By Crissy De Manuele, Senior Manager - Product Technical, Life Insurance, BT
Running a business means taking all sorts of risks, many of which can be difficult to control: economic ups and downs, increased competition and changing consumer behaviour, to name a few.
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 temporarily or permanently 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. When insurance is used for this purpose, it is to assist with protecting the business as an ongoing entity.
Life can be risky, as these grim statistics on two of the most prevalent diseases in Australia indicate: in 2017, cardiovascular disease claimed the lives of 43,477 Australians (accounting for nearly 30% of all deaths); and 1 in 2 Australians are expected to be diagnosed with cancer before the age of 85.1
Insurance can be used as a means of protecting against the financial implications of such risks. Key person insurance may include lump sum cover for revenue and capital purposes and key person income cover for temporary incapacity. Businesses may also hold business overheads insurance to cover specific expenses of the business such as electricity bills and rental costs.
Who is a ‘key person’?
A key person is someone who is critical to the financial wellbeing of a business through their continued association. A key person may be someone who plays an important role in generating the revenue for the business, they may provide a loan to the business, or make it possible for the business to obtain loans.
A key person can include:
- a director, managing director or CEO;
- a partner in a partnership;
- an employee with a unique 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.
Revenue or capital purpose
If a key person is disabled or passes away, and can no longer work in the business, either temporarily or permanently, their absence from this business may impact either the revenue or the capital of the business, or both. Therefore, it is important to understand the difference between taking out the insurance for revenue purposes or for capital purposes.
Key person lump sum cover – revenue purpose
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. This could occur, for example, where that person has a unique skill or has particular knowledge relevant to the business or has relationships with key clients.
If this happens, a business could consider replacing lost revenue by:
- Using existing cash reserves, if they have any;
- Drawing down from existing loan facilities;
- Selling some of the business assets; or
- Weathering 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.
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. Where this approach is taken, appropriate records should be kept for tax auditing purposes. This approach can be cumbersome.
Many advisers therefore 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 may also be 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 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 policies, on the other hand, can provide 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
Generally, a Key Person Income policy can only be owned by the business, and can be used to cover both key person owners and employees.
The policy may not be 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 to cover business overheads are generally owned by the business entity, sole traders 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 may include:
- a business overdraft;
- a secured loan from a bank; and
- a loan from a director or business owner.
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 or 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, whether the loan was used to purchase a business or non-business asset.
Finally, 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 themselves, 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 the arrangement is 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 is has paid to the lender. Removing this right can itself create separate CGT consequences.
As a separate 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 thorough legal and taxation advice is recommended.
When assisting a client to apply for insurance to cover a key person for a business, underwriters will want to know what the purpose of the cover is for, and why they want the amount of the insurance. The more information you can provide in the application, the better. There is a much better chance that the underwriters will allow the insurance cover if they have the whole picture.
The details of the client’s business and why they want to insure a key person may be included in the statement of advice (SOA) which can then be provided to the underwriters. Otherwise a detailed explanation will need to be provided in the financial questionnaire.
So, prior to completing the application for a client, it is best to spend some time understanding the client’s situation and their business. There needs to be an explanation as to why the cover is needed and why the insured person is in fact, a key person.
If the insurance is for capital purpose to cover debt for instance, it may be more obvious as to why the cover is needed and how much cover is needed. If the insurance is to cover a key person for revenue purpose, the underwriters will want more information as to what role the person plays in the business, particularly if is an employee who they are looking to insure.
When considering applications underwriters want to know the whole picture, so it may help to provide a detailed explanation which includes:
- The type of business;
- Whether the insurance is for the owner or partner of the business or an employee;
- What would happen to the business if the key person could no longer work in the business (either temporarily or permanently);
- Why the person is a key person (for example, they have unique skills or relationships with clients);
- How long would it take to replace the key person; and
- How easy it would be to replace the key person.
It also helps to have a good relationship with the underwriters. Before applying for the cover, it can be beneficial to speak to an underwriter to explain the client’s situation and, in more complex cases, the underwriting team should be able to let you know exactly what information they need to assess an application. If the right information is not provided, additional questionnaires may be required.
How much should a key person be insured for
The amount of insurance required will be determined by a number of factors and will depend on each scenario. However, as a guide, key person revenue cover could be calculated as:
- The cost and time associated with recruiting and training a replacement person;
- The loss of net profit while the replacement is working towards their predecessors’ previous capabilities; and
- The key person’s income in proportion to the net worth and profit of the business, taking into account their age and current duties.
Alternatively, the amount could be calculated based on the remuneration of the key person. For example, this may be calculated as somewhere between five to ten times their salary for the purposes of Death and TPD cover, and three to five times their salary for trauma cover.
Where it is likely that a business loan would be partially (or totally) called in, or the business would suffer 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 owed or the amount of goodwill which would be affected by the absence of the key person. If there are several key people in the business, then the level of cover should be apportioned between them accordingly.
There are a number of factors to consider when providing advice for key person insurance needs. When providing this type of insurance, it’s best to know your client well and understand their business and their business needs. If you are new to providing this type of insurance advice, underwriters can assist you, so it’s beneficial to have a good relationship with them. Advising clients with key person insurance needs can appear at first to be more difficult than advising on personal insurance, but it generally proves to be worthwhile.
BT and its related body corporates do not take any responsibility for the content of this article and reliance should not be placed on any matter without further independent research and advice.
This article was prepared by BT, a part of Westpac Banking Corporation ABN 33 007 457 141, AFSL and Australian Credit Licence 233714. This information is current as at 2 July 2019.
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