Business protection - Key person insurance - Case study
This case study explores how to make key person insurance relevant to a business owner and what would happen if they didn’t insure their key employees.
- It may not just be the loss of a company director/partner that could stop the business functioning.
- Critical illness cover is as essential as life assurance cover.
Alan Jones is the Managing Director of a private limited company. The company is recognised as one of the foremost design agencies in the Northwest. Sales revenues are increasing and much of this is down to the tireless enthusiasm of David Smith, the Sales Director. His skills have meant many accounts have been snatched away from larger established agencies. Indeed, his most recent successful pitch has netted a contract that will guarantee expansion for the next five years.
Alan is confident with the help of recently agreed finance with the bank, the company can look forward to a rewarding and profitable future.
Then everything changed, Alan was greeted with the tragic news David had been killed in a traffic accident. After the initial shock, Alan’s thoughts turned to David’s family. How must they be feeling? Will they be okay financially?
But then he began to think about the implications of David’s death on the future of the business. What if an important contract is now in danger without David’s enthusiasm and skills to manage the account? To many people David is the company - will his death mean loss of sales and loss of new accounts. Loss of sales will have a detrimental effect on cash flow, profits and turnover. What happens if the bank loses confidence in the company and decides to call in the recent loan?
David was a key employee. Alan has to face the reality that David’s death could also be the death of the business.
Just imagine if you were Alan Jones. How would you feel if the company you had devoted so much time and effort too suddenly faced an uncertain future due to the loss of a key employee. As an adviser you will be able to spot the tragic irony. Alan Jones could replace David’s company car because it was insured. If only Alan had the foresight to insure David himself - to insure the driver as well as the car.
A cash injection from a life assurance product on David’s life could replace lost revenue, pay off outstanding loans, or even cover the cost of recruiting a replacement. Most importantly, it could give Alan’s company the financial breathing space it needs to reassess its strategy and refocus its remaining resources.
Do companies understand the need for keyperson cover?
Despite this irrefutable logic, many companies do not have any form of keyperson cover. Why should this be? One reason may be they do not appreciate the need. But in many ways, businesses already acknowledge the problems they may face if a key individual leaves. All job adverts for key positions describe the excellent salary the successful applicant will earn. It also describes the company car, subsidised mortgage, health care and pension scheme.
These packages are designed not only to attract the best qualified staff but also to ensure those people remain in the position. If one of these executives received a better offer from a competitor, it is likely they would be offered a financial incentive to stay. So the business is effectively insuring itself from a key individual leaving of their own free will. Surely it would be willing to pay a similar financial amount to protect itself against the financial consequences of a person leaving through critical illness or death?
Such pictures have to be painted if the managing director of a company is to be convinced he needs insurance for his key employees. Insurance is, after all, a dull subject for most people. But whereas a phone call to a local business asking to discuss keyperson insurance may not receive a favourable response, asking to present a way a business could protect its profits may result in an appointment.
Keyperson insurance is profit protection, an altogether more interesting concept.
Who should be covered?
Identifying prospects requires a certain amount of knowledge about how businesses are structured. Try to get hold of a ‘family tree’ flow chart diagram of how the prospect company is set up. These diagrams usually place the managing director at the top and the senior managers or directors in the next line down. Further down the chart will be the middle managers and the staff. Now you can consider how the business would fare if one of those individuals was no longer there. Would the gap left be serious enough to cause the collapse of the whole business?
What should they be covered for?
Most companies that have had the foresight to take out keyperson insurance have simply effected death benefit only policies. This is fine, at least they have some cover, but is it enough?
Think about Alan Jones’ company again for a moment. What would have happened if David Smith had had a stroke instead of dying in a car crash? There would have been one added element: uncertainty. Alan’s company could well have faced all the same problems it would have if David had died. If David dies Alan knows the company has to cope with him not coming back, but with the stroke the future is less certain. Will David recover and return to work? Will it be after two weeks, two months or two years? Will his health ever improve to allow him to return to such a high powered position?
Critical Illness cover must be considered seriously in addition to death benefit. It can provide ‘interruption’ insurance to underpin profits whilst the business restructures to cope with the new situation.
What is the tax position?
If term assurance is selected then premiums will usually be eligible for corporation tax relief. This is subject to the plan:
- being used to compensate for loss of profits following the loss of a key individual
- having a term of 5 years or less
- not being convertible
The local inspector of taxes will need to confirm the situation with such a plan. If it does attract tax relief then any payment to the company of the sum assured would be taxed as a trading receipt at the usual rate of corporation tax. It is therefore important to gross up the sum assured at outset to compensate for the tax on the claim.
Some companies may require cover for a longer period than 5 years in which case a whole of life plan might be appropriate. Alternatively a term assurance plan is available on a five year renewable basis for all combinations of death, critical illness and total and permanent disability benefits. This gives the company flexibility to continue cover beyond five years if required, but still satisfy HMRC’s rules for corporation tax relief.
Advisers have a vital role to play in ensuring businesses of all shapes and sizes can look forward to a secure and profitable future.
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.