A key-person insurance policy can limit the losses if misfortune strikes a practice’s principal, reports Sylvia Pennington.
Advising clients on appropriate insurance is all in a day’s work for professionals in the financial-planning sector, but how many practise what they preach in their own businesses?
Key-person insurance is a form of life insurance policy which can help prevent the rapid demise of a professional practice should its principal pass away or be put out of action for an extended period by illness or incapacity.
The term ‘key person’ refers to someone whose input is pivotal to the profitability and viability of an enterprise.
Purchased and paid for by the business entity, not the individual it covers, key-person insurance is intended to solve some of the business-continuity issues which can arise from that individual’s death or disability.
Policy payments can go towards hiring and paying a replacement to assume the key person’s workload, maintaining cash flow or paying external debt.
How much cover?
The amount of cover is typically determined by the amount of debt the policy will cover, or the annual revenue generated by the key person. Premiums take into account the key person’s age, health and lifestyle.
A payout equivalent to a year’s turnover should be sufficient to allow a practice to recruit someone of similar education and experience to take on the mantle and get up to speed, according to Key Person Life financial adviser Mark Hardick.
It’s a form of insurance that’s well suited to advice firms where repeat business and profitability are typically associated with long-standing personal relationships between advisers and clients, Hardick says.
“Clients tend to be far more wedded to that key person than they are to their regular accountant or solicitor,” he adds.
“Advisers get to know the intimate detail of a person’s personality, their medical history, their assets, dreams, aspirations – the relationship can entail a great deal of trust and be very valuable. Key people carry much of the value of their practice with them and they can’t be replaced overnight.”
“If there’s one key person who generates the revenue and that person’s not able to come to work this cover can keep the business ticking over. After 12 months, if you’ve hired correctly, the business should be back on an even keel and in a position where it can survive long term.”
Paying the price
Premiums paid for policies taken out to protect business income may be tax deductible, but not for those acquired to repay debt or replace capital. Documenting the purpose of the cover, either in company minutes or a file note, can prevent complications if a claim is made. If the cover is to protect business income, any benefit payments under the policy will be taxable as income. (It is recommended you seek professional tax advice specific to the circumstances of your business.)
When multiple individuals enter a business arrangement, a buy-sell agreement can be used to ensure the smooth transition of ownership, in the event of the death or disablement of one of the parties.
A buy-sell agreement comprises a transfer agreement specifying how the departing party’s share of the business will be transferred to the remaining owners and a funding agreement which details how they, or their estate, will be compensated. Such an agreement is typically underpinned by insurance.
“Should one of the parties become incapacitated or die, the policy can be used to pay out their share of the business,” ANZ Wealth technical services manager Troy Smith says.
For practices owned by several partners, it may be the optimum form of contingency cover, Smith adds.
Weighing the benefits
Not sure whether it’s necessary? It won’t be if your practice has sufficient cash in the bank to self-insure against the risk. For the majority, a contingency plan and appropriate cover can prevent additional stress for all parties, should misfortune strike.
“I’ve seen advice partnerships placed under very significant strain because they hadn’t made any provisions,” Hardick says.
“One partner may be off work for quite some time and whilst they have their own income-protection insurance to maintain their family’s lifestyle, the situation can put a lot of pressure on the business and the other partner who’s doing 100 per cent of the work.
“If there’s no formal agreement in place, the situation can place all parties under tremendous stress. A what-if scenario, and key person or buy/sell insurance to cover the costs, can avert these problems.”