Risk management: Key person insurance
When a senior partner at a mid-sized accounting firm in his early fifties was suddenly killed in a car crash, his firm could have been greatly impacted financially. Instead, his practice transitioned smoothly within the firm and his spouse was paid handsomely for her husband’s interest in the practice.
The best way to protect your firm from financial hardships and to meet its financial obligations is through proper planning with the right professionals. By having key person insurance in place, this will ensure your firm’s survival and help each partner meet his or her financial and estate planning needs.
How did this accounting firm manage to stay financially healthy after one of its senior partners was gone? A year earlier, all the partners at this firm purchased key person life, disability, and critical illness insurance policies to insure two year’s profits in the event that any of the partners became critically ill, disabled or dead. The result? As I write this article the practice continues to flourish today while having provided for the deceased partner’s family.
It should be mandatory that every accounting firm across Canada has key person insurance coverage in place, but it is not. This type of insurance protects a firm against various financial setbacks that can result from an accident, sickness or death of a key member of the practice. This key person could be you or anyone else critical to your firm’s continued operation and success. Key person coverage can provide enough cash to replace lost revenue due to the death of an accountant, the repayment of business loans, recruitment and training of a replacement accountant.
Key person insurance can improve your firm’s chances for loan approval. Lenders look favorably on a firm with key person insurance since it shows responsible planning and makes it more likely creditors will be repaid.
How much key person coverage should you purchase? That depends on the impact that the key person’s death would have on the practice. Although this may be difficult to determine, aspects to consider include the person’s salary, industry knowledge, the goodwill generated by the person, the cost of hiring a replacement, and the firm’s outstanding loan balance. One rule of thumb is to buy five to ten times the key person’s salary. Another is to purchase two year’s net earnings that the firm produces.
Imagine a two-partner firm that has worked hard to establish a thriving accounting practice. Then, suddenly, one of the partners dies due to a massive heart attack. This event could put the surviving partner into debt and cause him to close-up the practice. However, by having a buy-sell agreement in place that is funded through a key person insurance policy, the practice will continue almost uninterrupted.
The buy-sell agreement had established the value of the firm and the funds necessary for the surviving partner to buy out his deceased partner’s interest. The CA practice survives, and the heirs of the deceased partner are paid in full for their interest in the firm.
If a firm is a partnership or closely held professional corporation, a properly funded buy-sell agreement is vital. When there is more than one partner, a buy-sell agreement allows the remaining partner(s) to purchase the business interest of the deceased, retired or permanently disabled owner.
A buy-sell agreement funded by life, disability or critical illness insurance policy can accomplish the following:
- Help eliminate potential lawsuits stemming from the business valuation.
- Help assure the continuation of the business for the remaining partner(s).
- Allow the surviving partner(s) to maintain control of the firm by requiring the deceased partner’s interest to be sold.
- Help assure that the partner’s heirs are quickly paid in full for their share of the firm, even if the surviving partners are not able to run the firm successfully.
Do you need key person insurance?
You should consider purchasing key person insurance if any one of the following is true:
- Your firm is likely to falter if you are no longer there.
- Your firm is likely to falter if another accountant is no longer there.
- You do not have adequate funds to offset any losses until an appropriate replacement for the key person can be found.
Whether your practice is considering key person coverage, a buy-sell agreement, or both, it is important that the documents and insurance policies be reviewed periodically to ensure that the valuation formula is current and that the plan is funded adequately. This should be done at least once every three years or if there is a major change occurring within your firm.
To receive the right advice and to be sold the right policy, you should consider your agent’s experience and professional qualifications. Certified Financial Planners (CFP) and Chartered Life Underwriters (CLU) are technically competent in the area of life, disability, critical illness, and long-term care insurances. These individuals who have attained either the CFP or CLU designations must continually meet education, examination, experience, and ethical standards.