Key Person Insurance Canada

Executive Summary

When a critical employee or owner dies, your business needs cash immediately. Key person insurance provides this working capital. Here's what matters:

• The problem: The death of a key person disrupts operations, affects cash flow, impacts credit, and creates immediate costs
• The solution: Life insurance provides cash exactly when it's needed:at death:to cover immediate needs and find a replacement
• The amount: Coverage depends on cash flow impact, credit needs, and replacement costs:not just salary multiples
• The tax benefit: Corporate-owned key person insurance creates a Capital Dividend Account (CDA) credit, allowing tax-free distribution
• The underwriting: Insurance companies typically approve coverage up to 5x salary, up to 10x in special situations with proper justification

This article explains how key person insurance works and how to think about coverage amounts for your business.

Mindset: Protecting Business Continuity

Before diving into coverage amounts, let's think about key person insurance from a business continuity perspective.

Some people in your business are hard to replace. They have knowledge, relationships, skills, or reputation that took years to build. When they're gone, the business needs cash to:

1. Cover immediate needs during disruption
2. Find and train a replacement
3. Maintain operations while transitioning
4. Protect credit relationships with lenders and suppliers

Without this cash, the business may struggle even if operations are profitable. Lenders may restrict credit. Suppliers may demand cash payments. Customers may lose confidence. Competitors may take advantage.

Key person insurance provides cash exactly when it's needed:at death. The insurance proceeds give the business time and resources to handle the transition without taking on debt or liquidating assets.

This is about protecting what you've built, not just covering a salary.

Mechanics: How Key Person Insurance Works

Key person insurance is life insurance owned by the business on the life of a critical employee or owner. When that person dies, the business receives the insurance proceeds.

The Basic Structure

1. The business owns a life insurance policy on the key person
2. The business pays the premiums
3. The business is the beneficiary and receives the proceeds at death
4. The proceeds provide working capital for immediate needs and replacement

What Makes Someone a "Key Person"?

A key person is someone whose death would significantly impact the business. This might include:

• Owners who drive business development or operations
• Key executives with critical knowledge or relationships
• Sales leaders with important client relationships
• Technical experts with specialized knowledge
• Operations managers who keep things running smoothly

The key factor is impact: if their death would disrupt operations, affect cash flow, or create immediate costs, they're likely a key person.

Determining Coverage Amounts: What Matters

There's no single formula for key person insurance coverage. The right amount depends on your business situation. Here's what to consider:

Cash Flow Impact

When a key person dies, operations may slow down. Sales may drop. Production may be disrupted. Customer service may suffer. This affects revenue and cash flow.

Questions to consider:

• How much would sales or production drop if this person died?
• How long would this disruption last?
• What's the financial impact over that period?

The insurance should cover the cash flow gap during the transition period.

Credit Impact

If cash flow drops, credit relationships may be affected. Lenders may restrict credit. Suppliers may demand cash payments. Existing loan terms may change.

Questions to consider:

• Would lenders restrict credit if this person died?
• Would suppliers change payment terms?
• Are there specific loans that should be repaid?
• How much credit protection does the business need?

The insurance should provide enough cash to maintain credit relationships and cover any loan repayments.

Replacement Costs

Finding a replacement takes time and money. You may need to:

• Recruit externally (which takes longer)
• Pay more for equivalent skills
• Train the new person
• Hire temporary help during the transition

Questions to consider:

• What does it cost to find, hire, and train a replacement?
• Would you need temporary help while searching?
• How much more would you pay for equivalent skills?
• How would other employees be affected?

The insurance should cover these replacement costs.

Combining the Factors

Add up:

• Cash flow impact during transition
• Credit protection needs
• Replacement costs

This gives you a starting point for coverage. Then consider whether you want a buffer for unexpected costs or longer transition periods.

Underwriting Considerations

Insurance companies need to approve the coverage amount. They typically use salary as a reference point:

• General rule: Up to 5x the key person's salary
• Special situations: Up to 10x salary with proper justification

The insurance company will review:

• The key person's role and impact
• Business financial statements
• How you calculated the coverage amount
• Business value and operations

Documentation helps: Explain how you determined the coverage amount. Show cash flow impact, credit needs, and replacement costs. This helps underwriters understand why higher coverage makes sense.

Tax Considerations: Corporate Ownership

When a corporation owns key person insurance, there are tax benefits to consider.

Capital Dividend Account (CDA) Credit

When the corporation receives life insurance proceeds, it gets a credit to the Capital Dividend Account (CDA) equal to the proceeds minus the policy's adjusted cost basis.

The corporation can then pay capital dividends from the CDA, which are received tax-free by shareholders.

This means:

• The insurance proceeds are received tax-free by the corporation
• The proceeds (minus ACB) can be distributed tax-free to shareholders
• This provides tax-efficient access to the insurance proceeds

Premium Deductibility

Life insurance premiums are generally not deductible for tax purposes. They're considered capital outlays, not business expenses.

However, if the insurance is required as collateral for a business loan, some premium deduction may be available under specific rules.

Financial Statement Impact

Corporate-owned life insurance appears on the balance sheet at cash surrender value. Premiums paid reduce cash, and the cash value increases over time.

When death benefits are received, they're recorded as income on the financial statements, which may affect:

• Debt covenants
• Financial ratios
• Business valuations

Work with your CPA to understand how key person insurance affects your financial statements.

How to Apply: Steps for Key Person Insurance

If you're considering key person insurance, here's how to approach it:

Step 1: Identify Key People

Think about who in your business would create significant disruption if they died:

• Owners who drive business development
• Key executives with critical knowledge
• Sales leaders with important relationships
• Technical experts with specialized skills

Step 2: Assess Impact

For each key person, consider:

• Cash flow impact: How would operations and revenue be affected?
• Credit impact: How would lenders and suppliers react?
• Replacement costs: What would it cost to find and train a replacement?

Step 3: Calculate Coverage Needs

Add up:

• Cash flow gap during transition
• Credit protection needs
• Replacement costs
• Buffer for unexpected costs

This gives you a coverage amount to discuss with your insurance advisor.

Step 4: Coordinate with Your Team

Work with your:

• Insurance advisor to structure the coverage and handle underwriting
• CPA to understand tax implications and financial statement impact
• Lawyer if ownership or beneficiary structures need documentation

Step 5: Review Regularly

Key person insurance needs change as your business grows:

• New key people may need coverage
• Coverage amounts may need to increase
• Key people may leave or change roles

Review coverage annually or when business circumstances change.

Worked Example: Determining Coverage

Let's say you have a sales director who drives 40% of your revenue and has relationships with your largest clients.

Cash flow impact:

• Sales drop 30% for 12 months
• Annual revenue is $2 million
• 30% drop = $600,000 revenue loss
• After costs, cash flow impact = $300,000

Credit impact:

• Bank line of credit: $200,000
• Want to maintain credit availability
• Coverage needed: $200,000

Replacement costs:

• Recruiting and hiring: $50,000
• Training and onboarding: $30,000
• Temporary help during transition: $40,000
• Total: $120,000

Total coverage:

• Cash flow impact: $300,000
• Credit protection: $200,000
• Replacement costs: $120,000
• Buffer: $80,000
• Total: $700,000

If the sales director's salary is $100,000, this is 7x salary:within the range that can be justified with proper documentation.

Decision Checklist

Key person insurance might make sense for your business if:

• [ ] You have employees or owners whose death would significantly disrupt operations
• [ ] Their loss would affect cash flow, credit relationships, or customer confidence
• [ ] Finding a replacement would take time and cost money
• [ ] The business doesn't have enough cash reserves to cover a transition period
• [ ] Lenders or suppliers might restrict credit if a key person died
• [ ] You want to protect business continuity without taking on debt

If several of these apply, consider discussing key person insurance with your insurance advisor.

Important Notes

This is educational information. Key person insurance requires coordination with insurance advisors, and tax implications should be reviewed with your CPA. Always consult with your professional team.

Every situation is unique. Coverage amounts, insurance structures, and tax implications depend on many factors including business type, corporate structure, key person roles, and financial situation. What works in one case may not be appropriate for your circumstances.

Underwriting varies. Insurance companies have different underwriting guidelines. Coverage amounts depend on the key person's role, business financials, and how coverage is justified. Work with your insurance advisor to structure coverage that meets your needs and can be approved.

Insurance is offered through iAssure Inc. Insurance products and related services are provided through iAssure Inc., an independent firm in the insurance of persons and in the group insurance of persons. These activities are neither the business nor the responsibility of WhiteHaven Securities Inc.

Next Steps

If key person insurance resonates with your situation:

• Identify key people: Think about who in your business would create significant disruption if they died
• Assess impact: Consider cash flow, credit, and replacement cost impacts
• Calculate needs: Add up cash flow gaps, credit protection, and replacement costs
• Coordinate with your team: Discuss with your insurance advisor, CPA, and lawyer
• Review regularly: Update coverage as your business grows and changes

If you'd like to discuss your specific situation, request a structure review to see if there's a fit.