What is Key Person insurance?
Key person insurance can protect your business from any adverse economic effects associated with profitability, or the capital value of your business, after suddenly losing a key person through death, total and permanent disablement (TPD) or a traumatic illness.
This type of cover replaces the lost profit or capital value of your incapacitated top performer, and stabilises the business until a suitable replacement is found and you're operating smoothly once more.
Who is a key person?
A key person can broadly be defined as someone whose continued association with a business provides that business with economic gain. The most common example is a key employee who is directly responsible for bringing in sales. The following are also examples of key people:
- Managing Director: whose expertise, ingenuity and abilities enable the company to run smoothly, and within budget.
- Financial Controller: who has set up a new budgeting and reporting system that has already saved the company money, and will continue to do so as it is developed further.
- Computer Programmer: who has been contracted to write a software program that the company can sell in the market.
- Specialist Engineer: whose specialist knowledge enables the company to win contracts.
- Working Director: who does the work of two employees, but only draws a moderate salary, so that more money can go back into the business.
- Silent Partner: who was brought in as a partner because of his/her reputation with financiers, and the credit the business can access as a result.
Why is key person insurance needed?
Losing a key person can have an adverse effect on the profitability or capital value of the business. Protecting the business with key person insurance replaces the lost profit or capital value, stabilising the business until a suitable replacement is found and operating proficiently.
The loss of a key person can have an adverse effect on profit, due to higher costs or lower revenue. Key person insurance proceeds are designed to replace the revenue that the key person would have generated, or to pay the extra costs incurred in finding a suitable replacement. Either way, the profitability of the business can be maintained, and the business stabilised. Some specific ways profitability can be affected are:
- Sales / Revenue: If the person was directly responsible for sales (e.g. sales representative), the loss of that person might result in a fall in sales until a replacement is found.
- Recruiting Costs: Extra costs may be incurred in attracting and recruiting a suitable replacement, which subsequently means lower profit.
- Training Costs: If the replacement requires special training before they can undertake the role, profit may be reduced.
- Destabilisation: The loss of a key person can have an indirect effect on revenue due to the re-organisation that has to occur in the short term. Other employees may have to adopt extra duties, which means they would not be able to perform to their usual standard. This is particularly the case if the key person is also an owner of the business. Business owners typically put more effort into their functions than their salary reflects. In this situation, a business is not just losing one key person, it is losing an incredibly productive key person whose salary is not commensurate with their workload.
The loss of a key person can also have an adverse effect on the capital value of the business. Key person insurance proceeds are used to maintain the capital value to stabilise the business. The following are specific ways the capital value can be affected:
- Goodwill: A person may be bringing a goodwill factor into the business by virtue of specialised knowledge, skills, business contacts and reputation (e.g. creative director of an advertising company). The loss of that person can affect this goodwill factor.
- Credit Standing: Some companies can secure credit lines more easily than others can, as a director may have sufficient personal assets to secure the credit. With the loss of this key person, access to credit may be much more difficult. Key person insurance proceeds give the company an alternative to the credit the key person would guarantee.
- Loan Accounts: The loss of a key person who has loaned money to the business may mean that the loan will have to be repaid immediately.
- Other Debts: If the business is destabilised and defaults on a loan, the financier could call in the loan. Capital purpose key person insurance aims to ensure that the business can repay debts, easing the financial burden of the business at a crucial point in time. This will give the remaining proprietors some breathing space to stabilise and maintain the capital value of the business.
Getting the right cover can make all the difference when it counts — helping your business, and your family, cope financially if something unexpected were to occur.