Key Person Insurance: How to Prepare for the Unexpected

Every company has at least one "key person" essential to its success—and perhaps its very livelihood. If you own a business, you are likely that key person.

What would happen if you, your business partner, or your wunderkind were to fall ill or otherwise be unable to work? Would your business collapse?

According to a TD Waterhouse survey, only 24 percent of business owners in Canada have a business continuation plan in place for their eventual retirement.

But what happens if there is no time to plan? How can you protect yourself if you or another key person is suddenly incapacitated? The best way is to create a business continuation plan, that includes investing in key person insurance (also known as key man insurance).

What is a Business Continuation Plan?

Business continuation planning ensures you have the processes and people in place to help someone step into the shoes of the departed key person. Ultimately, this plan helps make sure the business can continue to run.

A well thought out plan includes:

• A communication strategy

• Employment contracts for potential successors

• Incentives for potential successors to remain at the business

• Successor signatory to the banking agreement

• A shareholders’ agreement or a one way buy-sell agreement, if there is only one shareholder

• A salary continuance agreement

• Key person insurance

Planning for a change of control is paramount and will add value to your business.

What is Key Person Insurance?

Key person insurance is a life or disability policy placed on an owner, director, or employee who is essential to the business. The company is the beneficiary.

If a key person dies or becomes disabled, the company can use the insurance payout in various ways - for example, to continue operating, to pay debts, or to wind up the business.

You likely have insurance to protect and provide for your loved ones when you're gone. Similarly, key person coverage can ensure your business survives.

Investing in this insurance means your company will have a safety net for:

• lost revenue, and
• increased or unexpected expenses.

However, remember that without a plan and the necessary personnel in place, no amount of business insurance alone will keep things running.

What Are the Types of Coverage and What Do They Do?

1. Key person life insurance helps keep the company going

With key person life insurance, the company will receive a lump sum payment if a key employee dies. This can be used to offset lost revenue and to pay for expenses, such as the costly process of finding a replacement.

As with personal life insurance, coverage costs are based on the person's age, gender, and health. The amount of key person coverage depends on company size, structure, and industry.

Key person life insurance comes in many shapes and sizes. The right one will depend on your company’s maturity, future plans, budget, and the expected retirement age of its shareholders.

2. Key person disability coverage provides long-term security

Generally, the disability benefits offered through an employer-sponsored long-term disability plan are not enough to meet the needs of a key person who becomes disabled. This can be due to a variety of factors, including income level, compensation received in the form of dividends, or the nature of the key person’s duties.

That's where key person disability coverage comes in. This coverage ensures the key person receives enough personal income while out of commission. 

Most key person disability policies don't provide income to the business to compensate for lost revenue.

But they do ensure that the key person has enough income to cover personal expenses while recovering.

The business also benefits because it no longer needs to pay the key person's salary.

Depending on the size of the business, key person disability insurance might also cover overhead expenses, such as utilities and debt payments.

3. Key person critical illness coverage provides a safety net

Critical illness insurance provides a lump sum payment to the company, (similar to life insurance) 30 days after the diagnosis of a critical illness. Most relevant claims are for cancer, heart attack, and stroke. It also covers other conditions, including paralysis, multiple sclerosis, and kidney disease.

Note that this type of policy applies to catastrophic illness, which causes the person to be unable to work for an extended period of time. In that way, it's different from disability coverage, which is broader and often applies to stress, mental illness, and musculoskeletal problems, such as back pain.

4. Shareholder/partnership insurance protects other key people

If the departed key person is an owner of the business, shareholder/partnership insurance flows money either:

• to the company, or
• to the remaining shareholders or partners.

If the owner is disabled or critically ill, these entities have the option to buy shares or partnership from them. In case of death, the funds they receive are used to purchase shares from the estate of a deceased shareholder.

Shareholder or partnership insurance makes sense in most situations, including the following:

Critical Illness

Shareholder insurance is useful in this instance, since it's likely that the shareholder won't be able to return to work. Also, the shareholders’ agreement might trigger a purchase at a time when the operating company is struggling to continue. Correct

Death

Most shareholders’ agreements contain this type of shareholder insurance. If holding companies and/or family trusts are involved, be aware of where the insurance is held. And make sure the agreement clearly states how the insurance payout will be used.

Payouts are generally meant to help shareholders buy shares from the estate of the deceased. But often, the money is kept within the company instead, and used in operations.

This happens in cases where there isn't enough key person coverage. Also, without clear direction, the family of the deceased may not receive enough money, or the business may end up with an unexpected shareholder.

Disability

In certain cases, shareholder insurance for disability is expensive and often not worth the cost. For this type of coverage to be valid, a shareholder must:

• be continually absent from work for 12 consecutive months, and
• be in the process of selling their shares.

Often, this type of coverage does not make sense because:

• Shareholders often wish to return to work, at least part-time, even after a twelve month absence.
• The coverage decreases in value as the shareholder approaches age 65.

In most cases, instead of investing in shareholder disability insurance, you can proactively address this risk with a well-crafted clause in the shareholders’ agreement.

When Should a Company Invest in Key Person Coverage?

This critical insurance is useful whenever there is a risk of financial loss to the company or to the shareholders. Don't put off buying this insurance, because catastrophic losses can happen at any moment.

Decide on the types of business protection insurance that are appropriate for your business. Here’s a quick review:

• Key person life insurance provides a lump sum to the company in event of death of a key person

• Key person disability coverage ensures the key person has enough money while they are unable to work

• Key person critical illness coverage provides a lump sum payment to the company if a key person becomes critically ill

• Shareholder/partnership insurance flows money either to the company, or the other shareholders if a key person becomes critically ill, or dies.

Protecting your business, partners, shareholders, and employees will give everyone peace of mind. Most important, the company that you’ve worked so hard to build will survive—and thrive far into the future.

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