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Key person insurance is a means of protecting a business against the risks of death, disablement or illness to key people. This includes lump sum cover for revenue and capital purposes, key person income cover for temporary incapacity, and business overheads insurance.
No matter how small or large a business is, it will be exposed to a number of risks. These risks could relate to the economy, competition or changing consumer behaviour, and can be hard to control. However, one type of risk a business can have a degree of control over is people risk – that is, the financial impact to a business if a key person dies, becomes disabled or suffers a specific medical condition.
To protect itself against the temporary or permanent loss of a key person, a business can use what is commonly known as ‘key person’ insurance. This is distinct from buy/sell insurance in that it is concerned with protecting the business as an ongoing entity, as opposed to funding the transfer of business ownership.
The facts below remind us of just how risky life can be – and why insurance is an important consideration for many business owners.
One in five families will be affected by the death of a parent, or a serious accident or illness that renders a parent unable to work1.
Cardiovascular disease claimed the lives of 45,392 Australians (nearly 30 per cent of all deaths) in 20152.
One in two men and women are expected to be diagnosed with cancer before the age of 853.
Almost two million adults aged between 25-64 have had a disability4.
In this article, we will explore key person insurance as a means of protecting against these risks, including: lump sum cover for revenue and capital purposes, key person income cover for temporary incapacity, and business overheads insurance.
Who is a ‘key person’?
A key person is someone who is critical to the financial wellbeing of a business through their continued association. Key people play an important role in generating the revenue for the business, and/or obtaining business loans.
Typical examples of key people include:
a director, managing director or CEO;
a partner in a partnership;
an employee with a particular skill or technical expertise; and
a senior sales manager.
There may also be occasions when an external supplier is considered a key person to a business.
Key person lump sum cover – revenue
The death or disablement of a key person could have a significant impact on the revenue of a business and therefore, its ability to meet its day-to-day expenses. If this happens, there are a number of ways that a business might consider replacing lost revenue:
Use existing cash reserves, if any;
Draw down from existing loan facilities;
Sell some of the business assets; or
Weather a period of reduced profit.
For many businesses, these options are sometimes simply not possible or too expensive. For these reasons, insurance cover often represents the only commercially viable solution.
Key person cover for revenue purposes provides a lump sum to the business for the replacement of the revenue lost in the months following the exit of the key person. It is normally established in the form of a Term Life, Total Permanent Disability (TPD) and/or Trauma insurance policy.
Anthony runs a small structural engineering firm, BluePrint Pty Ltd, which provides services to a number of corporate clients and councils. Gary is a key employee of the business and clients rely on him for his technical expertise in solving difficult design problems.
Anthony realises that Gary is critical to the immediate survival of his business and estimates that it would take him 12 months to find and train a suitable replacement if Gary died or became permanently disabled.
Furthermore, Anthony has estimated that if Gary were unable to work, the net profit of the business would fall by $200,000 per annum. This would place the business, and Anthony, under significant financial pressure.
What can Anthony do to protect his business?
Anthony sees his financial adviser and together they calculate the level of protection that Anthony’s business will need:
Annual fall in net profit: $200,000
Cost to hire a replacement: $25,000
Cost to train a replacement: $25,000
Total insurance required: $250,000
Anthony establishes a Term Life and TPD policy over Gary’s life for $250,000. The policy is owned by BluePrint Pty Ltd. If Gary dies or becomes permanently disabled, the insurance proceeds can be used to replace the fall in net profit of $200,000 over the next 12 months, and cover the cost of finding and training a replacement for Gary.
Structure and taxation of key person revenue cover
Insurance policies that cover a key person for the purpose of protecting the business against a fall in revenue or sales are generally owned by the business entity or, for more complex arrangements, a trust (with the business entity as one of the beneficiaries of the trust). Business ownership is often the simplest method of ownership. Where a trust is used, the policy will normally serve a number of business needs, including debt reduction and even buy/sell funding.
With respect to taxation, the purpose of the cover will determine whether the premiums are tax deductible and how the proceeds are taxed. As a general rule, where the purpose of insurance is to protect the revenue of the business, through replacement of lost sales or provision for increased expenses, the premiums will be tax deductible and the proceeds will be assessed as income.
In circumstances where the business is expected to cease on the exit of the key person, an insurance policy is not considered to have a revenue replacement purpose and is therefore not generally tax deductible (see income tax ruling IT2434). This would commonly be seen in sole trader or one-person incorporated businesses.
If a business needs to insure the same person for a capital purpose, for example, for debt reduction, it could either establish a separate policy or cover both needs with the same policy.
By using a single policy, there can be greater flexibility when revenue and debt reduction needs fluctuate; however, only that portion of the premium which relates to revenue protection cover would be tax deductible. As a result, this approach to structuring is often seen as cumbersome.
Therefore, many advisers find it simpler to establish separate policies where both revenue and debt reduction needs exist. Depending on the policy features, the business may be able to increase the sum insured when revenue or debt reduction needs change, within certain limits but without additional underwriting.
Key person income cover
Traditionally, key person insurance cover in Australia has involved the use of lump sum insurance products, such as Term Life and TPD. Unfortunately, these policies do not typically address the risk of temporary disablement.
This is an important gap to acknowledge because a temporary disability is statistically more likely to occur than a permanent disability or death. The key person is also more likely to qualify for payment, as the definition under key person income cover is much more generous than the definition under TPD or death cover.
The absence of a key person due to temporary disablement can place a business under the same significant stress that occurs in the event of death or permanent disablement.
Often there is uncertainty as to when (or if) the key person will return, which makes it difficult for the business to make decisions about whether to hire and train a replacement, how to handle certain client relationships, and general business planning.
Key person income policies differ from the traditional business overheads policy in a number of important ways. Business overheads policies generally only provide cover for certain business expenses incurred during the period of disability. Key person income, on the other hand, provides a monthly benefit which can be used not only for fixed business expenses but also to cover lost revenue.
Structure and taxation of key person income cover
BT’s Key Person Income policy must be owned by the business, and can be used to cover both key person owners and employees.
The policy is not available to cover sole traders, however, it could be used to cover the key employees of a sole trader.
Because the purpose of key person income insurance is to protect the revenue of the business, the premiums are likely to be tax deductible and the proceeds will be assessed as income.
Business overheads cover
Business overheads cover, also known as business expenses cover, allows a business to continue to pay its fixed expenses if one of the business owners becomes sick or injured.
This type of cover pays a monthly benefit to the business, in respect of its day-to-day fixed costs, generally for up to 12 months, if the insured person is disabled and is unable to work in the business at their full capacity.
Insurance policies covering business overheads are generally owned by the business entity, sole trader or partners (in the case of a partnership)
The premiums for business overheads policies are generally tax deductible, and the proceeds treated as assessable income to the business.
Key person lump sum cover – capital protection
At some point, many businesses will borrow money from a financial institution or a director. This may be to provide a business with capital for a major purchase or improvement, or simply to provide a source of working capital.
Such loans could include:
a business overdraft;
a secured loan from a bank; or
a loan from a director.
On death, permanent disablement or a specified trauma event in respect of a key person, a business could experience financial difficulty and may find it hard to continue to meet all of its loan repayments – a default could result in a demand for a loan to be repaid in full. Alternatively, the lender may call in a loan if the key person was a guarantor or was specified in the loan agreement.
The purpose of debt reduction insurance is therefore two-fold: it is used to protect the business against its debts, but also to protect the guarantor and his/her estate against any claim over their personal assets.
Lump sum policies can also be used to protect the capital value of a business. For example, the loss of a key person could diminish the goodwill of the business or affect its credit rating. In the latter case, this could affect the ability of the business to secure credit lines or overdraft facilities. Key person insurance proceeds in these circumstances would give the business an alternative source of funding.
How much insurance is needed?
For debt reduction policies, the appropriate amount of insurance will depend both on the business owner’s requirements and the requirements of the lender. As a first step, it’s important to understand the terms and conditions of the loan contract. For example, the lender may require a personal guarantee and on the death of the guarantor (if there is no substitute), the loan may need to be repaid in full.
The business owner will also need to consider the ability of the business to continue servicing the loan on the death or incapacity of the key person. They will need to decide whether to cover the whole loan facility or only the amount of the facility drawn.
The availability of insurance cover, from an underwriting perspective, will normally depend on a number of factors, including the size and type of the debt, and the credit rating of those debts. It will also depend on whether the borrowers/guarantors for the loan are jointly and severally liable for the debt, and the purpose of the loan – for example, was the loan used to purchase a business or non-business asset.
Finally, capital gains tax (CGT) may be payable on insurance proceeds (see below). In these circumstances, the business will need to consider grossing up the sum insured to account for this tax liability.
Structure and taxation of key person capital cover
Where the purpose of the insurance is to protect the capital of the business, such as to pay out an outstanding loan, the premium will generally not be tax deductible and the proceeds will not be treated as assessable income. CGT may apply to the proceeds depending on the ownership structure. CGT does not generally apply on term life proceeds, regardless of the ownership structure, unless ownership of the policy has previously changed and consideration was paid for that transfer (see ITAA 1997, Section 118-300).
CGT legislation applies differently to TPD and Trauma insurance proceeds. The CGT exemption in ITAA 1997, Section 118-37, only exempts proceeds on such policies from CGT when those proceeds are paid to the life insured, a relative or a trust (where a beneficiary of the trust is the life insured or a relative).
A company is neither of these entities, so when a company owns and receives the proceeds from a TPD or Trauma policy (and that policy is held for a capital purpose), CGT will generally apply.
To avoid this problem, it may be possible to have the TPD cover owned by the life insured, and establish a legal agreement (called a debt reduction agreement), which requires the life insured to pay the proceeds of the policy to the lender on behalf of the company. In this way, the CGT proceeds are not immediately subject to CGT, however, it’s not without its potential complications.
Establishing a debt reduction arrangement can create a ‘right of contribution’, which entitles the insured to be reimbursed for the amount it has paid to the lender. Removing this right can itself create separate CGT consequences.
As an alternative, the insurance policy could be owned by a specifically drafted trust. In this arrangement, the insured would direct the trust to pay the lender on their behalf. While it may be possible to remove CGT consequences entirely by using such trusts, these arrangements can also give rise to negative outcomes, and therefore, require thorough legal and taxation advice.
Key person insurance is simple in principle – it is about protecting a business in the event of the temporary or permanent exit of the people that are critical to its ongoing success.
However, providing high quality advice in this area requires a good understanding of the fundamentals of tax structuring and, where required, referral to appropriately qualified taxation and legal professionals.
If executed correctly, providing clients with advice on business insurance can reap significant rewards for the adviser who wants to specialise in this segment of the market.
The LIFEWISE/NATSEM Underinsurance Report, February 2010. 2. Heart Foundation, www.heartfoundation.org.au/about-us/what-we-do/heart-disease-in-australia 3. Cancer Council, http://www.cancer.org.au/about-cancer/what-is-cancer/facts-and-figures.html 4. AIHW 2011. Australia’s welfare 2011, Australia’s welfare no. 10. Cat. no. AUS 142. Canberra: AIHW
The quiz to earn CPD points is now closed.
1. Where a company owns a term life insurance policy on a key person for revenue purposes, the following tax treatment will apply to the insurance premiums and claim proceeds:
Premiums deductible; proceeds assessable income.
Premiums deductible; proceeds not assessable income.
Premiums not deductible; proceeds not assessable income.
Premiums not deductible; proceeds assessable income.
2. Where a company owns Term Life, TPD and Trauma policies on a key person for capital purposes, the following tax treatment will apply to the insurance premiums and claim proceeds:
Premiums deductible; CGT payable on TPD and Trauma proceeds only.
Premiums not deductible; all proceeds are tax-free.
Premiums not deductible; CGT payable on TPD and Trauma proceeds only.
Premiums are deductible; CGT payable on all proceeds.
3. Mia and Oscar are co-owners of a photography business, valued at $500,000. Mia is the photographer and Oscar does not generate any income but loaned the business $400,000 to start it up. Who could be a key person of the business?
Both Mia and Oscar.
Neither Mia nor Oscar.
4. A policy over which of the following key person would generally not be seen to have a revenue purpose?
A partner in a partnership.
A director of a company.
A sole trader.
A senior sales manager.
5. Which of the following items would typically be covered under a Business Overheads Policy?
The capital amount of a loan.
A fall in business income.
The cost of hiring a replacement employee.
Salaries of non-income producing employees.
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