Key Man Insurance

Keyman insurance, which comes under the umbrella of business protection insurance, is a policy designed to pay out an agreed cash sum if a key employee suddenly stops work due to death or a critical illness.
If the policy pays out the proceeds go directly to the company and not to the individual, which is how it differs from a Life or Critical Illness policy. The sum insured is normally larger as well often running to hundreds of thousands of pounds if not more.

For many companies Key Man insurance is a critical component of their business plan, as running a successful and forward thinking business is as much about planning for the future as it is handling the day-to-day operations.

Depending on what type of Keyman policy was taken out (see below for more details) the money can be used for a myriad of purposes, including -

• An injection of cash - Enables the company to buy time plus offer financial reassurance
• Shore up profits - Chances are a key person is directly responsible for some of the profits
• Cover the cost of temporary staff - Staff costs aren't cheap especially emergency ones, and training costs can be high also.
• Recruitment - The cost of recruiting and training senior personal can be extremely costly
• Repay company debt or an overdraft - Offers peace of mind, especially to your bankers

Buy the deceased person's shares - Important as a significant shareholding can fall into the wrong hands

Tangible assets are insured. Why not people - they're often more important

Most businesses insure their tangible assets but not their most important asset - their employees. And the majority of tangible assets can easily be replaced, and are usually insured as a matter of course - for example -

• New stock can be bought
• Offices rebuilt
• New cars and lorries purchased etc

But people, or at least key people, can't be replaced quickly.

Director/Partner Share Protection

Director/Partner protection pays out a cash sum if a Partner or Director (with a shareholding) dies or suffers from a critical illness. If the policy pays out the money can be used by the remaining Partners/Directors to buy his shares.

For example

• The Managing Director who owns 20% of the company suddenly dies in a car crash
• His shares are left to his wife who has no business experience
• It's always possible with a 20% shareholding she could be a nuisance especially if sitting on the board
• Or she could sell the 20% to somebody or a company that the other Directors view as potentially hostile

Note that this type of insurance can go under many names including -

• Ownership protection insurance
• Shareholder protection

If an Director/Partner protection policy pays out the money has to be used for a distinct purpose - buying out the deceased Director's/Partner's shareholding.

The type of Keyman the policy is designed for

As its name suggests the owners, the shareholders (or Partners) of the firm. But of course the premium needed to cover the different owners will vary due to age and shareholding. This is discussed in more detail below.

How much cover is needed

Insure for all or part of the value of a Partner's or Director's shareholding which of course can fluctuate over time. Therefore, it's wise to evaluate the amount of cover needed on at least a yearly basis.

Who pays the premiums and are they tax deductible

The Partners and Directors do.

The company can pay on their behalf but this will usually be classed as a benefit in kind and the director/partner will then have a personal tax obligation.

The premiums will normally depend on a few factors -

• The age of the Directors with share holdings
• Possibly their medical conditions if the sum insured is large, and
• The percentage of shares the Partner/Director owns

And as the directors will normally always be of different ages plus have different shareholdings a premium calculation equation can be used. This means that each Director's premium will vary.

Tax situation

The premiums in most cases don't attract tax-relief and if the policy pays out this is usually tax-free.

Why use this type of insurance

One of the main areas to consider for Partnerships and company directors with large shareholdings should they pass away is

a) Who will their shares be left to, and
b) What in turn might this shareholder do

This example demonstrates again:

• The Managing Director who owns 20% of the company suddenly dies in a car crash
• His shares are left to his wife who has no business experience
• It's always possible with a 20% shareholding she could be a nuisance especially if sitting on the board
• Or she could sell the 20% to somebody or a company that the other Directors view as potentially hostile

Ownership Protection insures all parties get a fair deal

If a Director or Partner suddenly passes away or suffers a critical illness all sides can get a fair deal when the policy pays out -

• The company or partnership continues without any potential outside influence, and
• The deceased director's estate gets a fair price for his shares or partnership holding.

Advantages to Ownership Protection insurance

• It's sensible future planning - A well run and successful company is as much about preparing for the future as it is running the everyday operations
• Protects your family if you've given personal guarantees - Even if your shareholding is worth a considerable amount of money that doesn't mean the company won't suffer cash flow problems if a key person dies or suffers a critical illness. The company's bankers could for example call in their loans hence causing a major cash flow problem which in turn massively reduces the value of any stake left to your family
• Peace of mind for the company's bankers and backers - It's only common sense to reassure your banks and bankers that in the event of the death of a Keyman the company will have the problem covered
• Cost - Many view Keyman insurance as money well spent, not because of its actual cost, rather the real cost to the company if a Keyman dies and in turn the turmoil that might cause

Do you need Ownership Protection insurance

A good way to determine if you or your business needs a Keyman insurance policy is by asking the following questions -

• Do you have at least 1 key person in your firm?
• If a key member of your company dies or suffers from a critical illness and is out of action for a long period of time would the business still be operating in 12 months?
• And if still in operation after 12 months would the profits be serious affected?
• If your fellow executives or partners have a substantial shareholding in the firm, who would these shares be transferred to in the case of their death? If it's a child or spouse that might cause the business problems especially as they would be unlikely to have commercial experience.
• Is your company's debt and loan obligations insured? And if not what would happen if a key person, especially a major profit generator, dies or suffers from a critical illness?
• Is there a risk of any personal guarantees being called in by your banker's if a key person passes away or suffers a critical illness?
• If one or more of your top sales team were lost would your company's sales take a serious hit? Also, do your salesmen have invaluable contacts?

How many employees does your firm have? As a rule of thumb the less employees the more the firm will rely on 1-2 key employees

Loan Protection Insurance

What is Business Loan protection insurance

As its name suggests it's a form of insurance designed to repay all or part of a company's debts should a key employee die or suffer a critical illness.

It is a more restrictive policy than another form of keyman insurance called profit protection as the money can only be used to repay debt, including an overdraft facility rather than for general use such as shore up profits or retrain and recruit staff etc.

The type of Keyman the policy is designed for

• Managing Director/CEO or Executive Chairman etc
• Other Directors with shareholdings who may have a personal guarantee in place
• Head of sales/Marketing
• Star salesmen
• IT and Finance Directors

Or anyone else the company considers a key person.

Why insure company debt

Corporate banking experts suggest that around half of all corporate debt, especially among smaller firms and start-up, have some sort of personal guarantee in place undertaken by the directors. One of the most common is a second charge on a director's property.

Bankers are generally hard businessmen especially when their loans are under threat. This often means the small print has certain clauses which can be enacted if the company's operations are threatened, perhaps by the death of a key employee.

Clauses such as -

• Early repayment - The responsibility for early repayment of any loans including overdrafts
• Bank takes control of some assets - Company assets might fall under the control of the company's bankers should any debts not be repaid immediately

And in turn this can lead to loan defaults - insolvency (even of a healthy business) - major cash flow problems - the bank calling on personal assets even from the estate of the deceased Director/Partner.

Who pays the premiums and are they tax deductible

The company pays the insurance premiums and tax-relief isn't normally available.

In the case of a payout the cash isn't usually subject to tax. However, corporation tax is normally complex and so guidance should always be sought from the company's Finance director as well as from The Inland Revenue.

How to work out the level of cover needed

Obviously every company's debt obligations are different so how much to insure will be up to the Directors and other senior staff.

Companies often have different types of debt such as mortgages, overdrafts and business loans. And because a loan protection policy is highly customisable only certain types of debts can be insured for different percentages. For example -

• The company has an overdraft facility of £150k and £50k (33%) is insured
• But insurance is taken out on 80% of the business loan (£750,000), and
• The Director's deem it unwarranted or unnecessary to insure the mortgage on their office

Highlights the need for a specialist broker

Business loan protection is a good example of not so much how complex the insurance can be, rather the thought process that has to go into deciding what should be insured and for how much as well as what shouldn't.

Advantages to Business Loan protection insurance

• It's sensible future planning - A well run and successful company is as much about preparing for the future as it is running the everyday operations
• Protects your family if you've given personal guarantees - Even if your shareholding is worth a considerable amount of money that doesn't mean the company won't suffer cash flow problems if a key person dies or suffers a critical illness. The company's bankers could for example call in their loans hence causing a major cash flow problem which in turn massively reduces the value of any stake left to your family
• Peace of mind for the company's bankers and backers - It's only common sense to reassure your banks and bankers that in the event of the death of a Keyman the company will have the problem covered
• Cost - Many view Keyman insurance as money well spent, not because of its actual cost, rather the real cost to the company if a Keyman dies and in turn the financial turmoil that it might cause

Do you need it

A good way to determine if you or your business needs a Keyman insurance policy is by asking some of the following questions -

• Do you have at least 1 key person in your firm?
• If a key member of your company dies or suffers from a critical illness and is out of action for a long period of time would the business still be operating in 12 months?
• And if still in operation after 12 months would the profits be serious affected?
• If your fellow executives or partners have a substantial shareholding in the firm, who would these shares be transferred to in the case of their death? If it's a child or spouse that might cause the business problems especially as they would be unlikely to have commercial experience.
• Is your company's debt and loan obligations insured? And if not what would happen if a key person, especially a major profit generator, dies or suffers from a critical illness?
• Is there a risk of any personal guarantees being called in by your banker's if a key person passes away or suffers a critical illness?
• If one or more of your top sales team were lost would your company's sales take a serious hit? Also, do your salesmen have invaluable contacts?
• How many employees does your firm have? As a rule of thumb the less employees the more the firm will rely on 1-2 key employees

Cross Option Agreement

The death of a shareholder who is also a director can have a major impact on any business, particularly where the company has not made plans for such an event.  For owner/managers of small to medium-sized private companies, this is a particular concern, since the shareholder’s death can potentially give rise to a host of adverse consequences for the business.

Shareholders may also have concerns for the welfare of the beneficiaries in the event of death.  When a shareholder dies, his beneficiaries’ interests do not necessarily align with those of the other shareholders, especially where such beneficiaries lack any business experience. As the company is under no obligation to provide a deceased shareholder’s beneficiaries with benefits such as income or pensions, it is clear that such concerns are entirely legitimate.  Regardless of assurances a shareholder may give his fellow shareholder that he will make sure that his fellow shareholder’s wife and children are ‘looked after’ in the event of death, if the shareholders have not made formal provisions, the worst case scenario can, and sometimes does, happen.

In such circumstances, the question of whether the continuing shareholders have sufficient funds to buy the deceased’s shares becomes critical.  In many cases, a suitably-drafted cross-option agreement, backed by an appropriate term assurance policy is the solution.  This can be drafted on a stand-alone basis or can be included as a separate section in a shareholders’ agreement.

The fundamentals of a cross-option agreement are simple: each shareholder agrees that upon his death his fellow shareholders have the option to buy his shares (and, in some cases, those of his spouse), usually at market value (a so-called ‘call option’) and that his personal representatives (on death) have the option to sell his shares (and, in some cases, those of his spouse) to the continuing shareholders (a ‘put option’).

At the same time, each shareholder takes out a term assurance policy, under which any amount which becomes payable under the policy is held in trust by the continuing shareholders to pay for the deceased’s shares under the put and call options.

By structuring the transfer of shares in this way it is possible to ensure that the deceased’s shares qualify for business property relief (which, in valid circumstances, provides 100% relief from inheritance tax) whilst the proceeds of the insurance policy fall outside of the deceased’s estate and are not subject to inheritance tax.

It is essential that the person drafting the cross-option agreement appreciates the necessity to ensure that it does not fall foul of certain inheritance tax provisions, which could render the transfer of the shares ineligible for business property relief.   The key factor is that the ability for the continuing shareholders to buy the deceased’s shares and the ability for the deceased’s personal representatives to sell the shares must be drafted as a right, rather than an obligation.  If any of the parties is under an obligation to buy or sell the deceased’s shares, the transfer of the shares would effectively be subject to a binding contract for sale and, as such, for inheritance tax purposes would be treated as a transfer of cash and, consequently, business property relief would be lost.

A properly-drafted cross-option agreement with associated term policies not only ensures that a deceased shareholder’s beneficiaries can extract value from the company, but it does so in a way which is both tax-efficient and causes minimum disruption to the remaining shareholders.

The use of a cross-option can also be extended to partnerships.  Historically, some partnership agreements included provisions which required the continuing partners to purchase a deceased partner’s share from his beneficiaries and required his beneficiaries to sell it to them.  Such provisions meant that upon death there was a binding contract for the sale of his partnership share and thus business property relief would not be applicable to the transfer.  Increasingly, solicitors are replacing such provisions with cross-options, which, in valid circumstances, allow the deceased partner’s beneficiaries to take full advantage of business property relief.

Identifying A Key Person

Most of the companies look to provide key man cover for the following key personnel.

• A director, business owner, shareholder or partner in the firm
• The people who drive the business
• Senior Managers in key areas such as Sales, Operation, Technical Development
• People with the creative ideas that lead to new business opportunities and ventures for the company.
• People without whom the business would lose sales and profits or even the survival of the business.

We can help you assess all angles of the business and can facilitate to establish the right level of cover required. Few of things that you need to consider are as follows

Who does these things in your company?

• Who drives the company forward?
• Who manages your important customer accounts?
• Who does the business and sales development?
• Who keeps your operations on track?
• Who controls the legal issues of your business?
• Who manages your company finances?

Deciding on what protection your business needs and identifying the key individuals within the day to day running of your business can be tricky.  You will also need to get the right balance on choosing how much money to insure and protect your business for.  It is usually best to take advice on this, and as specialist Business Insurance Brokers we can take you through the process carefully to make sure that all your options are made available to you.