Key person cover is one of the most misunderstood — and most underused — tools in business financial planning. Here is where most businesses go wrong.
Most business owners, when pressed, will admit that their business depends heavily on one or two key individuals. A founding partner who holds the client relationships. A technical director whose expertise is irreplaceable. A sales leader who drives 70% of revenue.
Ask those same business owners what would happen to the business if that person died or became permanently disabled tomorrow — and the honest answer is usually somewhere between "serious disruption" and "it probably wouldn't survive."
Key person insurance exists to bridge exactly that gap. Yet it remains one of the most poorly understood and improperly structured financial products in the South African business landscape. Here are the five mistakes I see most often.
The most common misconception is that key person insurance is simply life cover taken out on an employee. It isn't — or rather, it doesn't have to be, and the distinction matters significantly.
Personal life cover is designed to provide for the policyholder's dependants. The purpose is personal financial protection.
Key person insurance is taken out by the business, on the life of a key individual, for the benefit of the business. The purpose is to compensate the business for the financial loss it would suffer from the death or disability of that person.
The distinction affects how the policy is owned, how it is taxed, how the premium is treated, and how the proceeds are used. Getting this wrong — taking out personal cover and expecting it to serve a business purpose — creates tax complications and may fail to protect the business at all.
When I ask business owners how much key person cover they think they need, the most common answer is a number that sounds large but has no calculation behind it.
The correct amount of key person cover should reflect the actual financial cost to the business of losing that person. This typically includes:
The calculation is specific to each business and each individual. A generic amount almost always leaves the business underprotected.
Death is insurable and widely understood. Disability is statistically more likely — and frequently overlooked.
The probability of a 45-year-old suffering a disability that prevents them from working for more than two years before retirement is significantly higher than the probability of dying before retirement. Yet most key person arrangements cover death only.
A key person who suffers a stroke, a serious accident, or a debilitating illness may be unable to work for months or years without dying. The financial impact on the business is the same — or worse, because the business may feel obligated to continue paying the individual while also needing to fund a replacement.
Key person disability cover — providing a lump sum or income benefit to the business on the disability of the insured individual — is a critical component of a complete business assurance structure that most businesses do not have.
A key person policy without a properly drafted legal agreement is an incomplete solution. The policy provides the money. The agreement determines what that money is for, how it is used, and what obligations it creates.
Without a clear agreement in place, a key person policy payout sitting in a business bank account can be disputed, misused, or treated as a windfall rather than a structured business protection mechanism. The tax treatment of the proceeds — whether they are capital or revenue in nature — also depends on the purpose and structure of the policy, which should be documented in the agreement.
This is where the combination of financial planning and legal expertise matters. Getting the policy right and the agreement right are two different skills — and both are necessary.
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Business values change. Revenue grows. Key people's roles evolve. A key person cover amount that was appropriate three years ago may be a fraction of the actual exposure today.
Most key person policies are set up once and never reviewed. The business doubles in revenue, the key person takes on additional responsibilities and relationships, the bank facility increases — and the cover amount remains unchanged from the original policy.
An annual review of your key person cover, aligned to your business's current financial position and the key individual's current role, is the difference between having business assurance and having the illusion of business assurance.
Want to work through this for your specific situation? Let's have a conversation.
Shaun Dalton CFP® | Postgraduate Diploma in Investment Planning | LLB
Efficient Wealth — Authorised FSP 655 | Potchefstroom