04 - Key person Insurance

Question 1

Why is key person insurance necessary?

Answer 1

Some employees / directors are crucial to the profitability of a business, e.g. a sales or marketing manager or someone with a scarce skill.

Death of such a key staff member can cause serious financial distress
- Loss of income
- Cost of replacement
- Recruitment costs
- Take-on bonus and/or salary increases
-  Relocation costs

Key person insurance can be used to soften the blow.

Question 2

How do you value a key person?

Answer 2

There are at least three ways to value the key person:

Methods

• A multiple of the key person’s annual remuneration (e.g. five times or seven times depending on the person’s impact on the business);
• The number of years it would take the business to restore profitability multiplied by the loss in net profits;
• Itemised cost of replacement.

Assessment
The first is an approximate method and should
not be used for high cover amounts.
The second focusses solely on profits
The last method is the most accurate

Question 3

Key man policy calculation

Answer 3

1. Replacement cost
   - Advertising for the replacement
   - Relocation cost of replacement
   - Increase in salary package
   - Other
2. Key person’s contribution to net profit
   - Average profit over last 5 years
   Minus: Reasonable yield on capital invested
   - Annual profit attributable to key staff
   - KP’s salary as % of key staff payroll
   - KP’s contribution to profit of key staff
   - Years needed to replace KP
   - Key person’s contribution to profit

Total value of person = 1+2

Question 4

What are the estate duty implications of key man policies?

Answer 4

Estate Duty Section 3 (3) (a) (ii)

except where the provisions of paragraph (i) or (iA) of this proviso apply, the Commissioner is satisfied and remains satisfied that

• Initiated - such policy was not effected by or at the instance of the deceased,
• Premium paid - that no premium on such policy was paid or borne by the deceased,
• Payment to estate - that no amount due or recoverable under such policy has been or will be paid into the estate of the deceased
• Payment to connected parties - and that no such amount has been or will be
• • paid to, or utilized for the benefit of, any relative of the deceased
• • or any person who was wholly or partly dependent for his maintenance upon the deceased
• • or any company which was at any time a family company in relation to the deceased;

If sec. 3(3)(a)(ii) does not apply,
the death claim value of the policy will fall in the estate for estate duty purposes and will potentially cause estate duty.

The level to which provision should be made for estate duty depends on whether the deceased was also a shareholder in the business – Estate Duty Act - sec. 4(p)

Question 5

How is relative defined in the estate duty act?

Answer 5

“relative”, in relation to any person, means

• the spouse of such person
• or anybody related to him or his spouse within the third degree of consanguinity,
• or any spouse of anybody so related, and for the purpose of determining the relationship between any child referred to in the definition of “child” in this subsection and any other person, such child shall be deemed to be related to its adoptive parent in the first degree of consanguinity;

Question 6

What is the definition of a family company in the estate duty act?

Answer 6

“family company”, in relation to a deceased person, means

any company (other than a company whose shares are quoted on a recognized stock exchange)

which at any relevant time was controlled or capable of being controlled directly or indirectly,

whether through a majority of the shares thereof or any other interest therein or in any other manner whatsoever,

by the deceased or by the deceased and one or more of his relatives;

Question 7

How should estate duty be provisioned for in the event that sec 3 (a) (ii) is not applicable?

Answer 7

4. Net value of an estate.—

The net value of any estate shall be determined by making the following deductions from the total value of all property included therein in accordance with section 3, that is to say—

(a) – (o) …
(p) so much of the value of any property deemed to be property of the deceased by virtue of the provisions of section 3(3) as has not been deducted under any of the other provisions of this section and as the Commissioner is satisfied has been taken into account under the provisions of section 5(1)(f)bis in the determination of the value of any company shares or a member’s interest in a close corporation included as property in the estate;
(q) …

Question 8

Calculating the sum insured for a policy subject to ESTATE DUTY ONLY

Answer 8

Sum insured = Amount needed/[0.8 + (X%(0.2))]

Where X% is the shareholding

Question 9

Calculating the sum insured for a policy subject to ESTATE DUTY AND INCOME TAX.

Answer 9

Sum insured = Amount needed / 0,72[0.8 + (X%(0.2))]

Question 10

Estate Duty - Sec 5(1)(f)bis

Answer 10

Clause basically says that a deduction can be made so long as it has already been captured in the value of the shares already taken into account in calculating the estate.