Key Person Insurance

As a business owner, you already know that your employees are your most valuable asset. But have you ever thought about what would happen to your business if one of your most valuable employees was suddenly gone? Or what if something suddenly happened to you? It’s a possibility that nobody likes to think about, but the sudden loss of a crucial employee can take a huge toll on a business. Key person insurance can help your business carry on if the unthinkable happens.

What is key person insurance?

Key person insurance is similar to life insurance, but for your business. If a key person suffers a major injury, illness, or death, key person insurance can help maintain profitability and cover some losses incurred. This might include the cost of replacing the employee, as well as losses from a decreased ability to do business. Unlike other types of life insurance, key person insurance is paid out to the business instead of an individual. It is usually paid in a lump sum, but in some cases may be paid out monthly to support ongoing loss of revenue.

Which businesses does key person insurance suit?

Key person insurance is used by small and large companies alike across many industries. Insurers might require that your business has been operating for a certain number of months, or sits above a certain revenue threshold.

What type of events can it cover?

Businesses can generally take out a policy for each key person, which will only come into effect if that key person dies suddenly or is permanently unable to work. Generally, there are three types of risk covered by key person insurance policies: 

• Life insurance: if a key person passes away
• Total and Permanent Disability insurance (TPB): if the key person becomes permanently disabled to the point where they will likely never work again¹
• Trauma insurance: if a key person is diagnosed with a critical illness or suffers a stroke or heart attack

Are there different reasons to take cover?

Generally, policies are taken out to cover either revenue purposes or capital purposes. This will depend on the key person, and their role in your business. 

Revenue purposes:

If a key person generates a lot of income for your business that would take time to replace, they could be covered under this type of policy. This could help supplement losses in revenue, or cover replacement costs like recruitment and training.

Example:
Elaine owns a small software company. She excels at sales, but early on realises she needs to bring on a business partner. She hires Mike as the business manager to help with client billing, HR, marketing, and accounting. This gives her the time to focus on winning new clients, and overtime their profits increase significantly. When their business partnership becomes official, Elaine and Mike decide they should both be insured as key persons. A few years later, Mike is diagnosed with terminal cancer and is forced to resign. Elaine has to take on Mike’s role while she searches for his replacement, leaving her no time to focus on new business. Luckily, Mike’s key person insurance policy helps pay for the cost of a recruiter to find his replacement, and helps supplement the business until Elaine can focus on sales again. Despite the devastating loss of Mike, the business is able to maintain profitability.

Example for illustration purposes only.

Capital purposes:

This is usually only used to cover the loss of a business owner or principal partner. This type of policy could help pay back loans or offset intangible losses like the loss of goodwill or relationships with suppliers and customers.

Example:
Craig owns a small clothing company. Over the years his business is extremely successful, and he wants to purchase a much bigger space to allow for expansion. He finds the perfect space but needs to procure a business loan to move forward. Craig backs the loan with a personal guarantee, a mortgage on the space and his home. When Craig becomes terminally ill a few years later and is unable to work, he realises he’ll need to sell the property, the business or his family’s home. His key person insurance policy helps with the loan, lifting a huge burden as the family copes with his illness.

Example for illustration purposes only.

Some policies, known as dual policies, can include both capital and revenue purposes. However these policies are less common, so when you start shopping for key person insurance it’s good to have an understanding of the different types of coverage.

Who could be considered a ‘Key Person’?

Generally, any owners or partners are key people but it might also include a senior team member or an especially effective salesperson. A key person could be an employee who has personally guaranteed loans for your business, or someone with specific skills or knowledge that would take a long time to replace. 

What about me?

As the owner of a business, you probably spend most of your time worrying about other people. But don’t forget yourself. If your own death or illness means your company could be forced to shut down, key person insurance could help pay off debts and employee severances and other costs of shutting the business down. 

What doesn’t it cover?

Like any insurance policy, key person insurance come with exclusions. It’s important to understand the Product Disclosure Statement (PDS), which will outline any exclusions and the contestability period, which is generally the first two years². These exclusions may include:

• Fraud
• Intentional misrepresentation or dishonesty
• Suicide within the contestability period

If I already have life insurance. What’s the difference?

Where life insurance supports your family if something happens to you, a key person insurance payout goes to your business and surviving employees. In the same way you’d insure any other business investment, insuring your key employees could help protect the future of your business.

How much coverage might I need?

How much coverage you take out will depend on the size of your business, how much the key person contributes to its profitability, and how difficult they’d be to replace.

It’s also important to remember that key person insurance is only one form of insurance that protects your business. If you’re a new business owner, take some time to learn about:

• Workers compensation: coverage in case you or one of your employees is injured or becomes sick from a work-related incident.
• Public liability insurance: this may be compulsory for your business or company. Public liability insurance covers you in the case of death or injury of a third party (i.e. a customer or client).
• Compulsory Third party personal injury insurance: if your company owns vehicles, it needs to be insured just like a personal vehicle.  

Choosing key person insurance can be tricky, but we’re here to help you compare policies and answer any questions you may have. Call on 13 19 20* to get started.

Sources:
1. https://moneysmart.gov.au/how-life-insurance-works/total-and-permanent-disability-tpd-insurance
2. https://moneysmart.gov.au/how-life-insurance-works/making-a-life-insurance-claim

Last updated: 08/07/2020