Few businesses think twice about insuring their physical assets against fire, flood, theft, malicious or accidental damage and so on. However, it seems that very few think about insuring their human assets against such risks as untimely death and permanent and total disability. With one person in six dying before age 65 and more than 2.2 million adults having been unable to work for six months or more, the risks are probably higher than most people think.
Profits, project work, development plans, client relationships and market share can all be hostages to fortune should the worst happen. Those organisations that convince themselves that they can cope without the day-to-day delivery of services by their key people are unnecessarily putting their businesses at risk.
Some intermediaries shy away from tackling the issues in this market, believing that meeting the protection needs for small to medium sized businesses is more complex than for the individual personal financial planning arena. Although there are undoubtedly differences between the two markets, the potential rewards available in forming close working relationships with small to medium sized companies should cause advisers to reconsider.
In addition, while some individual and family protection cover may be moving towards being handled on a direct basis, business protection remains firmly in the advice led market. This is because there are complex legal and taxation issues to be considered as well as the structure of the company itself. Time invested gaining additional skills can quickly result in clients who are likely to demand to be seen within office hours and are used to making quick decisions.
The advice gap
Royal & SunAlliance recently carried out research among 135,000 small to medium sized businesses. 73% of companies questioned said that they had one or more key people whose loss, even temporary, would have a serious impact on trading and profitability. In fact 67% said that they had between two to five such people. Despite this, over half of these businesses did not have any protection against the loss of key staff through death, critical illness or long term disability.
The research also reveals a surprising lack of market penetration. Of the businesses indicating that they did not have any such cover, 30% said that they had never even heard of key man insurance. 56% of businesses believed that they had suitable insurance in place to protect their business profits in the event of anything happening to an employee. When questioned further, it emerged that the majority of the companies had answered that question in the context of death, but had not considered the consequences of a key employee developing a critical illness, for example.
A high degree of confusion was evident among the companies surveyed with regards to which type of insurance covered their business for financial loss in which circumstances. For example, 51% of companies thought that group income protection insurance would cover their businesses for future financial loss of a key employee, regardless of whether that employee should die or fall ill. Also, 41% thought that accident, sickness and unemployment insurance would be suitable, and 35% thought that private medical insurance would be adequate to cover the business for most eventualities.
Establishing the need
So how does key man insurance work? The company applies for a key man insurance policy on the life of one of its senior managers or key executives and pays the premiums for that insurance. If the individual should die or become disabled during the period of cover, the business will receive a substantial lump sum to fund the costs of recruiting and bedding in a replacement and to make up for any fall in turnover and profits while it reorganises its resources. The policy must be either an annual or short term insurance. Monthly premiums for key man insurance can be as low as £22.93 to cover a 29 year old male, non-smoker, for £500,000 over 20 years, according to Royal & SunAlliance.
The need for key person cover normally arises in one of the following ways:
• Loan protection – where a company is likely to need cover on an individual who is vital to the delivery of a business plan against which a lender has agreed to advance finance. In reality it might well be a condition imposed by the lender.
• Loss of profits cover or business recovery benefit – this is a requirement when the profit stream for a company depends totally, or to a very large extent, on one or more key individuals.
Identifying key people
Traditionally key individuals were likely to be chair people, managing directors and finance directors. However, the net is likely to be much wider. Key people hold a wide variety of positions and responsibilities, ranging from sales directors to engineers, from production managers to chefs, from medical researchers to carpet designers. Perhaps not surprisingly, Royal & SunAlliance’s research also revealed that 63% of those companies questioned identified a woman within their organisation as a key individual. It is worth bearing in mind that some of these women may be working mothers, which brings an additional protection dimension into play.
Larger organisations are less likely to need key person cover since their responsibilities for delivering profit are usually spread across many people throughout the organisation. Also, well established human resources functions are likely to have created robust succession planning processes, allowing the organisation to react quickly if disaster strikes. As a result, the impact or loss can be significantly reduced in large businesses.
The market for key person cover is simply companies where the loss of a key individual or individuals would have a direct impact on profitability. What is good news is that in the UK the number of businesses falling into that target market is huge. Companies who employ up to 20 people account for around 96% of UK businesses.
When sitting down with the decision makers in any business to determine who is key, a checklist can be useful to identify the areas to cover. A positive answer to any of the following questions is likely to mean that an individual is key to the delivery of profit in that particular business.
Does he or she:
• play a critical role in the company?
• have a direct effect on turnover or profit?
• have business contacts vital to the company?
• carry out a vital sales function?
• play a vital role in a major project?
• have a credit rating dependence?
In addition, would he or she:
• be difficult to replace?
• affect stability if absent?
While this list is not by any means exhaustive it does provide some key triggers which can be used depending on the nature of the organisation.
Having identified a key individual, the company would almost certainly need help to estimate the potential financial loss they might experience should the individual die, become critically ill or suffer long-term disability. The ‘Cashflow calculation’ box inset shows one method of calculating the key person’s contribution to the company’s profit.
When the cover is for loan protection the sum assured is obvious. But, where loss of profits cover is concerned, there are some broad guidelines which can help settle the level of sum assured required:
• Multiple of salary. This basis can be used when the purpose of cover is to buy in a replacement. The normal maximum for calculating this sum assured may be up to 10 times salary. In exceptional circumstances, particularly at younger ages, this might be stretched to 15 times salary.
• Multiple of profits. A multiple of either gross or net profit can be taken. The multiple is usually five times the average net profit for the past three years or two thirds of gross profit, depending on the stage of growth of the company. Multiply this figure by the percentage proportion that each particular key employee contributes.
Grasp the nettle
Between the ages of 30 to 65 there is a 44% chance that only two out of three executives will survive. Around 250,000 new cases of life threatening cancer are diagnosed in the UK each year. An estimated one in six of 30-year old men will have a heart attack before they reach 65. A sobering thought!
But as with individual protection, key drivers in businesses do not like to think about these issues, their priority is to deliver profit for their organisation. The priority of intermediaries must be to make sure they are aware of the risks they are running. And, as the Royal & SunAlliance research will attest, there is clearly a lot of work to be done in this area. The lack of awareness and general confusion among businesses, with regards to the different types of protection available and their uses, means that the opportunities for intermediaries to penetrate this market are potentially huge and should not be ignored.