Every successful business has its MVP, its Most Valuable Player. It might be the founder, a senior executive, or a key employee with specialised knowledge, skills, or relationships that are difficult to replace.

But what happens if that person suddenly can't work due to illness, injury, or even death?

This is where Key Person Risk becomes important and it's one of the most overlooked areas of business protection.

Understanding Key Person Risk

Key Person Risk refers to the potential financial loss a business could suffer if a key individual is no longer able to contribute. For many small and medium-sized businesses, the loss of just one person can have a major impact on revenue, operations, and confidence from clients, lenders, or suppliers.

A "key person" is anyone whose continued involvement is essential to the financial success of the business. That might include:

• A founder or business owner who drives growth and decision-making
• A senior manager who oversees major operations or projects
• A specialist with unique technical knowledge or client relationships
• A rainmaker responsible for bringing in major clients or revenue streams

If that person is suddenly absent, the financial and operational consequences can be immediate and significant.

The Impact of Losing a Key Person

When a key person can't work, the business may be impacted in several ways:

• Reduced revenue
• Increased expenses
• Cash flow pressure
• Loss of goodwill

In some cases, businesses may even struggle to continue operating in the short term.

Managing Key Person Risk

Mitigating Key Person Risk starts with understanding what the business' vulnerabilities are. The process typically involves three key steps:

1. Identify your key people

Determine who the business relies on most heavily for revenue, operations, or relationships. Ask yourself – what would happen if that person couldn't work for at least six months?

1. Assess the potential financial impact

Estimate the potential loss in profits, additional expenses, and cash flow stress the business would experience. This helps you quantify the level of protection needed.

1. Put the right protection in place

This is where Key Person Insurance becomes critical. It provides the financial support needed to keep the business running while you recover, recruit, or restructure.

How Key Person Insurance Works

Key Person Insurance is designed to protect the business against the financial loss that results from the death, disability, or serious illness of a key individual.

Typically, the business takes out the policy, pays the premiums, and receives the benefit if the insured person can no longer work. Those funds can then be used to:

• Replace lost revenue or profit
• Cover recruitment and training costs
• Maintain loan repayments or business expenses
• Preserve business value during a transition period

It acts as a financial buffer, giving the business time and breathing room to adjust.

Tax and Ownership Considerations

The structure of a Key Person policy depends on its purpose. Generally, policies can be classified as revenue or capital in nature:

• Revenue Purpose: When the policy is designed to replace lost profits or cover ongoing expenses, premiums are usually tax-deductible to the business, but insurance proceeds are treated as assessable income.
• Capital Purpose: When the policy is used to protect or repay business debts, or to maintain business value, premiums are generally not tax-deductible to the business, but insurance proceeds may be received tax-free.

Getting the ownership and tax treatment right is essential. This is where professional advice can ensure your structure matches your goals and avoids unintended tax consequences.

Why Every Business Should Review Its Exposure

Many business owners underestimate how dependent their success is on a few key people. Even well-established companies can face serious disruption if they lose the wrong person at the wrong time.

By identifying your key people, assessing the potential impact, and putting a protection strategy in place, you can reduce this risk and strengthen your overall business resilience.

Although this article focuses on insurance as a method of protecting against key person risk, you should also first consider what else you can do within your business to mitigate the risk. This could include succession planning (i.e. preparing the next generation), training or upskilling your team, and even more broadly sharing responsibilities and relationships with suppliers/clients.

The Takeaway

There are risks in everyday life, including within your business.

Unless you are planning for the unexpected to occur, then the unexpected is likely to disrupt your personal life, business activities and financial wellbeing all at once. Remember, protecting your business is just as important as growing it.

Jeremy Bogovac is a Wealth Partner (Financial Planner) at Dorset Wealth Management and can discuss your business succession and protection plans with you, to ensure you are informed for your individual circumstances. If you would like to chat with us about what you could be doing, get in touch by calling (07) 3473 1618 or email Jeremy at jeremy.bogovac@dorsetwealth.au.

Disclaimer 

The information provided on this post is of a general nature and does not take into account your personal financial situation, objectives, or needs. Before acting on any information, consider its appropriateness and seek advice from a licensed financial advisor. Dorset Wealth Management is authorised to provide financial services under Australian Financial Services Licence (AFSL) No. 558504. For more information, refer to our Financial Services Guide (FSG) or contact us directly.