Finding the key to the right type of insurance for SMEs

Ask the average small business owner whether they insure their key people and they’ll probably look at you blankly. That’s because less than half (43 per cent) will have ever even heard of the cover and only one in 14 (7 per cent) taken out life insurance for this purpose, sometimes for all the wrong reasons.

Contrary to a popular misconception, the purpose of key person (contingency) cover is not to help the principals buy out each other’s share of the business in the event one of them dies, suffers a traumatic illness or becomes totally and permanently incapacitated. That’s the domain of business succession (buy/sell) insurance.

While the two insurance strategies share common objectives (that is, to ensure the business stays healthy after losing a key person) and common funding mechanisms (that is, a combination of life, trauma and total and permanent disability [TPD] cover), the purpose of key person is very different to that of business succession.

This in turn impacts everything from the amount of cover that’s required to the most appropriate policy ownership structure and tax treatment of premiums and benefits.

Indeed, one essential difference between the two strategies is that the business owns key person policies and pays the premiums, that is, the key person/estate has no interest or right to the policy, whereas business succession insurance can be structured in numerous ways, for example, self-owned, cross-owned, super or trust ownership.

Business succession insurance is there to protect the interests of the company’s principals by addressing transfer of ownership issues.

Meanwhile, key person insurance protects the business itself by addressing the potential loss of business expertise and associated costs.

Invariably, the sudden loss of a key person via death or disability has a negative financial impact on sales/profits as well as the business’ capital value, goodwill and credit rating.

Depending on the company’s circumstances, key person insurance can be used for the purpose of recovering revenue (e.g, lost profit) or capital (e.g, lost goodwill) — an important distinction for tax purposes that is addressed later.

For most businesses, both key person and business succession are essential considerations — regardless of whether the life/lives insured are one and the same.

Replacing a key person who is also a principal can be a catch 22 situation unless the business has both covers, given the business’ asset value hinges on their successful replacement.

People that matter

The most important asset of most companies is the people, especially those individuals whose special talents, expertise, skills, ideas and drive provide the business with a competitive advantage.

Key person insurance is designed to protect the business should it lose someone who makes such a significant contribution towards the company’s profitability, stability and growth potential.

Who is a key person? An organisation’s key people fulfil many different job descriptions — all of them hard to replace. They can include anyone from the managing director to working directors, financial controllers, computer programmers, specialist engineers, sales managers and other employees with expert skills.

As an example from the sporting arena, many international football clubs insure their star players against illness, injury and incapacity, with the club paying the premium and pocketing any benefit.

And though most small businesses operate on a much smaller scale than the English Premier League, the temporary or permanent loss of a key staff member in a team of two or three senior individuals is likely to be just as sharply felt.

Indeed, the smaller the enterprise, the more likely it is to be dependent on one or a few key individuals.

Likewise, at the big end of town, the unplanned loss of a chief executive officer has a direct influence on a company’s share price, according to the ‘UK Investors in People’ report prepared by the Centre for Economics and Business Research.

The study, which analysed movements in share prices between May 2002 and May 2005 for UK companies with at least one change in chief executive, found that those with unplanned successions (that is, where no replacement was immediately announced to the markets) saw their share prices fall by 2.1 per cent more than their peers with planned succession processes.

A tale of two companies

Businesses that are especially vulnerable to key person risk include those whose owners are ‘the face of the company’ and those whose principals are indispensable, either by virtue of their unique skills/expertise or extraordinary (and often undocumented) input.

The following two case studies from the US demonstrate the difference key person insurance can make to a business’ survival following the death of a key person who is also a company principal.

Mindworks was a successful computer and technical company until its founder and managing director, Bob Dingfield, died suddenly two years ago of a heart attack at age 58.

Former employee Mark Crowe said that while Mindworks had been a strong business before Dingfield’s death, the company’s lack of contingency planning and absence of key person insurance spelt the death knell for the business.

“We figured replacing him would take three people — an instructor, a network administrator and a business manager,” Crowe told a local newspaper after the company’s demise. “And there just wasn’t the capital (to hire them).”

In stark contrast, Kumin Associates, a high-profile US architectural firm with 25-plus employees, is still going strong two years after the death of its principal and namesake, Jon Kumin, following a six-month battle with cancer.

Charles Banister, who joined Kumin Associates in 1984 and has since stepped into Kumin’s shoes as chief executive and principal owner, said restructuring the company and letting clients know the team was still there was the biggest challenge.

“We had key-man insurance,” Banister told Alaska Business Monthly. “That helped quite a bit.”

Kumin’s marketing manager Louise Gire said the company had to overcome a lot of client concern following the death of its principal.

“There were a lot of challenges because of the (uncertainties, such as fears) that Kumin Associates was shutting its doors, merging with other firms, or in financial trouble,” Gire said.

“Jon was the face of the business. Because of this, people, clients, made the assumption that he was in his office doing drawings. It has always been a team effort. Jon was more involved in managing the business as opposed to managing individual problems.”

Revenue versus capital considerations

For tax reasons, the purpose of key person insurance needs to be clearly defined and documented from the outset and reviewed on a yearly basis to ensure that it hasn’t changed.

For example, the purpose may change if the insurance was originally taken out to wipe out a personal guarantee but the loan has subsequently been discharged.

Broadly speaking, key person insurance either needs to be attributed to a revenue purpose (e.g, replacing lost income, compensating for loss of profits and so on) or a capital purpose (e.g, repaying debts, discharging security over a guarantor’s property, compensating for loss of goodwill and so on).

If your client’s business is audited following a claim, the Australian Tax ation Office will not only look at the stated purpose for the insurance in your company records but also the actual use to which the proceeds are put (that is, revenue losses will be reflected in the company’s profit and loss statement, while capital losses will be directly reflected on its balance sheet).

If the main purpose for the key person insurance is revenue, the premium is tax deductible and the proceeds are assessable for term, TPD and trauma benefits.

Whereas if the company takes out insurance for capital purposes, the premium is not tax-deductible.

While term insurance benefits are not assessable, capital gains tax (CGT) will apply to trauma and TPD benefits paid directly to the company (as these proceeds do not receive the CGT concession afforded to life insurance proceeds when received by other than the insured or a defined relative).

That’s an important consideration in situations where small business owners have taken out key man insurance through the company for business succession purposes.

In this situation, grossing up the benefit to reflect the potential CGT liability on disposal of the interest in the business is an option.

If the policy is held for a split purpose (e.g, part revenue/part capital) no part of the premium is deductible.

Marc Fabris is strategic marketing manager, life risk at Zurich Financial Services Australia.