Many small businesses would be in dire straits if something happened to the owner or their main sales person. But unfortunately few appear to take action to guard against such occurrences.
One type of insurance that can protect a business in the event an essential staff member is incapacitated or dies is key person insurance. This protects the business in the event it loses someone who makes a significant contribution towards the company’s profitability, stability and growth potential. It doesn’t necessarily mean the managing director or owner but in a small business it usually does.
NAB Financial Planning’s national manager, insurance capabilities, Luke Ashby, says there is a lot of confusion surrounding key person insurance.
“The confusion is around what it means,” he says. “It is not a product; you can’t go online and buy it. It is a concept and involves businesses needing to identify their key dependencies.”
Ashby says there are two main elements to this insurance that determines the type of policy purchased. One deals with revenue, that is, who is the person who actively produces the revenue, and the other is capital or debt – what debt does the business hold and who has put guaranteed assets over this debt.
“Key person insurance is about identifying where the risk lies in these areas and if anything happens the business has a plan to mitigate the risk,” Ashby says.
He says once this is determined then individual policies are recommended that fall into the categories of life, trauma and income protection.
“The costs vary widely and depend on a lot of factors such as the number of people you want to protect, their age, health, and gender,” he says. “The very broad rule of thumb for the cost is 1 per cent of the turnover for a revenue protection policy but it does vary widely.”
AIIB Financial Services general manager Nathaniel Hawkins says it is usually the business that takes out key person insurance and the most popular type is a policy that covers revenue protection.
“If something happens to a key person then the organisation’s revenue is very likely affected,” he says. “The insurance can cover things like loss of revenue, recruitment costs to find a replacement, and the bonus to entice someone from another company.”
He adds this is not a simple insurance and for small businesses it is one of the most ill-understood types.
“Often the owners underestimate their value to the business,” he says. “The wake-up call tends to be if something happens to someone they know. And if something has happened to them personally, it is much harder to get this insurance.”
According to Hawkins about 85 per cent of claims involve trauma insurance such as those related to heart attacks.
The tax treatment of key person insurance can also be complex and Ashby advises anyone thinking about taking out a policy to talk to an expert.
“The tax implications are different depending on the purpose,” he says. “If a policy is in place to replace revenue then when it is paid out it is treated as revenue and is assessable. The basic reasoning is that when you receive compensation it takes the nature of what it replaces. The premiums are generally tax deductible as well.”
But he says from a capital or debt point of view, the payout is not generally treated as income so is not tax deductible. “Often however, it depends on who receives the proceeds,” Ashby says.
Businessman James Eling has had key person insurance for nearly five years. He runs two businesses: Marketing4Restaurants, which helps restaurants find customers and turns them into repeat customers; and an IT company that he runs with his wife.
They have 17 staff across both companies and know that if anything happens to either of them, the business would be greatly affected.
“If anything happens to us, because we have key person insurance, there would be a sum of money that could be used to hire a senior manager for around 12-18 months to ensure the business continues to grow,” Eling says. “It’s all about keeping the business running and I feel this insurance is especially important for family businesses.”
Eling cites one customer whose principal died and within six months the business went under. “The person who died was the principal salesperson,” he says. “Sales dried up and the business was no longer able to grow. It employed eight people so it was particularly sad.