Keyman Insurance: A Definitive Guide (Updated 2016)

If you’re like most of our clients, you’re a busy business owner running a growing and profitable business.

You have a reliable team of employees who are as passionate as you are about going to work and a work culture that breeds positivity.

But there are one or two employees whom your company heavily relies on.

This might be your co-founder, your head of marketing…

…it might even be you.

Now:

What would happen if you or that person were to die suddenly or become critically ill?

How long would your company survive?

A morbid thought, granted, but it’s one so many businesses overlook…

And it can cost them dearly.

It’s not secret that as a business owner, you need to do everything you can to protect your company.

(If not only for you but your employees, too)

But how do you protect your business from going under in times of death or critical illness?

Keyman insurance.

In this comprehensive article, you’ll learn everything you need to know about keyman insurance.

Specifically:

What keyman insurance is, why you need it and how to find the best price available
The potential tax ramifications to a business that receives proceeds from key man insurance
What you need to know before applying for keyman insurance

Ready?

Let’s get started.

What is Keyman Insurance?

We’ve all been there:

We’re doing everything we can to run and grow our businesses, focusing on the urgent and important activities that come with such a responsibility.

Prospecting, hiring employees and servicing your clients comes at the highest priority…

…and non-urgent but important tasks—like researching keyman insurance—can easily fall by the wayside.

While many business owners are unfamiliar with keyman insurance it’s actually pretty simple.

Keyman insurance (also known as a keyman insurance policy, key person or key employee insurance) is an insurance policy that is taken out by a business to cover an important individual within a business.

This is often a key partner, executive or employee whose life is integral to the day-to-day running of the company and whose death would create substantial financial hardship for everyone involved.

If that key person were to pass away or succumb to illness, but the company had taken out keyman insurance, proceeds from the policy would be paid to prevent irreparable damage to the company.

Keyman insurance is popular with many business owners for an obvious reason: it affords another option other than bankruptcy.

While no amount of money in the world can replace the death of a valued employee, it can buy the peace of mind that your company’s future won’t be affected because of it.

Who Can Be Considered a Keyman?

Anyone in your company can be considered a key person, but generally, key people are individuals whose skills, knowledge, experience or leadership are important to your business’ profitability.

Granted, every individual employed at your company plays some role in how much money is brought in, but generally, keyman insurance will only be taken out by the person who runs the entire operation.

What Can Keyman Insurance Be Used For?

Keyman insurance does more than just protect your company and retain precious employees; it covers many of the costs that are associated with the day-to-day running of a company.

Here are just some of the ways keyman insurance can be used:

Recruitment, selection and training of new employees. We all know how expensive onboarding new employees can be. As Jason Hesse writes in Forbes, “The contrast between hiring just the one employee and hiring when you’re a larger company is striking.” We probably don’t need to tell you that losing a key person is costly, but with keyman insurance, the costs of hiring and retaining a suitable replacement become less of a financial concern.
Covering expenses. A death of a key person can send your company into turmoil. There are daily expenses to cover, bills to pay and debt repayments to be made (the last thing you need at a time of crisis is wolves at the door). With keyman insurance, you’ll have the peace of mind that all the day-to-day running costs of your business are covered, leaving you to get back to what you do best: running and growing your company.
Provides funding for the restructuring of your business. With the passing of a key person, a complete restructuring of a business is often required. And, like recruitment, this can become a costly expense. But with keyman insurance in place, you can secure new partners without the need to shut down your business.
Buy the stock from the deceased owner’s estate. Imagine you’ve co-founded your company and one day, your co-founder becomes incapacitated or worse, passes away. What would his or her surviving family members do with your co-founder’s share of the company? Would they hold onto it, or would they cash it in? Having keyman insurance puts you in a position to compensate them fairly while retaining full ownership of the company you helped build.

The profit your business generates is its lifeline…

…and protecting those profits at all costs is one of the wisest investments you can make.

When Can I Use Keyman Insurance?

Let’s imagine for a moment you’re running a digital marketing agency.

Most of your company’s revenue comes from “John,” your number one salesperson.

This is because John has many valuable connections in the online space and knows how to close the higher-end deals.

Now:

If John was to become critically ill or die suddenly—would your business survive?

This is an uncomfortable question to answer, but it’s one every business owner must consider (especially when your company and your employees’ livelihoods are at stake).

John often generates at least 50 percent of the agency’ sales and is critical to the business’ continued success.

In addition to this possibility, you recognize you need to reward his performance so that he isn’t tempted to leave the company and work for a competitor.

You don’t currently offer a retirement plan for your employees, but you would like to provide John with a supplemental income stream—if he stays with the agency, long-term.

John is currently 40 years old and in very good health.

What would you do?

One solution would be to invest in keyman insurance.

Here’s what that would look like:

You estimate it would take two years for John’s replacement to be trained and build a highly-nurtured pipeline of prospects.

To address your need to reward and retain John, the agency’s legal, tax and financial advisors also draft a formal business agreement for supplemental benefits.

If John should die before receiving any retirement income, the business promises to pay a $500,000 survivor benefit to his beneficiary.

Using the key person life insurance strategy, the agency is able to prepare for the financial challenges which would result if John were to suddenly pass away.

For a manageable annual premium, you would be able to immediately secure the financial stability of your business. Moreover, you would be able to provide a substantial incentive for John to continue working at the agency.

What Types of Keyman Insurance Are There?

There are two basic types of keyman insurance, each covering different areas.

The type of policy that’s the right fit for your business will often depend on what you want to achieve with the policy, and of course, how much budget you have.

That’s why we recommend you speak to a consultant to help decide what’s right for you and your business.

Here’s what you need to know:

Buy-Sell Insurance. Also known as a buy-sell agreement or buyout agreement, buy-sell insurance is a legally binding agreement between co-owners if a business covers the value of shares in their company. It’s mainly used to determine what events will trigger a buyout in the event of death or disability or what price will be paid for a partner’s or shareholder’s interest in the partnership.
Capital Protection Insurance. Imagine your co-founder is the guarantor of a substantial business loan you have outstanding. If he were to die suddenly or become seriously incapacitated, what would you do? How could you shield your company from financial ruin? The answer is capital protection insurance. With it, you could call on the loan to be repaid or put a stop on any further funds being loaned, safeguarding your company from going out of business.

What Are The Advantages of Keyman Insurance?

In addition to protecting your company in the event of death or critical illness and strengthening trust and loyalty among employees in your company, keyman insurance offers a number of overlooked advantages.

These include:

Security at an affordable price. While you can’t prevent events such as the death of a key person in your business, you can mitigate the consequences of such events. And for a modest monthly fee, you can secure the peace of mind that if something bad does happen, you can maintain a certain standard of living and your finances won’t be burdened.
Freedom of choice. Keyman insurance offers the freedom of being in control. With the insurance policy in place, you have the freedom to decide which employees to insure. As mentioned above, anyone who is an asset to your company can be protected

What Does Keyman Insurance Cover?

There are four categories of loss for which keyman insurance can provide compensation:

Loss of revenue. If a key person passes away or becomes ill for an extended period, keyman insurance provides temporary personnel and, if necessary, finances the recruitment and training of a replacement.
Insurance to protect profits. Keyman insurance can be used to offset lost income from lost sales, losses resulting from the delay or cancellation of any business project that the key person was involved in, loss of opportunity to expand, loss of specialized skills or knowledge, and more.
Insurance to protect shareholders or partnership interests. This enables shareholdings or partnership interests to be purchased by existing shareholders or partners. (Note: if you’re a venture-backed startup, most venture capitalist will insist you have keyman insurance before they invest in your company.)
Insurance for anyone involved in guaranteeing business loans or banking facilities. As mentioned above, this covers the guarantor of any outstanding debt in your company. (Note: the value of insurance coverage is arranged to equal the value of the guarantee.)

Is Keyman Insurance Tax Deductible?

(Note: We recommend seeking taxation advice from your accountant before considering keyman insurance as the below statements are a guide only.)

This is a common question we’re asked.

And for good reason:

Tax treatment for keyman insurance varies from country to country.

In Australia, for example, keyman insurance is tax deductible depending on how it’s used.

As per Section 51 of the Income Tax Assessment Act, the following practices are in place:

treat the premiums as non-deductible under section 51 and the proceeds as non-assessable of a life policy is involved
treat the premiums as deductible under section 51 and the proceeds as assessable income if an accident/sickness or term/whole of life policy is involved.

When it comes to paying tax on the benefits received by the beneficiary, the following ruling usually applies:

the claim payment is not taxable if received by the original beneficial owner if a life insurance policy is involved
the claim payment may be subject to capital gains tax (CGT) if the benefits are received by a company or trust for an accident/sickness/life policy
the claim payment is usually not taxable if received by the life insured, spouse or relative for any policy involved

As with any insurance policy, it’s important to understand that keyman insurance has both tax-deductible and non tax-deductible components.

Most businesses either purchase keyman insurance for revenue, capital, or both.

Key person insurance is considered to be bought for revenue purposes if it’s to find a suitable replacement or replace lost income that comes as a result of losing a keyman.

As Finder writes,

Any purpose that ensures continued revenue and profits for the business and any expense that has to be incurred for the successful running of day-to-day business activities that directly result in income are considered as revenue purposes.

On the other hand, if key person insurance is purchased to back a loan you’ve taken out, or to ensure your company debts are repaid, then the Australian Taxation Office might consider the fact that you took out keyman insurance for capital purposes.

Put another way:

If the funds from the key person insurance are NOT used for income generating activities but are instead used to further the company after the loss of its key person, then it’s for capital purposes and the premiums paid for the insurance will NOT be tax deductible.

To clear up the confusion that often comes with identifying whether keyman insurance is deductible or not, we’ve broken it down into two categories below:

When keyman insurance is tax deductible

When it is used to compensate for the loss of profits and revenues of your company or business
When it used to hire and train the replacement of your key person
When it is used to pay the temporary replacement you have employed until a full-time replacement is found
When it is used to pay debts incurred by the loss of your key person

When keyman insurance is NOT tax deductible

When the benefit is used to pay the debts of a key person
When the benefit is used to pay other debts incurred by the loss of the key person
When the value of goodwill is replaced because of the absence of your key person
When lines of credit are replaced guaranteed by your key person

How Much Does Keyman Insurance Cost?

While the cost of keyman insurance varies from one insurance provider to the next, the amount of cover will often be calculated based on the amount of profit a key person brings into the company and the loss that would occur without them.

As with all insurance policies, it’s worth shopping around to get a fair quote. Ask for quotes on $100,000, $250,000, $500,000, $750,000 and $1 million and compare the costs of each. Then, consider how much money your business would need to operate, in the event of a tragedy.

A common question we’re asked is, “How much keyman insurance do I need?”

Here are a few things to consider:

(Note: The figures below are general advice only and have not taken your personal circumstances into consideration. Please seek advice from your accountant or one of our financial planners before deciding the right amount for you)

The size of your business and the cost to replace an employee. You need to consider the size and financial situation of your business operations, but in most cases, you want to insure your key person for as much as you can afford. In Australia, for instance, 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 recruitment and training.
The structure of your business. The structure of your business will obviously influence 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 your business.
Review your cover frequently. Make sure the level of coverage is regularly reassessed to ensure the benefit will be enough to cover the costs during the loss of a key person (especially if you plan to use the benefit to buy back shares from an estate).

What Do I Need to Know Before Applying for Keyman Insurance?

Before you apply for keyman insurance, make sure you:

Know the value of your key person. While it’s difficult to put a value on your own head or that of someone important to the company, you need to estimate their value to determine the level of cover you want to apply for. Consider the value of business that could be jeopardized or lost without that person, the percentage of sales generated by that person and the costs associated with replacing them.
Know whether you need key person insurance. Not every business is eligible for keyman insurance. If, for example, your business already has credit insurance which covers outstanding loans and debt amounts, you might not need keyman insurance. Consult with a financial planner before moving forward with your application.
Know how your business will recover from a loss. Often, keyman insurance applications require business continuation plans as part of their application process. With that in mind, it’s important you create a plan that outlines how your business would continue to operate after the loss of a keyman.

Conclusion

Keyman insurance is not for everyone.

But you shouldn’t dismiss it without doing some research, first.

While it isn’t always convenient, investing in keyman insurance is one of the best ways of protecting your business—and those involved.

To learn how keyman insurance can protect you and your business, contact us for a free quote today.