Key person insurance is a policy that pays out to a business if a key contributor dies, becomes disabled or is diagnosed with a covered critical illness. The goal is to offset some of the financial losses caused by the absence of a key person.
This overview draws on the federal life insurance guide, the Government of Canada’s business succession discussion, section 20 of the Income Tax Act and CRA’s capital dividend folio.
Our editorial team created this guide to help you figure out if you need key person insurance, what policy makes sense for your business and how key person insurance differs from buy-sell insurance.
Does Your Business Need Key Person Insurance?
Key person coverage makes sense when the death or incapacity of a particular person would have a negative effect on cash flow that cannot be managed. Quantify this effect by evaluating impact on contribution margin, customer attrition, cost of replacement, debt covenant compliance and how long it would take to recover.
However, if the effect is minimal or temporary or if you have adequate liquid reserves and succession plans to deal with the issue, it may not be the most efficient use of your cash.
What’s Included in Key Person Insurance?
| Protection | Trigger | Business use to model | Important limit |
|---|---|---|---|
| Key person life | Covered death while the policy is in force | Recruitment, lost margin, debt or transition cash | No benefit for resignation, retirement or a non-death absence |
| Key person disability | Disability under the contract after any waiting period | Monthly overhead or temporary replacement cost | Occupation definition, benefit cap and benefit period matter |
| Key person critical illness | Diagnosis and survival period for a covered condition | A lump sum for recovery or role transition | Only listed conditions meeting the policy definition qualify |
| Personal coverage for the individual | Event insured under a personally owned policy | Family or personal financial needs | It is not automatically a business continuity asset |
How Much Key Person Coverage Should You Buy?
Keep in mind:
- The insurer is going to look at whether or not there is justification for the total amount.
- Don’t count a debt in both the buy-sell calculation and the key person calculation.
Start with cash effect.
Specify the time horizon for recovery. If applicable, use the contribution margin, not revenue, because it reflects the profit they contribute.
This is a methodology, not a quote or recommendation.
Recalculate coverage amounts if the role, reserve, debt or recovery time changes.
Read More: Read How Buy-Sell Agreements Work
How Losing a Key Person Affects Business Valuation
Weak succession planning can lead a buyer or lender to discount business value.
Key person coverage should be supported by documented processes, information access plans, key-client introductions, emergency decision-making and other steps to reduce business risk.
Key Person Funding and Buy-Sell Funding Are Not the Same
Key person insurance is meant to protect a business from loss. Buy-sell insurance is designed to provide funding to buy out a business interest according to the buy-sell agreement.
A policy can serve both purposes, but ownership, beneficiaries, valuations and timing of payment must dovetail with the legal document. Have your corporate lawyer, accountant and a licensed insurance adviser review it.
How Is Key Person Insurance Taxed in Canada?
The accountant should document in writing, before any implementation, the tax consequences of paying the premiums. This includes the portion of premiums that may be deductible under paragraph 20(1)(e.2) of the Income Tax Act, the adjusted cost basis of the policy, estimated capital dividend account implications and any collateral assignment.
Do not implement a life-insurance transaction based only on a claim that everything will be tax-free. Insurance premiums are deductible only in certain circumstances. Paragraph 20(1)(e.2) of the Act sets out what constitutes a deductible amount, such as life insurance assigned to a financial institution as collateral for a qualifying loan, subject to restrictions. Only a prescribed amount determined through a specific calculation can be deducted.
Death-benefit proceeds received by a corporation generally increase its capital dividend account by an amount equal to the proceeds less the adjusted cost basis of the policy immediately before death, with modifications.
Whether tax-free capital dividends can be paid to shareholders depends on several factors, including the available capital dividend account and a proper election. The corporation receiving the insurance proceeds and distributing proceeds to shareholders are separate events with their own tax implications.