Do you need key person insurance?
Businesses are insured against fire and theft, protecting their physical assets. But what about the much more valuable human assets, the people who keep that business going?
If you’re the owner or director of a small business, it is probably highly dependent on you for meeting customer, staff and shareholder obligations.
So what would happen if you suddenly became ill and unable to work for a period of time – or if you died?
That’s where a crucial business insurance policy steps in: key person insurance. But with as few as one in five businesses1 insured this way, not enough are protected.
"Key person insurance is really important for small and medium businesses, where there may be a partnership or a few shareholders," explains Citi’s Head of Insurance Tim Shepherd.
"Not just because that director or partner is the main revenue-earner: it’s often connected with buy-sell arrangements.
Let’s say one partner passes away, and their spouse inherits the share of the firm – but has no interest in being actively involved. Key person insurance enables the surviving partner to take over the firm, and the estate is compensated through the insurance benefit,” explains Tim.
Busting some key person myths
So why aren’t more firms covered? Tim believes professional advice plays a big role here.
“Those who own insurance directly tend to miss this really valuable product. There’s also the prevalent ‘she’ll be right’ attitude – people just don’t realise how necessary it is until they see another business – often a supplier or client – suffer financially from the loss of a key person.”
Many business owners also believe their income protection insurance will take care of this risk. However, that only covers their own income, disregarding the much larger impact on the business - the loss (whether temporary or permanent) of their unique skills and reputation. While they’re out of action, staff still need to be paid, debts need to be covered and customers need to be serviced.
A strategic business hedge
The main benefit of key person insurance is business continuity.
“If the major shareholder also runs the day to day business, it can be catastrophic if they are sick, injured or pass away,” emphasises Tim. “Key person insurance covers a wide range of possible scenarios: cancer, stroke, heart attack or coronary bypass, long-term degenerative diseases and shorter-term illnesses. Until it happens, it can be hard to quantify the impact time out of the business could have.”
The insurance would then provide funds to employ a qualified, experienced manager to run the business – and keep customers and staff happy.
“Accidents can also lead to significant time out of action while rehabilitating,” adds Tim. “They may not be able to return to work for months.”
Revenue or capital?
Key person insurance typically pays a lump sum to the business. But when you’re weighing up your key person insurance options, you first need to decide if you want to that lump sum to cover capital requirements or revenue. You may choose to take out both.
If the business has debt, the priority may be to pay that off first and remove any personal guarantees – that’s where Key Person Capital policies can help.
“For example, let’s say a two partner business has a $1million loan in place for machinery and equipment,” explains Tim. “If you insure each partner for $500,000 for life, TPD and trauma, their share of the business debt could be removed.”
This has an additional benefit to the partner, as SME business debt may be secured against the family home. If they were ill or permanently disabled, they certainly wouldn’t need the additional stress of losing their home to pay off a business debt.
If the business is highly dependent on one person for revenue, that’s when a Key Person Revenue policy is more suitable. The lump sum can be used to cover the cost of replacement staff, and compensate for the resulting fall in sales or profit.
“Key Person Revenue policies could be taken out on any staff member – so if you have an amazing salesperson bringing in half your revenue you may want to manage the risk of their loss to trauma, illness, TPD or death,” says Tim.
“However Key Person Capital policies are usually limited to covering business owners – as they are the ones responsible for business liabilities.”
The ATO treats each element of a key person insurance policy differently – so it’s also important to consider future tax issues.
“Generally, key person capital policy premiums are not tax deductible, but the claimant won’t pay tax on any benefits,” says Tim.
“On the other hand, key person revenue policy premiums are fully tax deductible, while the claim payment is assessed as income. So if the company declares a profit, tax will be payable.”
There may be other tax implications of a claims payment, such as capital gains tax, so it’s worth seeking specialist advice for specific situations.
“If the major shareholder also runs the day to day business, it can be catastrophic if they are sick, injured or pass away”
Check your business is covered for all possible scenarios
Citi has a team of experienced insurance specialists who can advise on key person insurance.
“We also partner with external insurance advisers who understand the issues for small and medium businesses. It’s really important to understand your business needs first.” says Tim.
- 1. http://www.icaew.com/en/archive/library/subject-gateways/risk/business-insurance/small-business-update/key-man-insurance-is-it-for-small-businesses
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