Key Person Insurance

Key person insurance (sometimes called Key Man Insurance) is life insurance that is taken out to cover the "key person," usually a director, owner, or partner, in a business. It pays a benefit to the company if illness or injury of that "key person" result in losses to the company.

In the case of the death of that key person, the benefit is used to pay out the key person's family for their shares in the company.

Why should I get key person insurance for my business?

Key person insurance proceeds can be used in many ways depending on how your business plans to recover from the loss of the key person.

• It can be used to pay off debts, particularly secured business loans where the company stands to lose important assets if they go unpaid.
• If the business cannot continue without the key person, then the benefits can fund employee severance and liquidation procedures.
• The insurance proceeds are often used to fund the recruitment, training and salary of a replacement. It can even fund extra incentives and employee transfers to help you find a top calibre replacement.
• If a key person passes away, their partner will often inherit equity or their share of the company. To get it back inside the business you will need to buy it off them, usually at market price. This is an essential use of key person insurance when applicable.
• If the provision of your company's goods or services has been disrupted, key person insurance benefits can be spent on giving your customers discounts or incentives to compensate them in the hope they will stay with you through the transition period.

Consider the cost of losing a key person

Who is considered a key person?

People who are typically classified as key people include:

How to decide who is a key person in your organisation

To decide whether you may 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. Key person's typically include

• The owner of the business. In a small business the key person may be you, the owner, because you are the one who manages all aspect of the company.
• High level employees. In a larger company it 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.
• Some lower level employees. You also might consider insuring lower level employees who may have built up relationships with important distributors or clients, without whom you could lose those connections.

Additionally insurers will require a key person to be:

• A direct associate. A key person must be directly associated with the business.
• A key contributor. Their loss must be seen to cause financial difficulties for the business e.g. how much profit do they contribute to?

What types of criteria need to be met in order to insure a key person?

It's up to both the business and the key person to meet criteria set out by an insurer. Here's an example of what an insurer's eligibility criteria can look like:

Who?	Criteria for a capital
The business entity	Has been trading for more than 24 months Has been net-profitable for more than 24 months*
The key person	Contributes to the profitability or capital value of a business Contributes to a percentage of the businesses revenue Owns a certain amount of the business Doesn't fall into a dangerous occupation category

*For a key person who is insured for a revenue purpose

How much must a key person contribute to a business?

Most policies will have a certain level of contribution to the business that key person must make. Depending on whether the key person is an employee or a business owner, contribution is typically in the form of either:

• Gross annual profit
• Ownership

What are buy/sell agreements in key person insurance?

A buy/sell agreement is a legal contract that automatically determines what happens to someone's share of a company if something occurs. Essentially it's an agreement which lists different conditions that might impact a shareholder, such as illness, disability, death, disappearance, insanity and anything else, and then says what happens to their equity if that condition does eventuate.

Consider the example of a company that is equally owned by three directors when one of them dies. Depending on whether or not a buy/sell agreement was in place results in two very different outcomes:

Is a buy/sell agreement in place?	What happens?	What's the outcome?
Yes	When executing the estate, lawyers discover a buy/sell agreement which dictates that if a director dies their shares are automatically bought by the company at 75% of market value. They execute this, and the two surviving board members now have complete ownership in an effortless and cost-effective way.	The key person insurance policy covers this with plenty left over. Because the buy/sell agreement was in place before they took out the key person insurance policy they could even plan for its cost and find a policy to suit.
No	The deceased's family, named as beneficiaries of all assets in the will, divides the shares amongst themselves. To keep ownership within the company the two surviving directors have to negotiate individually with each family member to buy back the shares.	They end up spending a lot of time on it and paying well above market price for the shares. This in turn eats up most of the key person insurance payout.

If you are considering a buy/sell agreement keep these points in mind:

• All shareholders involved in a buy/sell agreement must unanimously agree to its terms for it to apply.
• A buy/sell agreement is not legally required, but is strongly recommended as part of business continuity planning.
• You should consider the merits of a buy/sell agreement when taking out a key person insurance policy as the terms of such an agreement can have an impact on which policy is ideal for you.

How do I choose a key person insurance policy?

• Identify a key person by working out what proportion of the company revenue would be impossible without them. Certain policies might require a key person to meet certain requirements, such as being directly responsible for more than 20% of a company's revenue, but there are no official across-the-board requirements.
• Have a plan for the money in the event of a payout. This plan should detail what the money will be spent on, and will be different depending on who the key person is and what they do. This is a legal requirement because there are different tax implications depending on whether the money is used for revenue purposes or for capital purposes.
• Compare policies according to their limits, exclusions, premiums, benefits payable and other conditions. As a policy that pays in the event of death or serious health events, you can expect key person insurance to have higher premiums for smokers, hazardous occupations, pre-existing conditions and similar risk factors.
• Using an insurance broker, accountant and/or financial adviser is highly recommended for key person insurance policies. They can help you navigate related tax issues.

Is key person insurance tax-deductible?

This will depend on the purpose of the key person insurance:

1. A revenue purpose. For example, replacing lost income, and compensation for lost profits.
2. A capital purpose. For example, repaying debts, discharging security over a guarantor's property or compensating for the loss of goodwill.

Type	Are premiums tax deductible?	Are insurance benefits taxed?	Are the insurance benefits subject to capital gains tax?
Revenue Purposes	Yes	Yes	No
Capital purposes	No	No	No
Conditions	Only for business taxes	Only for business taxes	CGT is applied if the payout is received by anyone other than the policy owner. For TPD and Trauma payouts, CGT does not apply to the life insured or a relative of the insured.

• What if the policy is for both revenue and capital purposes

  • The capital portion of the policy is generally not tax assessable, meaning that portion of the premium is usually not tax-deductible.
  • The revenue portion of the policy is tax assessable, and that portion of the insurance premium is tax-deductible.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. 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.

How is revenue purpose or capital purpose determined?

The benefit paid to a business with key person insurance is in place to cover the revenue and/or capital contributions that will no longer be made by the lost employee. Purpose is determined by what types of business losses will be incurred from loosing the key person.

• Revenue purposes
• Capital purposes

When is it determined?

This is done during the application purpose. Key person insurance policies will a section where applicant indicates:

• The purpose
• The amount of cover
• Details of the key person

Who owns and manages key person insurance policies?

The owner of the actual policy will depend on the nature of the business and the life insured.

• If the Key Person is a Sole Trader the policy owner would be their spouse or self. Sole traders would need to consider their own policy as the business technically ceases on the death of the sole trader. This is similarly the case for partners.
• If the Key Person is a principal in a one-man company they will be insured by their spouse or by their own policy.
• If the Key Person is an employee of a company (may include director of a company) the policy will be owned by the employer (can include sole trader, partnership, company or trust).

Before you apply for a key person policy

• An insurance company may 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 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. Consider the value of projects that 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 loans 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. Make sure you create a plan that 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.

How much key person insurance do I need?

• Size of business and cost to replace worker: 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 cover for between $500,000 and $10 million.They may seem like exorbitant amounts, but 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.
• Structure of business: The structure of the business will also determine the amount of cover 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.
• Review cover frequently: Make sure the level of coverage 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.

Is cover required?

• 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 a contingency plan in place to repay your debts even if the worst does happen. In paying the key person insurance premiums, your business lists the lender as a beneficiary, which allows the bank to collect on some, if not all, of their funds.

Frequently asked questions

• What can keyman insurance benefits be spent on?

  A. Key person insurance benefits are intended to fill the gap left by the absence of your key person. This can take many different forms, including training a replacement or maintaining client goodwill until they return. In the event of a key person’s death, the proceeds can be used to retain ownership of the business and buy the key person’s share of the company from their descendants.

• Should I get a policy for each key person, or can I cover them all with one?

  A. Both are viable options with their own benefits and downsides and neither is inherently better. It depends on your own needs and circumstances, but the implications may be complex and dependent on the specifics of your business so it is recommended that you contact a key person insurance broker or your business financial adviser before proceeding. Generally you will pay more for an individual policy for everyone, but will have more tailored cover if something happens to one or more of them.

• Do keyman insurance policies need medical tests?

  A. Typically yes, but not necessarily. Potentially high payouts mean insurers prefer to conduct medical tests for a better understanding of the health risks faced by your key employees, but depending on the nature of your policy this may not always be applicable.

• What’s a buy sell agreement and what does it mean for keyman insurance?

  A. A buy sell agreement is an arrangement among the board members of a company which determines what will happen to everyone’s share of the company should they pass away, and at what price their shares will be valued at. It automatically ensures appropriate succession procedures are followed, and as a legally binding agreement which must be unanimously passed by all involved board members, it can save a lot of time, money and legal hassle by settling potential disputes before they begin. Without it, the proceeds of a keyman insurance policy may need to be put towards buying the shares back at a negotiable price rather than those dictated by the buy sell agreement.

• What’s the difference between capital purposes and revenue purposes?

  A. When you take out a keyman insurance policy you will need to earmark revenue for either revenue purposes or capital purposes. Revenue purposes are for when the loss of your keyman has revenue implications such as loss of customers, while capital purposes are for replacing lost business capital value resulting from the loss of the key person, such as buying back their share of the company. You are required to earmark funds for these purposes ahead of time for tax reasons, but if and when the time comes you are able to spend the benefits on either as needed.