Covering the key people
It has always been true that the biggest asset to a business is its people. Losing the people who make up the cornerstones of any business can have a devastating effect on the company. While there is still no way of insuring yourself against key persons leaving the company, key person insurance does offer some help when tragedy strikes.
Key person cover is a life insurance that ensures businesses are able to recoup the financial loss to a company after one of its cornerstones unexpectedly passes away. The fact remains that, especially in a country where skills are in short supply, qualified people are difficult to find and employees who contribute specialist skills and knowledge are vital to the profitability of their companies. Recruitment, training and downtime all cost significant amounts of money and there is usually no quick way around it. Alternatively, the cover can be used to pay salaries and debts if an irreplaceable member of the company passes away. The loss of a director or a CEO in a small company usually spells the end of the business but company debts and responsibilities to employees does not go away. Product specialist at Altrisk, Andre Froneman tells RISKSA that structurally, key person insurance has been the same for quite some time, but it remains a very important part of any
business structure. “The only thing that changed recently was tax legislation removing CGT from a key person life cover,” he says. “We do not have key man cover in place, as such but in the case of Altrisk, we did put together a number of solutions to take care of this for business. The dilemma that the business sits with is just life insurance because they probably do not have a flush amount of R5 million laying around for replacement costs. The best thing to do is to take out an insurance policy, and the company becomes the policy owner,” he says. “You need a normal life insurance policy to do that. All we do from an insurer’s perspective is attach an endorsement to the policy saying that the policy qualifies for the relevant tax deductions,” Froneman says.
Calculating a client’s cover
According to Altrisk, understanding a client’s business dynamics is essential to calculating the amount of cover required. One needs to study the impact that a key person loss would have on the turnover of the company. “What could the cost of recruitment or headhunting be? Remember that, the more specialised and entrenched the person is in the business, the more difficult it will be to find a suitable replacement. To successfully calculate key man cover, discuss the following important points with your client: calculate the actual costs involved in replacing the employee and the cost of a consultant until a replacement is in place; calculate the approximate number of years it would take for a replacement to equal the key person in terms of profitability and knowledge, and consider a multiple of the annual salary of the key employee as a benchmark of what it would cost to replace them with someone of the same calibre,” the company advises. “As the proceeds of a key- man policy are paid to the employer or business partner, it is often assumed by the insured individual that there will be no estate duty implications for them. While this is often true, there can be exceptions depending on the structure of the arrangement. It is essential to ensure that any estate duty implications are carefully considered and that you manage your client’s expectations in this regard,” Altrisk adds.
The move away from large companies
Just like life insurance, there is currently no real way to insure the key positions in the company, only key people. This means that the premiums spent on key people are lost when they leave the company. Chris Kilfoil, financial advisor at Squier Financial Services tells RISKSA that larger organisations are moving away from this kind of insurance for key positions, opting to rather institute buffers within the company and well devised succession plans in the event of death. “Smaller businesses make up the majority of key person insurance sales for us, and they are still very much dependent on this model,” he starts. Though it is a grudge purchase, Kilfoil points out that loans at credit institutions depend on having cover in place and it maintains investor confidence. It needs to be remembered that key person insurance is not an ‘ all or nothing’ situation. “One must take into account that death is not the only thing that can interrupt the business in terms of its key people. Sudden disability is also possible and if your key people are still able to function in the business, but at a diminished capacity, having covered for disability would make it much easier to keep them in their roles while still compensating for a measurable loss,” he says. This is however one of the most important factors to remember, according to Kilfoil. “As an advisor, you have to remember that you can only cover your client for measurable damage to the business. Therefore, you have to get to know the business inside and out, and you need to be able to put a monetary value to everything. Concepts like investor confidence and losses that cannot be definitively linked to the loss, can’t be covered,” he cautions. “We do have some challenges in the area because, in many cases, the director of a small to medium sized company is also somewhat older, which impacts the cost of premiums,” Kilfoil states. He points to one example where a business run by a client in his seventies faced extremely high premiums. There is, unfortunately, no way around this and the only alternative is to put a succession plan in place that will allow for the seamless transference of the business. This does not however solve the problem of applying for loans. It is important to remember that key person cover is meant to cover business costs and Kilfoil points out that many advisers and clients alike often confuse buy- back insurance with key person cover. “Buy- back insurance is life cover that partners in a business take out on one another in order to buy the other’s shares in the event of death. In those cases, there needs to be a provision in the partners’ contract with each other and separate life policies on the life of each partner. Businesses often encounter problems down the line when they treat key person and buy- back as synonymous,” he concludes. Key person cover is unlikely to change much in the coming years and, according to Froneman, will always be a vital part of a business.