A primary goal of most entrepreneurs is to make sure the company they founded will survive after they have gone. If you have clients who are small-business owners, you need to talk to them about key person insurance as the primary way to ensure stability and continuity in a worst-case scenario.

A strategy rather than a product, key person insurance protects a company from the impact of the unexpected death or disability of an owner-manager or other key employee. It is used to cover some of the most immediate needs a company faces in this type of emergency, including: covering the loss of owner income; covering the loss of employee-generated revenue; paying off a bank loan; keeping suppliers at bay; paying the recruitment costs of finding an employee replacement; and providing a death benefit to the grieving family of the owner or key employee.

But it can also be part of a long-term strategy: key person coverage can evolve to suit longer-term needs, such as estate planning for the owner or funding the retirement of a key employee.

The products used in employing a key person insurance strategy are life insurance, disability insurance and critical illness insurance. For an insurance advisor, talking about these products for the first time with a new small-business client may be difficult. And simply pulling one or more products off the shelf for your client probably will not get you very far.

“It doesn’t take into account the client’s emotion — what they really want,” says Mitchell Singer, assistant vice president of tax and estate planning at Toronto-based Transamerica Life Canada.

The age of the business owner and stage of the business need to be considered, says Jon Hitchcock, director of Sun Life Financial Inc. ’s internal marketing division in Toronto. A 23-year-old will have a different view of his business than a 57-year-old, he says.

Meanwhile, advisors bringing individualized risk-management solutions to the table need to let clients know they understand the needs of the business owner, says Hitchcock.





Calculating key person coverage for an owner-manager will mean taking a look at how the client operates, says Roger McMillan, president of Toronto-based McMillan Financial and chairman of Advocis.

He points out that many entrepreneurs take out an annual salary, but plow a lot of their earnings back into the company. For example, he says, an owner may pay himself $100,000 a year, but may be putting $700,000 back into the company as retained earnings.

And beyond the immediate financial figures, notes McMillan, is the entrepreneur’s “vision.” Is the company one that simply pays its bills and employees? Or is the entrepreneur someone with a plan who is striving to build his company?

The difference in vision will affect insurance needs, says McMillan. Putting a value on that difference is what makes providing key person coverage “an art rather than a science,” he says.

Another way to look at the value of an entrepreneur is by assessing the goodwill that has been developed among his or her customers as a means of incurring future profit, says Jim Kraft, Toronto-based vice president of marketing for the independent advisors channel at Manulife Financial Corp.

For example, Kraft says, a restaurant may be worth $1 million as a going concern when the owner is the chef and driving personality behind it. But if the owner dies, the restaurant might be sold for only $200,000, he adds.

That means the underwriting process has to be as comprehensive as possible.

Kraft says if the client is an owner-manager, the underwriting process might require three or more years of financial statements.

Of course, he points out, this kind of financial information is in addition to the usual types of medical factors involved in underwriting a life or living benefits insurance policy: age, gender, health status and whether the person smokes.

In more concrete terms, it may be quicker and simpler to value the financial impact if the owner dies today as opposed to years down the road. That’s why it is important for you to keep in constant contact with small-business clients to make certain their insurance coverage matches the evolving profile of their companies.





The second type of key person insurance applies to employees — the one or more employees who are critical to a company’s success.

@page_break@In order for a business to grow, says McMillan, the owner must put key people in place. Therefore, in the embryonic stage of a business, there is a definite need to identify these important people.

There are a few ways to make that identification, says Peter Wouters, national director of tax and estate planning for Empire Life Insurance Co. , based in Kingston, Ont.

First, does the employee have a specialized skill set that will have to be replaced at a price? Second, does the employee have a customer base that results in a significant amount of business for the company? Third, will the loss of the employee have an adverse effect on the company’s capital?

The general rule of thumb for setting the value for a policy on a key employee is three to five times the person’s annual salary. So T4 information is useful in the underwriting process. However, you also have to look at the revenue that the key person brings in the door.

In addition, it could be helpful to look at how the loss of the key employee would compare with the impact of the loss of a similar employee in the same industry.

Your owner-manager client may want to look at insurance that will cover more than one person — perhaps up to five key people, including himself or herself. It’s possible to get separate policies for each person, says Wouters. Joint policies are another option, but coverage ends once one of the key people dies.

A multiple-life policy is probably the best option. If one of the insured people dies, the multiple-life policy stays in force, says Wouters. This type of policy offers other advantages, he says: the administrative cost of a single policy is lower, and when one of the insureds leaves the company, another person can be substituted under the policy.

Another part of the “art” of providing key person coverage is examining how the contributions of key people can vary. For example, says Wouters, how much income is brought in by a key salesperson could vary from year to year by as much as 10%-15%.

The upside of that is the cost of replacing that key person will be less, notes Wouters. However, a new person probably will bring in less than a salesperson who has been with the company for several years. This offset must also be accounted for in the overall coverage/premium calculation.





It’s a legal requirement that another person’s life cannot be insured without their consent. So, when a key employee is approached regarding key person insurance, it’s quite likely that he or she will want the company to provide a similar life policy for which they will name the beneficiary.

There are a couple of possible options in this case: the company could fund a separate policy for the employee; or it could buy a “split dollar” policy. The latter involves dual ownership of a permanent type of policy, usually universal life. It is purchased jointly — both parties are responsible for paying their respective share of the premiums.

The company would get the death benefit, and the employee would own the remaining interest in the policy — generally, the cash surrender value. The cash surrender value can be held out as an incentive to the employee to stay with the company for a set period, such as five or 10 years, says McMillan.

The strategy can also be used to supplement the employee’s retirement; the key person coverage “kills two birds with one stone,” says Wouters.

Also known as providing “golden handcuffs,” this type of retirement planning using key person insurance is one of the more advanced applications of the strategy, says Singer.

He suggests yet another alternative: instead of giving the cash portion of a policy directly to the employee, it might go toward funding a retirement compensation arrangement for high-end employees. “An RCA can be a valuable tool in providing deferred compensation for a key employee without the employee incurring any taxes today,” he says.

RCAs can have a vesting period of five years or more, during which the employee does not have access to the funds. “This puts the need for insurance together with tax-deferred benefits,” says Singer.

An insurance-funded RCA can make both the company owner and the key employee happy, he adds.

Alternatively, when an employee retires or leaves the company, the company can offer to transfer the death-benefit portion of the policy to the employee, who would take over paying that portion of the premium.

There are tax implications, based on how a key person policy is purchased. Premiums for a policy with the company as beneficiary are not deductible. But if the company buys a policy for a non-shareholder employee as beneficiary, the premiums are deductible for the company and a taxable benefit for the employee.

If both parties buy the policy jointly, when the death-benefit portion is transferred to the employee, the Canada Revenue Agency would likely deem it to be a taxable employee benefit.

For these reasons, it may be advisable for the company and the employee to have separate policies, says Wouters. That way they won’t be running into problems with the CRA over mixing payments, and later looking for a properly maintained paper trail.





It is also possible to buy corporate-owned disability and CI insurance policies on key employees. In both cases, the benefit goes to the corporation. As with life insurance, separate policies could be bought simultaneously, with the employee the beneficiary of one.

The rule of thumb — up to five times the key employee’s salary or three times plus their bonuses — may be the maximum amount of coverage a company could get for the purchase of disability or CI insurance on a key employee. “The client may get capped at that amount,” says Wouters.

Any company that adds disability and CI to the corporate insurance package probably has a cash flow that is larger than average. However, it is possible to bring down the costs of disability insurance, for example, by extending the wait time for the coverage to kick in. Wouters suggests 60 to 120 days.

Joe Kordovi, vice president and pricing actuary at Transamerica, notes that the cost of CI insurance has risen 30% in the past few years. Therefore, he suggests that an alternative way to fund living-benefit needs is to use the investment portion in a universal life policy.

The ability to choose coverage will depend on the company’s cash flow. For many start-ups, high monthly premiums are not an option. So, they are more likely to buy a 10- or 20-year policy that can be renewed and converted to a permanent policy — as long as poor health doesn’t become an issue.

Companies with larger cash flows may opt for permanent insurance — whole life or universal life — from the beginning. The premiums typically range from $400 to $3,000 a month, depending on how much the company wants to put in up front to build the cash value of the policy. But the premiums will remain steady.

With term policies, the premiums will rise constantly over time. For example, says McMillan, for a 10-year term, convertible, $1-million policy for a 40-year-old non-smoker, the premiums could start at $80 a month and increase to $400 a month in 10 years, and more than $1,000 a month in the 21st year.

The argument against increasing premiums is that term insurance provides only the basic death benefit, and none of the benefits of the tax-deferred cash value buildup inherent in permanent forms of insurance.

Bev Moir, a senior investment executive with ScotiaMcLeod Inc. in Toronto, holds a life insurance licence and has an insurance specialist as part of her team. She generally suggests clients go for some level of permanent insurance. If they choose term insurance, she says, they could find out down the road that they don’t qualify for a conversion to permanent insurance because of health complications.

Chris Ireland, vice president of planning services for PPI Financial Group Inc. in Vancouver, says you should make sure the insurance policy you sell to the client is convertible to permanent insurance.

“For young people, it should be OK,” he says. “If they are in their mid-30s to mid-40s, it should be fine.” However, he adds, the risk rises when clients reach their mid-50s.





Over time, the use of life insurance held by a company can evolve from dealing with the financial impact of the sudden death of the owner to longer-term needs.

A common use for coverage that was initially meant to replace a key person is to provide funding for a buy/sell arrangement. For example, if two brothers jointly own a company and one dies, the insurance can be used by the firm to buy the shares that the deceased brother’s family have inherited.

Simultaneously, part of the funds can be used to replace the deceased brother’s expertise, says Wouters. The remaining brother “would still need the benefit of key person coverage. The company could have one policy that does both,” he says.

RBC Insurance in Miss-issauga, Ont., offers life insurance that can cover key person needs as well as a buyout. It also offers separate disability insurance products — one for the company’s key person needs, and another to fund a buyout, says Paul Rowe, director of the central region with RBC’s life and health division. A buyout can be personal, generating capital gains for the surviving shareholder; or corporate, generating deemed dividends.

The structure of the buyout should be dictated in a shareholders’ agreement, notes Herb Huck, RBC’s director of professional advisory services.

In considering the long-term needs of the client, you may want to consult tax and estate planning specialists made available by the insurer that is providing the key person coverage. “The business owner wants to make sure his needs are covered. He will be looking for solutions, not products,” says Wouters.

You should also check that the policy issued is the one that was applied for, he adds.

PPI’s Ireland says his company agrees that the planning process must be “thought all the way through.” He says PPI works with its associates to make sure the client’s insurance coverage matches the needs in his or her will. PPI employs a large number of lawyers and accountants who specialize in tax and estate planning to back up its associates.

Meanwhile, says Ireland, effectively helping the client will mean working with the client’s other advisors, such as an estate lawyer or tax accountant.

Another way to use the insurance coverage is to pay capital gains taxes upon the owner’s death. For example, suppose an owner started from nothing and at death the company is worth $5 million. Half the capital gain, $2.5 million, will be subject to taxes. If the lifetime capital gains exemption of $750,000, which was proposed in the 2007 federal budget, is deducted, that still leaves a tax liability of $1,750,000.

If that amount is taxed at 46% (the highest marginal rate in Ontario), the taxes owing will be $805,000. That tax bill could cut significantly into your client’s estate.

“Insurance could take care of the tax bill — rather than selling assets to pay it,” says Kraft.

Another estate planning use of the coverage may be to pay the proceeds to an owner-manager’s family. This isn’t done directly, Wouters explains: the key person policy proceeds will be payable to the company, no matter what the monies are used for.

However, the difference between the death benefit and the adjusted cost base of the policy (usually zero at death because the policy will have been paid for) are credited into what the CRA calls a “capital dividend account,” and then payments in the form of tax-free capital dividends can be made to the deceased’s family. IE