Key person insurance safeguards your business in the event of a key person’s death, disability or significant medical event.
Why do I need Key Person Insurance?
The loss of a key person can have a devastating effect on the financial stability of the business. Key Person Insurance is designed to pay out a lump sum on the death or disability of the insured key person, during the length of the policy. It is paid as a lump sum and could significantly help the business to recover.
There are many ways to determine the need and quantify this in dollar and cents terms. The method used will be determined by what makes the person important to the business. Your business risk specialist will assist you in this process.
For instance, the person has given a personal guarantee for a business loan or has given a director’s loan to the business, then the need is simply the amount outstanding under the loan.
In other cases, when determining the needs of the business, it may also be necessary to take into account:
Some of the factors which must be considered when determining needs are:
Key Person Insurance Scenario
Green Waste Pty Ltd are a niche waste recycling business. Mr. Right (an environmental specialist) is employed by Green Waste Pty Ltd and is largely responsible for providing recommendations and negotiating large contracts with local councils and businesses.
After recent discussions, the shareholders have realised that their business has started relying heavily on Mr Right’s sales, negotiation skills and expertise. If he were to become critically ill or die during the length of policy, their business could suffer and they could potentially lose up to 40% of their profits. In addition, they may have to recruit and retrain a replacement, which could take at least 1 year.
SCENARIO 1
They decide to take out a Key Person Protection Plan, which would provide the funds to deal with these problems should anything happen to Mr Right. With Key Person Protection in place – Green Waste Pty Ltd own the policy on Mr Right.
SCENARIO 2
Without Key Person Protection in place.
When two or more parties share the ownership of a business, they each own shares in a company or units in a unit trust that carries on the business.
In the event one party dies or becomes disabled the other parties want to ensure they are able to purchase the outgoing party’s interest and in turn the outgoing party wants to ensure that their estate is paid a fair value for the interest.
Example
A, B and C own shares in XYZ Pty Ltd, a management consulting
business worth $1.5 million. They have a business succession (buy/sell) arrangement covering death or disablement. “A” dies suddenly of a heart attack, because an agreement is in place they should have a smooth transfer of ownership.
Business owners are utilising life insurance to provide the funds to purchase an outgoing owner’s interest. It is imperative that if the parties intend on funding either or all parts of the funds for the purchase via an insurance policy that a buy/sell agreement is in place.
Example
Assume X, Y and Z own equal shares between them in ABC Pty Ltd. A Buy/Sell option agreement is in place that gives each of them the option of forcing the sale to the other of their shares should any one party die.
X dies. Y and Z exercise their option to purchase X’s share from X’s estate. (Alternatively, X’s executor could exercise the option to force Y and Z to buy). The business is valued at $1.5m. X’s shares are worth $500,000. There is a life insurance policy in place on X for $500,000. The $500,000 is paid to X’s estate. X’s executor must transfer X’s share to Y and Z.
The purpose of a buy/sell arrangement is to ensure a fair outcome for the parties carrying on a business, in the event one of them die or become disabled. Examples of problems that can arise if agreements are not in place
SCENARIO 1
A and B run a recruitment firm XYZ Pty Ltd. In the event A dies, his or her spouse offer to sell A’s share of the company for a fair price.
However, partner B decline the offer.
Partner B ends up setting up his/her own business AAA Pty Ltd over a period of 6 months and succeed in taking the XYZ Pty Ltd clientele with them. Therefore XYZ Pty Ltd becomes worthless and B gains A’s share for nothing.
SCENARIO 2
A and B run a restaurant together. B dies and A offers to purchase B’s share in the restaurant business from B’s estate. B’s Will left everything to his spouse. B’s spouse believed she had adequate management skills to run the restaurant and wants to take an active role in the business.
Although party A did not want this to happen, B has no choice and therefore B’s spouse attends to running of the restaurant. Her skills are not adequate for the business and thus results in profits deteriorating and no growth.
Business fails.
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