Every day shareholders and directors take steps to protect and grow their businesses – from employing and retaining the best staff, through to listening to their customers’ needs and insuring their business assets.
But have they overlooked themselves?
Having adequate business protection in place could help resolve these issues.
The payout from a business protection plan could enable the company to continue trading, replace key people or protect corporate debt. Alternatively, it could be used to buy out a shareholder following a critical illness or their family on death.
When business owners are asked what company assets they insure, they always list their premises, plant and machinery, vehicles, computer equipment and so on. They know they need cover for the cost of replacement, potential loss of profits and ultimately to minimise any business disruption.
However, what would happen to the company if a key employee, director or shareholder were to die or become critically ill? The cost to the company could be devastating. Consider for example the sudden death of the head engineer of a private company when it’s in the process of tendering for a major project. Their death could result in the loss of that contract which may be critical to the company’s future survival.
A key person is anyone whose death or disability would have a serious effect on the company’s future profits. Some companies will have several key individuals, others only one, but to identify who is key requires a thorough understanding of the business itself. In some cases, it may be immediately apparent that the majority shareholder and figurehead of the company is the only key person.
In other cases, one of the directors may be key despite only being a minority shareholder. The size of an individual’s shareholding level is not necessarily a good indicator of who is a key person, as a non-shareholding employee could easily be key to the business.
There are no specific rules when assessing the financial value of a key person. Insurable interest must be demonstrated, and here are several ways you can assess a reasonable amount of cover:
This is the main way of calculating a key person’s worth. As key person cover is concerned with protecting the profitability of the business, considering profit is usually the first step. The normal multiple is:
The profit may need to be split where there’s more than one key person. It would be apportioned according to contribution. Higher multiples may be justified for a rapidly expanding business.
A multiple of gross salary including benefits in kind can give a useful guide to the amount needed to bring in a replacement. This might be up to 10 times gross salary for life cover and up to 5 times gross salary for critical illness cover. The disadvantage of this method is that for shareholding employees, an accurate measure of the key person’s worth to the business may
not be related to their remuneration.
This method covers the key person’s contribution to business turnover. It can be distorted by a shareholding director taking a low salary with a dividend as a substitute, so that profits can be reinvested, or by a director taking a relatively high salary. The formula is shown below.
The working capital at risk must be calculated, together with the key person’s proportion of this risk.
The outstanding loan will need to be covered (divided between the relevant key people as appropriate).
Where there are multiple applications for directors in the same company, it may be possible to allow cover for 100% of the commercial loan on each life (limits may apply).
As in loan security the amount at risk, should they lose the key person, must be calculated.
Some businesses raise capital through private equity or venture capital firms. The capital investment would be calculated and covered as appropriate.
As a company has its own legal identity, it will be both the applicant and the plan owner. The person
covered will be the key person. Some providers allow life of another applications to be made as follows:
In this case there’s no need to use a trust. Instead, the company owns the plan, pays the premiums and receives the proceeds.
Plans can be written with a single owner but joint lives, paying out on the first event.
For example, if there are two key people one joint life plan may be better than two single plans. This may be appropriate, for example, if a company with 2 x 50% shareholders has borrowed money and now needs cover so that the debt can be repaid if one of the shareholders falls critically ill or dies.
When the company gets the proceeds it can then decide how to use them. For example, they may be needed to settle corporate debt or perhaps used to meet the company’s financial needs while it reorganises or recruits a replacement. In the case of a critical illness claim, it’s possible the key person will return to work, so the funds could be used to pay a temporary replacement or replace lost profits.
Income Protection could also be taken out to provide a regular payment if the key person was off for
any length of time. This ‘income’ could be used as compensation for loss of revenue, to pay a temporary replacement or to fund ‘sick pay’ for the key person.
The information provided is based on our current understanding of the relevant legislation and regulations and may be subject to alteration as a result of changes in legislation or practice. Also it may not reflect the options available under a specific product which may not be as wide as legislations and regulations allow.
All references to taxation are based on our understanding of current taxation law and practice and may be affected by future changes in legislation and the individual circumstances of the investor.