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Entrepreneurs are the lifeblood of the economy, creating businesses, jobs and economic activity from scratch through a combination of hard work and ingenuity. But too often the companies they start and the jobs they create are at risk of destruction, if the entrepreneur is not properly insured.

Key person insurance represents both potential sales growth for advisors and protection for companies with key executives who are vital to operations. Insurers do not underwrite key person insurance as a specific product, but frame the policy around a conventional life insurance or living benefit product.

The life insurance variety is sold more frequently than DI, apparently because carriers are reluctant to insure the large amounts needed to keep a company afloat as a single payment in the event of disability.

In an effort to ease the sale, insurers have developed more innovative products, including “first-to-claim” policies, which combine life coverage with and critical illness insurance. With these products, a lump sum is paid out upon diagnosis of a critical illness or decease, but not both.

Regardless of the underlying product, a buy-sell insurance policy will typically have a key person component, but the reverse is not necessarily true.

Buy-sell insurance covers the ownership interest of an individual shareholder whose death would trigger a need to settle his or her interest in a company with his or her estate and has no use for individuals who do not have an ownership interest in a company, explains Peter Merrick, president of Toronto-based Merrickwealth.com. 

Key person life insurance provides a relatively inexpensive means of covering costs of replacing a deceased executive, but it also provides re-assurance to the company’s creditors by ensuring that the death does not threaten the company’s survival. Moreover although premiums are paid in after-tax dollars the benefits are tax free.

Merrick sees selling key person insurance as a two part process, selling the client first on the concept—the easy part—then on the numbers.

On the numbers, the first task is determining the value of the insurable interest in the business, which will dictate the face value of the policy. This must be justified not only in the eyes of the  client company, but in those of the carrier’s underwriter.

That means calculating three major factors: the individual’s salary, the individual’s impact on the company’s bottom line, and the cost to replace him or her upon decease.

In a prototypical scenario drawn by Merrick, an individual earns a salary of $100,000 and is believed to contribute $1 million annually to the company’s bottom line. Upon his or her decease, the company will spend approximately $30,000 on an executive search firm to find a suitable replacement. The incoming executive needs 18 months to become fully productive in order to make the same contribution as the deceased key person; assuming they are paid the same $100,000 per annum salary, the company incurs an indirect cost of $150,000.

Combining the costs of the search firm, the replacement’s salary and the cost of the lost contribution to the bottom line, it will cost the client company $1,680,000 to replace the deceased key executive. That calculation becomes the insurable interest and forms the core of the underwriting letter.

Merrick balances that calculation with the cost of premiums. In the same scenario, $1,680,000 in coverage on a 50-year old male non-smoker in a group plan would cost $2,500 annually, or 15 basis points of potential liability.

Alternatively, the company could self-fund the cost of replacing the key person, by setting aside regular cash deposits in a separate account. But in doing so, the company

runs the risk that the Canada Revenue Agency will deem the portion payable to the individual’s estate as a Retirement Compensation Arrangement, leading to other complications.

“When CRA designates funds as an RCA, 50% of these monies must be pre-paid to the CRA in an RCA tax account,” Merrick explains.

Some companies—particularly in the resource sectors—may experience trouble in securing key person insurance, if executives routinely travel to the world’s hotspots.

“Key executives travelling to troubled zones will often not qualify for key person insurance,” says Lorne Marr, CFP and founder of Markham-based LSM Insurance. “Parts of the Middle East are on the no-go list now,” he says.

Key person insurance is particularly important in sectors where talent can be highly specialized, such as the IT industry, where the health of the company can be intertwined with a single person—think Apple and Steve Jobs.

Moreover, the economic recovery has varied between different sectors in Canada. The technology sector has enjoyed a stronger recovery than a traditional sector such as the printing industry, meaning that sales potential can vary between sectors.

Al Emid, a Toronto-based financial journalist, covers insurance, investing and banking.

Originally published on Advisor.ca
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JoanneMcD

Key Person insurance is a specific type of coverage owned by the employer,on an employee, for the benefit of the corporation. That said, if it were a life policy, the premiums are not tax deductible, but the death benefit is tax free and goes into the CDA. However, Key Person DI does not have the benefit of tax free status, and the income is considered taxable profit tot he company. To further confuse things, a recent tax ruling seems to say that the courts are interpretting the premium as a taxable benefit to the employee… http://www.jamiegolombek.com/printfriendly.php?article_id=1113 if this link is accurate. It appears that key person DI is so fraught with tax issues, it is no wonder that it is rarely sold.

Saturday, Feb 11, 2012 at 5:50 pm Reply

LTCI #1

Also, there is no way a carrier will pay a large lump sum like this on a DI case. There are simply too many opportunities for abuse – and frankly too many motivations. Company not doing as well as expected? Key person develops a “stress” claim. If you want to have some form of protection against “Key Person” disabilities, probably your only option will be CI – or perhaps a specialty carrier. Key Man DI does exist – but not as a lump sum and I do not see it happening

Monday, Sep 12, 2011 at 2:09 pm Reply

LTCI #1

The simple reason why so little Key Person DI (or any living benefits products) are sold is because of the non existent training offered by our industry and the dream world carriers live in. What the carriers SHOULD do is hold seminars in large centers and invite only those with SIGNIFICANT LB experience – absolute minimum 10 years and I would prefer 20 – to get a proper design for an industry-wide training program – which will also include company reps so we do not repeat the fiasco we had with CI – no awareness that clients have budgets – too much emphasis on ROP – not enough training on WHY ROP is not needed to sell the product – a common vocabulary for group and individual DI products – Group does not sell “own occupation” and should NEVER use that term in its definitions – etc. I could go on for hours but I think you get my points

Saturday, Aug 27, 2011 at 5:39 pm Reply