Beyond key person: The benefits of life insurance for business
Few business owners will argue with the need for key person insurance. But they could be missing out on opportunities to boost tax efficiency and improve liquidity
Date: January 25, 2018
When it comes to financial planning for business owners, it's important to hope for the best, but plan for the worst.
The job of an advisor is to help create wealth while minimizing risks for their clients. When a client owns a business, a discussion about the inherent risks associated with entrepreneurship should be part of the approach to helping build a comprehensive financial strategy.
Clement Chung, a certified financial planner and life underwriter in Burnaby, B.C., points to a particularly critical risk for business owners: the death of one or more key people in their company.
"In pretty much all businesses, there are people who are crucial to the success and ongoing survival of the company," says Mr. Chung. "What happens when one of these people passes away? If you don't plan for this, the business can fail completely."
Business owners often don't realize the true cost of losing a partner or key employee, which in some cases can run up to hundreds of thousands of dollars. Mr. Chung says this is why it's important for companies to have key person insurance, which pays out a cash benefit to the company when the key person covered by the policy dies.
Mr. Chung notes that few business owners will argue with the wisdom of purchasing key person insurance. But for many, the question becomes: should they purchase permanent life or term life insurance for key personnel?
"There isn't one solution that fits everybody," says Majid Behravesh, an independent financial advisor with IFS Integrated Financial Solutions Inc. in Vancouver. "With businesses, you need to consider what problem you're trying to solve and how the solution aligns with your situation, including your cash flow and tax bracket."
Mark Arruda, assistant vice-president of strategic business development and marketing actuary at Sun Life Financial, says many businesses opt for term life insurance for their key people — a decision usually based on that product's relatively lower premiums.
It's time for business owners to reconsider their views on insurance, says Mr. Arruda.
"Some business owners see insurance as an expense, so to minimize their expenses they'll automatically go with term life insurance," he says. "By doing this, they're missing out on opportunities to create tax-efficient value and even improve liquidity in their business."
One of the benefits of permanent life insurance is the ability to grow cash value, tax-free, explains Mr. Arruda.
"Outside of an insurance policy, you would pay tax on the growth of those investments — on interest earned and on dividends," he says. "But when you hold those investments within a permanent life insurance policy, the growth is tax-free for the life of the policy."
A permanent life insurance policy can, after a certain period, also give businesses the option to access cash, says Mr. Arruda.
With some permanent life insurance plans, companies can borrow up to 90 per cent of the cash value of their policy. Compare this to fixed income assets, which generally allow business owners to borrow only about 75 per cent of their total market value.
"There can be a risk of a margin call on fixed income assets if market values decline. On the other hand, some types of life insurance offer stable cash values, so banks are willing to leverage higher amounts against that cash value," says Mr. Arruda.
Selling fixed income assets can trigger a tax liability, adds Mr. Arruda. By comparison, leveraging a permanent life policy does not generate a tax bill.
Jeffrey Waugh, director, wealth and insurance tax solutions at Sun Life Financial, calls out another benefit of permanent life insurance: potential for a tax-free death benefit.
How does this work? After the insured person passes away, the death benefit is paid to the company (beneficiary), which can flow a portion of the funds to the surviving shareholder or shareholders through a capital dividend account.
"It's a tax-free benefit which the corporation can use to cover any estate needs of the deceased insured and to potentially pay a tax free dividend to the shareholders," says Mr. Waugh.
Advisors are well positioned to help clients determine the best choices for their insurance plan, says Mr. Waugh.
Mr. Chung agrees, noting that it's important for advisors to take the time to learn about their client's business and the risks within the business.
"You really can't make a sound recommendation without getting to know the business, its challenges and the risks it's exposed to," says Mr. Chung. "In the end, it's really about — how we can help our clients protect themselves and their families, their business, employees, and shareholders. That's the value advisors bring to their clients."
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