Covering the cost of serious illness among key personnel

What would happen to your business if a key employee developed a serious illness or died prematurely? While the platitude that nobody is irreplaceable may ultimately be true, some businesses nonetheless depend overwhelmingly on key individuals for their profitability.

These can include the sales account manager with personal connections or the R & D engineer who's the only one who can produce the widgets that give you the edge.

Businesses can be damaged or even collapse if profitability declines through the critical illness or death of a key individual. Moreover, a company can face unexpected costs while recruiting or training a replacement. And it can take some time before the replacement is as effective as his or her predecessor. Meanwhile, a financial institution can call in a loan if a key director was its sole guarantor.

Keyman Assurance sometimes called Keyman Insurance is a policy taken out by a company or partnership to provide it with funds against lost profits and extra costs incurred by the serious illness or death of a key employee. It is a policy taken out by a business for the business the employee doesn't benefit from it in any way.

The amount of cover chosen will be based on a subjective estimate of the employee's contribution to past profits and future projections. It should include the cost of recruiting and training a replacement; the time it would take him or her to master a predecessor's role; and meet any loans that would be called in on the employee's death.

According to Mr Barry Coleman of Finance Matters in Ranelagh, Dublin, one accepted method for calculating the sum assured is to multiply by between five or 10 times the key person's total remuneration "including any fluctuating emoluments and fringe benefits".

But anomalies can arise in the case of a small business in its early years. For instance an employee could accept a modest income that fails to reflect his or her true worth to the business. In such a case Mr Coleman says a multiple of up to five times the net profit or twice the gross profit over the previous three years can be used.

However, he advises care in using the net profit bench-mark since businesses can legitimately determine low net profit figures to reduce their tax liability.

Adjustments of the sum assured need to be made if there's more than one key person in a small developing business. Further adjustments arise for rapidly expanding businesses an individual's contribution to an enterprise could be worth considerably more even in the short-term future.

Proceeds on any claim are treated as trading receipts and are subject to tax. However, premiums are usually considered admissible deductions by the Revenue Commissioners if the following conditions are met: the relationship must be that of an employer and employee; the employee cannot own or control 15 per cent or more of the ordinary share capital of the company; the insurance must be intended to meet the loss of profit resulting from the serious illness or death of the employee; the policy must be for a fixed term and cannot extend beyond the employee's expected years of service; the policy must not acquire a surrender value and the proceeds on the serious illness or death must be payable to the employer.

The company should seek confirmation of the tax treatment of the premiums and proceeds from the Inspector of Taxes.

Companies taking out Keyman Assurance must pass a board resolution specifying that the company is taking out a serious illness and life policy on a named employee who holds such-and-such a position.

It specifies that the insurance is against the loss of profits in the event of the serious illness or death of the employee and that in the event of a claim the proceeds will be payable to the company.

Coleman provided the following illustration of Joe Bloggs, a 35-year-old nonsmoker. A monthly premium of £56.40 was determined for 25 years with £100,000 payable to the company on his death or earlier serious illness.

It covered: serious illnesses like heart attack, cancer, stroke, kidney failure, HIV/AIDS; major surgery like aorta graft, balloon angioplasty, coronary artery bypass and heart valve surgery; and organ transplants such as heart, lung, liver, kidney, pancreas and bone marrow.

Disabling conditions like multiple sclerosis, blindness, benign brain tumour and motor neurone disease were also covered. Also included was total permanent disability caused by paralysis or paraplegia; loss of limbs, speech or hearing; coma; severe burns; rheumatoid arthritis; Parkinson's disease; Alzheimers disease and emphysema.

Coleman stresses it's "extremely important" to acquire and scrutinise a detailed breakdown of what illnesses are or are not covered. While that's a cautionary note, it works both ways: it can and does happen that companies draw down the full sum insured and welcome back their colleague hail and hearty after a brief operation and month's convalescence.