Key person insurance an overlooked opportunity

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.