Life is all about taking risks, as these serious statistics on two of the most widespread diseases in Australia designate. In 2017, cardiovascular disease claimed the lives of 43,477 Australians (Accounting for nearly 30% of all death) (Heart foundation n.d.). One in two Australians are expected to be diagnosed with cancer before age of 85 (Cancer Council 2018). Therefore insurance can be a useful tool to protect against the financial implications of these risks.
Key person insurance is a type of life insurance, which insures the crucial person in a business. In the small business, it is usually an owner (funder) of the business, or perhaps one or two key employees. It is used by both large corporation and small partnership alike.
A key person can include:
- A director, managing director or CEO
- A partner in a partnership
- An employee with an unique skill or technical expertise
- A senior sales manager
Revenue or capital purpose
If a key person is unable to work in the business due to disability or passing away, their absence from this business may impact the revenue or capital of the business, or combination of both.
Key person lump sum cover for revenue purpose
The absence of this key person could have a consequential impact on the revenue of the business. For example, that key person has a unique skill relevant to the business or particular relationships with critical clients. If this happens, business could considerate take the place of lost revenue by:
- Using existing cash reserves, if it has any
- Drawing down from existing loan facilities
- Selling some of the business assets
- Weathering a period of reduced profit
For many businesses, these options might not be possible or even too costly. Based on above reasons, insurance cover can be providing solution and avoiding such risks. 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.
Structure and taxation of key person revenue cover
Insurance policies cover a key person to protect that business against a drop in revenue or sales are generally owned by the business entity or a trust. Concerning taxation, the purpose of insurance is to preserve business revenue, through replacement of lost sales or allocation for increased expenses, the premium is usually tax deductible.
If the business is expected to terminate on the exit of the key person, an insurance policy is not considerable to have a revenue replacement purpose and is therefore not generally tax deductable ( See Income Tax Ruling IT 2434 Income tax: split dollar insurance arrangement). This could frequently be seen in sole trader or one-person incorporated business.
If a business needs to insure the same person for a capital purpose, it could set up a separate policy or cover both needs with the same policy. Through using the same policy, there can be a considerable flexibility, when revenue and deduction needs fluctuate. Nevertheless, only that portion of the premium which related to revenue protection cover is able to be tax deductible. This perspective can be complicated, therefore many financial planners find it manageable to create separate policies when both revenue and debt reduction needs exist.
Key person income cover
In Australia, key person insurance has involved to use lump sum insurance products, such as term life and TPD. It is unfortunate that these policies do not usually inscribe the temporary disablement risk. It is a prime gap to recognise that a temporary disability is statistically probably to occur than a permanent disability or death. The key person is more likely to qualify for payment, as the definition under key person income cover may be more generous than the definition under TPD or death cover.
The absence of a key person caused by temporary disablement can put a business under the same situation as in the event of death or permanent disablement. As there is uncertainty as to when the key person will return to work. This can make business tough to decide whether to hire or train a staff to replace, how to manage and smoothly maintain client relationships, etc.
Key person income policies dissent from traditional business overheads policy in several essential ways. Business overheads policies normally provide cover for certain business expenses incurred during the period of disability. While key person income policies provide monthly benefit which can be used for fixed business expenses and cover lost revenue.
Key person income policy may not be accessible to cover sole trader, however it could cover the key employee of sole trader. As the purpose of key person income insurance is to protect the revenue of the business, and the premiums are tax deductable, the proceeds will be assessed as that of income.
Business overheads cover
Business overheads insurance cover can protect business by providing cash flow when owner is unable to work due to injured or sickness. This cover pays a monthly premium to the business regarding its daily fixed costs, normally for up to 12 months, if the insured person is disabled and unable to work in the business at their full capacity. The premium of business overheads policies are normally tax deductable, the proceeds traded as assessable income to the business.
Key person lump sum cover- capital protection
While at the certain time, businesses may borrow money from a financial institution or a director to provide a business with capital for a major procure, improvement, or to provide a source of working capital.
Loans may include:
- A business overdraft
- A secured loan from a bank
- A loan from a director or business owner
Once a key person of a business is on death, permanent disability or a particular trauma, that business could be facing financial difficulty and may find it tough to meet its loan repayments – a default could result in a demand for a loan to be repaid in full. As another option, the lender may call in the loan if the key person was a guarantor or was specified in the loan agreement.
The principle for debt reduction insurance is to protect the business against its debts and also protect the guarantor to his or her state against any claim over their personal assets.
Lump sum policies can be used to protect the capital value of a business. For example, as loss of a key person could reduce business goodwill, which could affect ability of the business overdraft facilities. Key person insurance proceeds in these situations would provide an alternative source of funding for the business.
How much insurance is needed?
For debt-reduction policies, insurance amount depends on the business owner requirements and the requirements of the lender. It is vital to understand the terms and conditions of the loan contract. The business owner also needs to consider the ability of the business to continue servicing the loan on the death or incapacity of the key person.
The ability of insurance cover normally depends on many factors, such as the size and type of the debt, the credit rating of those debts, etc. GST may be payable on insurance proceeds, in such situations the business needs to consider grossing up the sum insured to account for this tax liability.
Structure and taxation of key person capital cover
GST does not generally apply on term life proceeds, regardless of the ownership structure, unless ownership of the policy as previously changed and consideration was paid for that transfer ( See section 118-300 of the Income Tax Assessment Act 1997 (ITTA 97))
GST legislation applies differently to TPD and trauma insurance proceeds. The GST exemption section 118-37 of the ITAA97 only exempts proceeds on such policies from GST when those proceeds are paid to the life insured, a relative or a trust (where a beneficiary of the trust is the life insurance or a relative).
When a company owns and receives the incomes from a TPD or trauma policy, and that policy is held for a capital purpose, then GST will generally apply.
To avoid such problem, it may be possible to have the TPD cover owned by the life insured themselves, and set a legal agreement, which requires the life insured to pay the income to the lender on behalf of the company. In this respect, the GST proceeds are not immediately subject to GST, however, the arrangement is not without its potential complications
Once assisting a client apply insurance to cover a key person of the business, the purpose of the cover and why they want the amount to be insured need to be provided fully to the underwriter. The more information can be provided in the application, the better. If the insurance is for capital purposes to cover debt for insurance, it may be clearer as to why the cover is needed and how much is needed. If the insurance covers a key person for revenue purpose, the underwriters may want more detailed information, such as what role that person plays in the business.
In order to create the whole picture to the underwriters, it may be helpful to consider the following areas:
- The type of the business
- The insurance is for the owner or partner of the business or an employee
- What could happen to the business if the key person could no longer work in the business (Temporarily or permanently)
- Why the person is the key person
- How long would it take to replace to the key person
- How easy it would be to replace the key person
It can be helpful to speak to an underwriter and explain the client’s situation before applying the cover to get a pre-assessment first. In some complex situations, the underwriter team should be able to provide advice on what exactly information they need to assess an application. This will help to get the application in force sooner.
How much a key person should be insured for?
This may depend on different factors. As a guide, the key person cover could be calculated as:
- The cost and time associated with recruiting and training a replacing person
- The loss of net profit while the replacement is working towards their predecessors’ previous capabilities
- The key person’s income protection to the business’s net worth and profit, taking into account their age and current duties
As another option, the amount should be based on the remuneration of the key person. It may be calculated as somewhere between five to 10 times their earnings, for the purposes of death or TPD cover, and three to five times to their salary for trauma cover.
Furthermore, when a business suffers a capital loss due to the death, disablement, sickness or injury of an individual, key person capital protection may be calculated based on the amount owned or th amount of goodwill which would be affected by the absence of the key person.
Fully understand your clients’ situation and needs
In conclusion, when offering the key person insurance service, spend decent amount of time on understanding your clients’ situations and their business needs. If you are new to provide this type of insurance advices/services, bear in mind that the insurance providers’ underwriting team can assist you further. Maintain a good relationship with them, therefore, will be very helpful down the road.