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Financial Planning

How Keyman insurance can help protect the life of a business

10 January 2017
Know what Keyman insurance is and how can it protect more than just your business!
 

By C Ramanathan

Most of us are familiar with how the life insurance policy of a family's breadwinner helps out in case of his/her untimely demise. However, the fact that life insurance can play a similar role, in the form of Keyman insurance, for businesses is not so well known.

What is Keyman insurance used for?

Keyman insurance helps a business recover from the loss of its valuable assets viz the persons who run it and/or own it. Individual talents are becoming critical to the success of many companies and employees are also becoming an important factor in investors' valuation of the entities. Every business has at least a few very valuable employees who contribute significantly to the running and growth of the company. It makes sense to insure against the unfortunate event of their untimely demise. This is because the company may face business/financial loss in case of sudden death of such valuable employees. It is here that Keyman insurance comes into play.

Keyman insurance defined

Keyman insurance can be defined as an insurance policy where the proposer as well as the premium payer is the employer, the life to be insured is that of the same employer's key employee (Keyman) and the benefit, in case of a claim, goes to the employer. The `Keyman' here can be any employee, having a special skill set or substantial responsibilities, who contributes significantly to the profits of that organization. It is not a special plan of insurance but just application of life insurance to fulfill a special need.

The object of Keyman insurance is to cover the life of a Keyman for a monetary value so that in case of untimely death of such Keyman, the loss to the firm is recouped with monetary assistance (insured amount) received from the insurance company. As the name implies, the 'key person' is the key to the business' success; without him or her, the company would stumble.

Keyman includes a key-woman also and there can be more than one Keyman in a company. Keyman insurance can also be used to cover the partners in a partnership firm.

What happens if a Keyman quits the company to join another?

The first employer, who has bought the Keyman policy, can choose any one of the following options.

1. The first company (employer) can stop paying the premiums and allow the policy to lapse. 2.It may continue paying the premiums and collect the proceeds on a claim arising. 3. The policy could be transferred to the new employer of the Keyman on terms mutually agreed upon by both the companies. 4. It can be assigned in favour of the life assured / keyman

Basic eligibility requirements for Keyman insurance

Basic conditions required to be fulfilled in order to buy a Keyman policy from an insurance company include:

1. The 'key-man' should hold less than 51% of the company's shares. 2. The total number of shares of the company held by the Keyman and his family together should be less than 70% of the company's shares. 3. Some proof of the critical role that the proposed life (the Keyman) plays in the business of the company, is required.

The maximum sum assured for Keyman insurance is lower of: 

1. Ten times the keyman's annual compensation package.

2. Three times the average gross profit of the company for the past three years.

3. Five times the average net profit for the past 3 years.

Keyman insurance is normally not issued if a company's profit or turnover is declining unless there are very special circumstances. Factors like age limit and coverage term varies from one insurance company to another.
Loss making companies cannot buy Keyman insurance.

Type of policies allowed to be bought as Keyman insurance

Till recently endowment life insurance policies with maturity benefits as well as term insurance were allowed. However, following change in rules by the IRDAI now only term insurance is allowed to be bought as Keyman insurance. The term of the policy usually coincides with the retirement age or the contract period of the key employee. Loan against policy and riders are not permitted. In this policy, nomination can be done only in favour of the company.

Benefits of Keyman insurance to the company

1. It protects against business risk in the event of unfortunate death of the key person.

2. The premium paid will be treated as business expenses and the company would save 30% plus surcharge on every rupee of premium paid for such a policy as per current tax law.

3. Disruption of lines of business credit due to the death of the Keyman can seriously affect the business. Here, the insurance money can help as a guarantee of loan repayment in case of death of the key person.

4. The morale of the key employee is boosted. He/she feels important. The sense of belonging increases productivity and helps in retention of the key employee.

5. It helps in keeping the market price of the company's shares stable in case of death of the keyman. If the keyman dies the price of the company's shares is likely to fall but if the investors know that any financial loss can be made up through the insurance proceeds, they may not start offloading the shares immediately.

6. It protects the company's valuation. For example, in case of the company being put up for sale, prospective buyers are likely to put a higher value to the company if they know that it has a monetary back-up (insurance) to meet the cost of replacement of its key person.

 



Taxation aspects of Keyman insurance:

Prior to change in rules, companies could buy cash value life insurance policies as keyman insurance. In many cases, after buying such a policy the company assigned it to the Keyman during the tenure of the policy. In return the Keyman would generally pay the surrender value of the policy (which was very little compared to the premiums paid and also the maturity value of the policy) to the company. The Keyman would keep the policy and then on maturity of the policy the Keyman would get maturity proceeds which were tax free under the then income tax rules. The policy premiums paid by the company were treated as an expense and therefore deductible from its taxable income.

However, in 2013 the income tax law was changed. As a result, any proceeds of a keyman insurance policy are now fully taxable. The new tax rules are effective from April 1, 2013.

The new rules also provide that a keyman insurance policy which has been assigned to any person during its term, with or without consideration, shall continue to be treated as a keyman insurance policy and consequently would not be eligible for any exemption under section 10(10D) of the Income-tax Act. With the amendment to Section 10 (10D) of IT Act 1961 and IRDAI fiat of allowing only term insurance policies to be bought as Keyman insurance, the present position is as under:

I. In the hands of the company : 

The premium paid by the company buying the Keyman insurance policy is an allowable business expenditure for the company under section 37(1) of the Income-Tax Act.

In case there is a claim (on death of the insured), the claim proceeds are taxable as business income in the hands of the company. The Keyman insurance policy death benefits are not tax-free under section 10 (10D) of the Income Tax Act.

II. In the hands of Keyman : 

The premium paid by the company is not taken as a perquisite in the hands of the Keyman under section 17(2) of the Income Tax as the policy is for the benefit of the company and not the Keyman. The Keyman is thus not required to pay any tax on the premium paid by the company on a policy on his life. There is no maturity or surrender benefit either to the company or to the Keyman as now only term policies can be bought as Keyman insurance and these policies do not have any surrender or maturity benefits.

In case the policy is assigned to a keyman he/she can nominate his/her dependents in the policy. Consequently, in case of demise of the keyman/insured during the policy term, the death benefits would go to these dependents. However, even these death benefits would not be tax-free under section 10 (10D). The author is retired executive director, Life Insurance Corporation of India.

Source: Economic Times

 
 
 

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