Key Person Insurance for Canadian Businesses

Introduction

Key person insurance is an important risk management tool for Canadian businesses seeking to protect themselves financially in the event of losing an owner, founder, or essential employee due to death, illness, or disability. This type of insurance provides funds that can help the company maintain operations, repay debts, and survive the temporary or permanent loss of human capital that is vital to the success of the business.

In this guide, we will explore what key person insurance is, who needs it, why it is so critical for certain businesses, what it covers, how much you need, and the benefits it provides. We will also look at key considerations like cost, taxes, types of policies, and how to determine the right amount of coverage.

What is Key Person Insurance?

Key person insurance, also known as keyman insurance or key employee insurance, is a life insurance policy that a company purchases on the life of an individual considered irreplaceable or indispensable to the success and profitability of the business. This could be an owner, founder, top executive, or employee whose unique skills, knowledge, experience, or other attributes are deemed essential to the company’s financial viability.

The business pays the premiums on the policy and is named as the beneficiary. If the key person passes away, suffers a critical illness, or becomes disabled, the company receives a payout from the insurer to help mitigate the costs and losses associated with that individual’s absence. This lump-sum payment can provide vital financial support during a difficult transition period.

Key person insurance helps minimize business disruption and improves the chances of survival in the face of losing human capital that cannot be easily or quickly replaced. It provides continuity value to the company.

Who is Considered a Key Person?

Not every employee will qualify for key person insurance. This type of policy is meant for those rare individuals whose sudden departure would wreak havoc on the company’s finances and operations. Some examples of key persons include:

• Business owners or founders: Especially with small or new companies, the owner is often the driving force and indispensable to daily functions. Their absence can lead to insolvency.
• C-suite executives: The CEO, CFO, COO, CMO, or other executives in vital leadership roles often possess unique experience and expertise that keeps the company profitable.
• Top salespersons: If one salesperson generates 50% or more of total revenue, their loss could be devastating financially.
• Technical experts: Certain engineers, developers, scientists, or other technical experts may have rare knowledge the company relies on for R&D and innovation.
• “Face of the company”: The celebrity or founder after which the company or brand is named can be a key person if their reputation drives business.
• Major clients or account managers: Key account managers often maintain large client contracts that are crucial financially.

Essentially, any employee whose unexpected departure would directly undermine the stability, viability, or profitability of the company can potentially be insured as a key person. Their absence represents a threat to business continuity.

Why is Key Person Insurance Needed?

There are several scenarios where key person insurance makes good business sense and can protect the company from financial harm:

Succession Planning and Business Continuity

• Losing an owner or founder can lead to insolvency for small firms. Key person insurance provides funds to keep operating.
• The loss of a CEO or top executive requires an urgent succession plan. Insurance proceeds enable a smooth leadership transition.
• Certain employees are impossible to replace quickly. Insurance payouts help the company stay solvent in their absence.

Securing Business Loans and Credit

• Banks often require insurance on key people as a condition when lending to small or new companies.
• With collateral assignment, payouts go directly toward repaying debts. This lowers lender risk.

Owner Buyouts

• If a shareholder or partner dies, insurance provides the funds to buy out their shares from heirs (called Buy-Sell Agreements).
• This is vital to avoid disruptive partial ownership by non-active relatives.

Protecting Owner’s Family and Estate

• Sole proprietors can use insurance proceeds to shut down operations smoothly and repay business debts.
• This protects the owner’s heirs and estate from inheriting business liabilities.

What Does Key Person Insurance Cover?

There are three main types of key person insurance, each providing protection against different loss scenarios:

Key Person Life Insurance Policies

Life insurance is the most common type of key person insurance companies utilize. This covers the death of a key person. Both term and permanent life insurance policies can be used. The death benefit helps the company handle costs during a transition.

Here is an overview of how key person life insurance works and the options:

How It Works

• The company buys a life insurance policy on a key individual’s life.
• Business pays ongoing premiums and owns the contract.
• If the key person dies, the company receives a tax-free death benefit payout.

Term Life Insurance

• Offers temporary coverage for 1 – 30 years.
• Ideal if the key person is in a short-term role or has the potential to leave.
• Renewable if the key person remains with the company.
• Lower premiums but no cash value accumulation.

See also: Business-Owned Term Life Insurance in Canada

Permanent Life Insurance

• Provides lifelong coverage as long as premiums are paid.
• Better if the key person is a long-term presence.
• Cash value builds up and is available via policy loans.
• Includes whole and universal life insurance options.
• More expensive premiums but offers more benefits.

See also: Business-Owned Permanent Life Insurance in Canada

Amount of Coverage Needed

• Enough to cover costs of replacing and potential financial losses.
• Recommended multiples range from 5x to 10x salary.
• Also factor in revenue, debts tied to the employee, etc.
• Consult a professional to determine the right amount.

Ownership Structure

• The company owns the contract, pays premiums, and is the beneficiary.
• The Key employee must provide consent to be insured.
• Benefits are payable only to the company, not the individual’s heirs.

Tax Implications

• Premiums are not tax deductible.
• Death benefits received are tax-free in most cases.
• Exceptions if there’s policy ownership transferred.

See also: Corporate-Owned Life Insurance in Canada

Key Person Disability Insurance

One of the options to provide protection to your business in case one of your key employees can no longer work due to an accident or sickness is key person disability insurance. Here are some key details about this type of insurance:

What It Covers

• Replaces income if the key person suffers an illness or injury causing total disability.
• Benefits help supplement the absent employee’s salary so the business can keep running smoothly.
• Policies can be customized with different waiting periods before benefits kick in (30, 60, or 90 days), benefit amounts, and benefit periods.

Eligibility

• Key employees ages 18-60 are generally eligible, depending on medical underwriting.
• The person must be full-time and essential to business operations.
• The definition of “total disability” may vary between insurers.

Cost Factors

• Rates are based on age, occupation class, gender, nicotine use, benefit amount, and riders.
• Price can range from 1% to 5% of the total disability coverage amount.
• Group plans with 3+ key people can significantly reduce premium costs.

Benefits to the Company

• Replaces lost productivity and contributions of the disabled worker.
• Provides time to find and train a replacement.
• Protects revenue by enabling continued market share and sales.
• Supplements overhead expenses during disruption.
• Bolsters recruitment capabilities with a benefits package.

Drawbacks and Risks

• Pre-existing condition exclusions may apply.
• Disability definitions and requirements vary.
• Psychological illnesses may not be covered.
• Benefits can be reduced by any Social Security disability income.
• Rates can increase over time due to aging.

See also: Buy-Sell Disability Insurance Simplified

Critical Illness Insurance for Key People

Insuring essential employees against critical illnesses and health events is another option. Critical Illness Insurance provides a lump sum payout if a key person is diagnosed with a covered condition like cancer, stroke, or heart attack. Even if they recover, this money can help counterbalance lost productivity during treatment. Here are the key details on key person critical illness insurance:

How It Works

• Covers major illnesses like cancer, stroke, heart attack, blindness, paralysis, and major organ failure.
• Pays a lump sum cash payment directly to the company if the key person is diagnosed.
• Benefits are used to counterbalance lost productivity, hire assistants, and pay for treatment.
• Premiums are based on age, gender, health, and lifestyle factors like smoking.
• Coverage often ranges from $50,000 to $500,000.

Benefits to the Company

• Protects against lost revenue when vital the employee is being treated.
• Provides funding sources to hire temporary help.
• Repays debts threatened by reduced cash flow during the recovery period.
• Money to pay for experimental treatments not covered by health insurance.

Risks and Limitations

• Pre-existing conditions may be excluded for a period of time.
• Some illnesses can initially be denied coverage.
• Lack of clarity around when benefits must be paid.
• Condition must fully meet the policy’s defined criteria.
• Disputes around pre-existing conditions.

The best plans combine life insurance with disability and critical illness to fully protect against losing key people due to any unexpected situation or health event.

How Much Key Person Insurance Do You Need?

Choosing the right coverage amount is crucial. Too little insurance exposes the company to risk, while excessive amounts result in unnecessary premium costs. Companies should analyze:

• Cost to Replace: Accounting for headhunting, training, ramp-up time, lost productivity, and income.
• Revenue Generated: The sales, profits, deals, clients, and other business that the key person directly brings in.
• Special Skills: Unique contributions like institutional knowledge, technical expertise, innovation, brand equity, etc.
• Salary and Benefits: Base pay, bonuses, incentives, equity packages, benefits, payroll taxes, etc.
• Debt Protection: Potential debts or obligations the company would struggle to repay without the key person.

As a general guideline, coverage between 5 to 10 times the key person’s annual compensation is recommended. However, a detailed valuation should be conducted to arrive at the most appropriate amount tailored to the individual and their role.

What Are The Tax Implications?

• Premiums paid are typically not tax deductible for the business as a regular expense.
• Any payouts received by the company are usually tax-free, with exceptions in certain cases.

There are some notable exceptions:

• Disability payouts may be taxable depending on how premiums were handled.
• Critical illness payouts can also be taxable if paid out directly to the ill employee rather than the company.
• If policy ownership is later transferred from the company to the employee, gains may be taxable.

Overall, key person insurance provides very favorable tax treatment in most circumstances. The premiums are not deductible, but any lump-sum payouts to the company are received tax-free in most scenarios.

What Are The Benefits Of Key Person Insurance For Businesses?

There are numerous valuable benefits key person insurance delivers to both large and small companies:

• Maintains Business Operations: Provides vital funding to minimize disruption and survive the loss of productivity and contributions of a top employee.
• Recruits Talent: Insurance proceeds help fund the expensive costs of headhunting, hiring, and training a replacement.
• Covers Revenue Losses: Payouts can offset potential dips in sales, profits, client contracts, and other financial metrics stemming from the key person’s absence.
• Repays Debt Obligations: Serves as an invaluable tool to repay loans, lines of credit, or other liabilities that would otherwise be jeopardized.
• Provides Partner Buyout Funds: Creates a means for buying out a deceased partner’s or shareholder’s interest in the company. (See also: Shareholder/Partner Insurance)
• Secures Credit Access: Improves ability to obtain business loans by reassuring lenders of continuity.
• Creates Employee Retention Tool: Can be used as a retention incentive by transferring ownership to key employees later on.
• Protects Owner’s Estate: Provides heirs with funds to shut down operations smoothly if the business owner dies.
• Delivers Peace of Mind: Knowing that financial protection is in place should calamity strike.

Key person insurance delivers multifaceted financial and operational benefits to businesses across a wide range of possible scenarios.

How To Apply For Key Person Insurance?

Applying for key person insurance involves six key steps:

Step 1: Identify the Key People

First, closely analyze your workforce and pinpoint the people whose loss would truly jeopardize your business financially or operationally. Consider factors like specialized skills, responsibilities, revenue generated, and difficulty to replace.

Step 2: Calculate Coverage Needed

For each identified person, calculate the potential financial impact of their sudden absence. Account for lost income, recruiting costs, lost sales, debts or obligations tied to them, and other consequences. Use multiples like 5-10x salary as a starting point.

Step 3: Choose Insurance Products

Determine what insurance products make sense for each key person based on factors like their role, age, health, and the budget. Life insurance is most common, paired with disability and critical illness.

Step 4: Find an Insurance Provider

Research top insurers in Canada like Sun Life, Canada Life, RBC, and others. Get quotes from multiple providers with Lifebuzz to compare. Work with a seasoned commercial insurance broker.

Step 5: Complete Application Process

Fill out applications and submit information about the key people. Be prepared to provide their age, lifestyle details, job duties, and medical history. Have them take part in any required health exams or tests.

Step 6: Get Approved and Pay Premiums

If approved, the insurer will issue a policy outlining terms, conditions, benefits, and premium amounts you will pay. Make sure to review carefully before accepting.

Key Takeaways

• Key person insurance protects businesses against financial losses if vital employees die, become ill, or can’t work.
• It provides lump-sum payouts to recruit replacements, maintain operations, and offset lost revenue.
• Ideal for small companies reliant on owners and founders or any firm with irreplaceable employees.
• Covers death (life insurance), disability, and critical illness scenarios.
• Companies purchase policies on key people and pay premiums annually.
• Payout amounts should equal 5-10x salary or higher depending on the specific value.
• Proceeds are tax-free in most cases and used to carry on business activities.
• Helps retain employees, repay debts, fund owner buyouts, and secure loans.
• Applications involve identifying key persons, calculating needs, finding insurers, and getting approved.
• Every company should determine if this insurance could benefit them in a worst-case scenario.

Frequently Asked Questions About Key Person Insurance in Canada

What is key person insurance?

Key person insurance is a life insurance policy taken out by a company to protect against financial losses if a VIP employee dies or can no longer work. The business pays premiums and receives the payout if the employee passes away, becomes disabled, or suffers a covered critical illness.

Why is key person insurance important?

It helps compensate for the potentially huge lost earnings, recruitment costs, reduced revenue, additional expenses, and overall disruption stemming from unexpectedly losing an owner or indispensable employee.

Who qualifies as a key person?

Executives, technical experts, major rainmakers, brand champions, and anyone else whose absence puts the financial health or operational viability of the company at severe risk. Usually less than 5% of employees.

What policy types are available?

The main options are life insurance, disability insurance, and critical illness insurance. These can be purchased individually or in a combined bundle. Term or permanent life insurance plans are available.

Who pays for the policy?

The employer purchases the policy, pays the ongoing premiums, and is the beneficiary. The key employee must consent to be insured and may supply medical history.

How much coverage should be purchased?

A minimum of 5-10 times the key person's annual salary is commonly recommended. Other valuation metrics can be used too, accounting for costs to replace them and revenue they generate.

What does key person insurance cover?

This depends on which type of policy is chosen. Life insurance covers death. Disability insurance covers injury/illness causing inability to work. Critical illness covers specific severe illnesses.

Is the payout taxable?

In most cases, payouts are tax-free to the company. There are certain exceptions depending on the situation. Premiums paid are typically not tax deductible.

How does applying for coverage work?

The main steps include identifying key people, calculating ideal coverage amounts, choosing insurance products, finding providers, completing applications, undergoing medical evaluation, and getting approved for a policy.