A recent survey found that 97% of businesses that could have key person cover do not have any. Yet losing a key person could cost you the business, or at least a loss of profits, which should be protected.
Even the biggest companies protect their key employees against business financial loss – often for millions of pounds. You don’t need to be the business owner to be a key person – it could be a valuable person in your organisation such as the head of production or design or, more commonly, highly valued salespeople, who fulfil this function. Some financial losses are absorbable by the business. Others need to be specifically covered by ‘key person’ insurance, after assessing the commercial risk.
Below are some of the effects of a business losing one or more key people through death or incapacity, or even retirement.
Direct key person losses
• Profits could fall - especially if the key person was a revenue contributor. It is not only replacing the key person (and the costs of a locum), but also his contacts, know-how, contractual payments and work in progress being lost.
• Costs of immediately having to provide benefits to the key person or their dependants, such as pension benefits or income, at a time when the key person is a taker, not a contributor.
• If the key person had loaned the business money, this would have to be repaid on death (e.g. a director’s loan account).
• If the key person was a party to bank finance, the bank could call in its loan, which could be catastrophic for the business.
The above could largely be covered through life assurance to protect against death; income protection to protect against disability or accident; or critical illness cover to protect against a ‘dread’ disease, such as heart attack, stroke, cancer.
Why companies don’t feel they need key person cover
1. Key people can actually be replaced relatively easily (some can, some can’t).
2. The chances of a catastrophe happening are just too remote in our business (in every business where there are people, risk of death or disability or accident can happen. You stand an 8 times greater chance of disability before age 65 than dying).
3. Key person life cover is too expensive, and disability cover is even more expensive (this is dependent on age and medical fitness. Premiums for younger people will be cheaper. How much are you prepared to spend to save the business?).
4. Key person life cover policy proceeds are taxable, so we need even more cover to fund the tax. (For term policies, the policy proceeds are taxable in the company. For whole of life policies, the proceeds are not taxable – but any policy gains may be taxable).
5. The premiums cannot be deducted from taxable profits (premiums on non-renewable term policies under 5 years’ duration, are generally deductible by the company – however the life assured should hold less than 5% of company equity).
6. How do we find out who is a key person? Many could be ‘key’ in some way (an analysis will show who is really key to the business).
Why key person cover is most necessary
Key person cover:
1. Provides cash at the point it is most needed.
2. Buys important management time to settle the financial affairs of the company.
3. Gives your bank and other lenders comfort so that they do not pursue you.
4. Replaces loss of profits.
5. Enables the company to continue; to replace a key individual; to provide for unseen costs.
6. Allows benefit payments to be made to the individual or his family.
7. Allows succession planning to continue unhindered.
8. Repayment of a director’s loan account to his estate is possible.
It makes good commercial sense to cover the key people in the business. In some cases the policy premiums are deductible to the company, although the policy proceeds are taxable. Many companies do not take out key person cover because: (i) they are unaware of it; (ii) they don’t act until after the catastrophe occurs; (iii) premium costs seen as high; (iv) taxation issues; (v) no forward planning; or (vi) cannot see the benefits of it.
Practical Tip :
1. Where the company owns the key person life and disability policy, premiums can be deductible to the business, thus saving on costs; or,
2. The directors or shareholders could own the policy. Often they combine key person policies with shareholder cover (if directors or shareholders) and then use whole of life policies; the policy proceeds are payable to the surviving shareholders tax free (instead of the business where it may be taxable), who introduce cash to the business thus saving tax and creating flexibility.
3. At the very least get a second opinion from a corporate financial planner on how much key person cover your business requires.
As always, seek independent advice from a suitably qualified and experienced financial adviser.
Tony Granger
