Financial Data
Updated 29 Sep 2020


Key person insurance and why you need it

One of the biggest risks in small business is the fact that a company's operations generally revolve around one or two key people, without whom the business cannot continue.


14 April 2009  Share  0 comments  Print


All the answers to your unique business lifestage questions

Key person insurance is simply life insurance on those key people.

As a business owner you no doubt value the contributions each of your employees make to your business.

However, there are also key individuals who are critical to the continued success of your venture. Losing such a key individual would impact you on a personal as well as business level.

A key person is anyone who significantly improves the profitability and effective management of your business. He or she is someone who:

  • Has specialist, expert skills vital to success in your industry.
  • Attracts and retains competent staff members.
  • Increases the creditworthiness of the business.
  • Builds goodwill for the business.

Should one of your key people die or become disabled, the impact on your business can be devastating:

  • A slowdown in turnover
  • Decline in profitability and/or sales
  • Stricter terms from suppliers
  • Difficulty in raising finance

Normally, a company purchases life insurance on the key employee, pays the premiums and is the beneficiary of the policy.

If that person dies unexpectedly, the company receives the insurance payout.

This payout helps to:

  • cover expenses until a replacement is found;
  • pay off debts;
  • distribute money to investors, if necessary;
  • pay severance to employees; and
  • ensure the orderly closure of the business.

No formula or set of rules can be applied when determining the value of a human life. For insurance purposes, however, the amount of key person cover is usually determined using one of the following methods:

  1. Seven times the annual salary of the key person.
  2. The estimated number of years that it would take for a replacement to reach the key person's present level of profitability, multiplied by the drop in profits as a result of the death or disability of the key person.
  3. Itemising the costs involved in replacing the key person. Such costs could involve:
  • the actual cost of replacing the key person;
  • the key person's worth in terms of net profits;
  • the cost to the business if the key person were to die or become disabled today; and
  • the degree to which the business wishes to protect itself against the loss that would be sustained upon the loss of the key person.

Protection for business partners

Buy & sell insurance is risk insurance that business co-owners take out on one another's lives to enable them to buy a deceased or disabled co-owner's share in the business.

The loss of a co-owner to death or disability could impact your business in the following ways:

  • The existence of the business may be in jeopardy.
  • Credit facilities may be affected adversely.
  • Outsiders may obtain a controlling interest.
  • Remaining co-owners may be unable to afford the deceased's interest or shares.
  • The business interest may be sold below fair market value.

Buy & sell insurance enables business continuity. It works as follows:

  • The co-owners enter into an agreement where they undertake to purchase the interest of their fellow co-owners should any of them die or become disabled.
  • A co-owner effects an insurance benefit on the life of another co-owner and vice-versa. Each co-owner will consequently own a benefit on the life of the other and pay the premiums under the benefit of which they are owner.
  • The insurance payout provides the cash to facilitate the purchase of an interest in the business, thus ensuring business continuity and the financial welfare of the deceased's dependants.
  • When more than one co-owner is involved, the benefit on the life of each co-owner will be jointly owned by the other co-owners, proportionate to their interest in the business.
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