10 May What is key man insurance?
Key man insurance minimises business risk on death or disability. Owning and managing a business is not a task for the faint hearted. Risk and assurance issues are often overlooked, such the death or disability of a key employee, and the death or disability of a shareholder.
Small businesses are often reliant on one or two key individuals. The loss of one through either death or disability would place significant financial pressure on the company. The purpose of key man insurance is to cover this scenario.
Financial pressure will result from the loss of a key person by way of loss of income due to specific knowledge lost, additional costs incurred to recruit and train a replacement, and loss of goodwill as customers may be less inclined to deal with a new incumbent. Key man insurance can help to ease this.
In the event that key individuals have signed surety on credit facilities, their estate is at risk as the bank may call up the facility in the event of death due to the amount of liquidity in the estate and their ability to recover. In this case, it is sensible for the directors to insist on surety cover in event of their death in order to cover their liability.
If the purpose of the key man insurance cover is to cover an expense, then the premiums should be deducted from tax, and any death payouts will be taxable.
A key man insurance policy is usually owned by the company, on the life of an employee, with the proceeds being paid to the company in the event of the employeeâ€™s death or disability. While this is not the only structure available, it will result in the premiums being tax deductible and the proceeds being taxable. Any losses or expenses incurred due to the demise of the key person would usually be tax deductible. An alternative would be to make the premiums non-deductible, making the proceeds non-taxable. It is important that these are structured properly at the outset, as there are also capital gains tax and estate duty implications if you get it wrong. The effects of cession of these policies between parties can also become complex. A financial advisor should discuss the merits with you on a case-by-case basis, and help you structure the policies correctly.
The purpose of the buy-and-sell policy is completely different. Business owners often have the majority of their wealth tied up in their businesses. They need to know that in the case of their death, the remaining shareholders will be able to pay a fair value to the deceased estate for the deceasedâ€™s share in the business. As this shareholding may be significant, it may be impossible for the existing shareholders to access sufficient capital at short notice. Without any capital provision, new shareholders may need to be sought in order to purchase the deceasedâ€™s share of the business. This may be against the wishes of the existing shareholders. Buy-and-sell assurance enables existing shareholders to purchase the interest of a deceased or disabled shareholder at a fair value. This ensures business continuity.
There are two parts to a buy-and-sell agreement. One is the insurance policy on the life of the shareholder, and the other is a written agreement between the shareholders setting out the agreement to pay the proceeds to the deceasedâ€™s family or to the disabled shareholder. Besides formalizing the agreement between the shareholders and setting out the intention for the surviving shareholders to purchase and the deceasedâ€™s intention to sell, the agreement also needs to deal with the valuation of the business.
Just like key man insurance (or assurance), buy-and-sell assurance should be structured correctly at the outset. The appropriate level of cover required by each shareholder on the lives of the other shareholders must be calculated based on the shareholding percentages and the valuation of the business. The insurability of the various shareholders and the willingness of all the shareholders to enter into such an agreement need also be considered. A financial planner can facilitate discussion with the shareholders and work with your attorney in drawing up a suitable agreement.
Buy and sell policies can also be structured in various ways but it is most common for the policies to be owned by the various shareholders on each others lives. This means that the premiums are not tax deductible but the proceeds, when received, are tax free and exempt from estate duty. Complications can arise where the shares are not owned by a natural person. The implications should be understood beforehand. You may wish to review your existing arrangements with your professional team.
Ian Beere, CA(SA) CFP® was Financial Planner of the Year in 2007.