’s death, can be added on.
- Can also be bought as vehicle to buy shares of shareholders of the business.
- Premiums paid by the business can be deducted and may also form part of the remuneration of the key employee.
- Taking care of the liability for signed surety on credit facilities can be a much needed extension to protect the key employee’s estate in the event of death.
As the purpose of Key Person Insurance is to cover an expense – the premiums are tax deductible[the insurance pay out will then be taxable]. There is an option to make premiums non tax deductible and the insurance pay out the same. It becomes essential to structure this aspect properly at the outset as there are capital gains tax and estate duty implications. The effects of cession[eg. Using the policy as security during application of a business loan from the bank] of the policy between the parties can also get complex if the policy is not structured effectively.
WHAT DOES KEY PERSON INSURANCE COVER?
Upon death, disability or serious illness of the insured key employee, the business would receive a lump sum to cover:
- Expensive replacement costs.
- Provides for potential losses like decreased sales or drop in profits while a replacement is being trained.
- To ensure existing or potential client’s contracts are not affected.
- To assist with winding down of a business in an orderly manner, as this fate can be a reality.
HOW MUCH DOES KEY PERSON INSURANCE COST?
The general rule of thumb would be to evaluate the cost of replacing the key employee and comes down to their contribution to the business’s bottom line. Done in consultation with the business owner and accountant. Some insurer’s use the annual salary of the key employee and multiply the amount by 5 or 10. Premiums would also become dependant on the insured key employee’s health and lifestyle.
Employees are the critical asset of any business and ensuring there is business continuity through the purchase of Key Person Insurance is vital to any business’s risk management programme. To retain a key employee’s special skills set, intellect and experience, business owners need to structure the Permanent Life type policy as a benefit plan to reward the insured upon retirement, after a certain number of years or upon a certain level of performance. Most importantly adding a business exchange rider to this type of policy allows the key person insured to be changed should they leave the company or be head hunted by a competitor. Fostering a culture of health and resilience to narrow the gap between lifespan and health span among all employees could prove invaluable.
Off the back of the pandemic and the uncertainty this or any other black swan event may present, Key Person Insurance will ensure continued existence and development of any business.