What a Corporate Contract Leaves on the Balance Sheet

Key person coverage is presented on the strength of a death and purchased, often enough, on the strength of a balance sheet. Those are two different purchases, and a corporation that confuses them pays for a contract it did not need, in a size nobody calculated. This page starts with what the coverage does not do, because the reasons a company should ordinarily cover this exposure with term life insurance are stronger than most owners are told, and because the narrow case for anything else becomes visible only once those reasons have been set out in full.

Nothing here recommends a product or a structure. The figures that decide the question belong to one company, with one lender, one shareholders agreement and one plan for the next decade, and this practice holds an insurance licence and gives no tax advice and no legal advice. The tax treatment in each paragraph below stays attached to the provision cited and belongs to the company's CPA. Anything that has to be drafted belongs to a lawyer or a notary, before the insurer issues a contract.

What does key person coverage not do?

It does not replace the person. It does not repair a business whose revenue, relationships and judgement lived in one head, and it does not buy the years that person spent learning the trade. What it does is put money into the company at the moment the company is least able to raise any.

The list of what it leaves untouched is longer than the list of what it settles. A company that loses its founder still has to find someone who can do the work, and money does not shorten that search by a week. Customers who dealt with one person may leave before a replacement is hired. A lender who was comfortable because of one signature may stop being comfortable, whatever the company now holds in cash. Coverage pays for time and it manufactures none.

That limit sets the honest boundary of the subject. Key person coverage is a financing answer to a business problem, and the business problem itself is solved by written processes, by a second person who knows the accounts, and by relationships that belong to the company. An owner who begins with the coverage and never does that work has bought an expensive delay. An owner who does the work first usually finds the coverage needed is smaller than the one that was presented.

What actually makes someone a key person?

A key person is someone whose absence would measurably damage revenue, financing or continuity, in a way the company could demonstrate to a lender or an auditor. The test asks what damage the business could put a number on. Seniority, title and long service answer an entirely different question.

Three questions separate the real cases from the assumed ones. Does the company lose revenue that will not return on its own if this person is gone on Monday. Does a lending covenant, a supply agreement or a customer contract name them or depend on them. Would the board have to hire, and how long would a competent replacement take to become productive. A company that can answer all three with figures has found a key person. A company that cannot has found a valued employee.

The distinction matters because the answers fix the size of the coverage and the period over which it is needed. A production manager whose loss would cost eighteen months of disrupted margin is a different file from a founder who personally holds every material customer relationship. Both may be key people. They are key in different amounts and for different periods, and an arrangement built without those figures rests on an assumption that will never be tested until it gives way.

Why is the label applied more loosely than it should be?

Because the label justifies a premium, and because owners find it flattering. A company can name almost anyone a key person and nothing prevents it, since no regulator polices the word. The looseness costs money twice, once on people who were never an exposure and once on amounts nobody calculated.

Two pressures push in the same direction. The first sits with whoever sells the contract, because a larger number of insured lives and a larger amount of coverage both enlarge the transaction, and this practice is compensated when a contract is issued, which is worth writing on a page that argues for less coverage. The second sits with the owner, who would find it uncomfortable to tell a long serving colleague that the company carries no financial exposure to their absence.

The correction is unglamorous and it works. Write down each person the company proposes to insure, and beside each name write the figure the company would lose and the number of months over which it would lose it. The names that survive that exercise belong in a coverage discussion. The names that do not survive it belong in a conversation about compensation, retention or succession, and each of those conversations puts the same money to better use. The exercise takes an afternoon and it settles most of the argument.

What is the coverage genuinely for?

It is for the cost of losing someone the business depends on, a cost that breaks into measurable items, the margin lost while the work goes undone, the cost of recruiting and training a replacement, loans that may be called or covenants that may be tripped, and customer or supplier relationships that were personal.

Each of those four items carries a period attached to it, and the period is what most arrangements record nowhere. Lost margin runs from the death until the business stabilises. Recruiting and training run from the search until the replacement becomes productive, which in a technical trade can be a long stretch. A loan covenant tied to a named individual runs until the loan is repaid or renegotiated. Personal relationships decay over a definable number of months, after which they have either transferred or gone.

Sum the four and the company has an amount and a horizon. The amount is what the coverage should pay. The horizon is how long the company needs it, and for most exposures that horizon ends, the loan matures, the replacement is trained, the relationships move onto contracts held by the company. An exposure carrying an amount and an end date is a defined exposure, and defined exposures have an ordinary answer in the Canadian market.

Why is term life insurance the ordinary answer here?

Because a defined amount over a defined period is exactly the shape term life insurance was built for. For the same amount payable on death, a term life insurance contract costs a company materially less each year than a participating one, and the difference stays inside the business, funding the payroll and the equipment the coverage was bought to protect.

Term life insurance also matches the way the exposure behaves. A ten year contract on a production manager expires around the time the company has trained a successor, and a contract written to the maturity of a credit facility ends when the covenant does. Coverage that finishes when the exposure finishes is coverage the company stops paying for at the right moment. Renewal and conversion privileges exist where the horizon turns out to be longer, and those provisions are read at the application stage or they are read too late.

This is the recommendation most key person files should close on, and it is the reason this page is built the way it is. A corporation that has measured its exposure, has a lender to satisfy and a replacement to train can meet all three with term life insurance and keep its surplus working. Any argument for a more expensive arrangement has to earn its place against that one, on the company's own figures, examined by the company's own CPA.

What does a participating contract add while everyone is alive?

It adds an accumulating cash value the company carries on its balance sheet as an asset and can reach during the life of the contract by requesting an advance from the insurer secured by that value, which is a policy loan. The amount payable on death sits behind it, unchanged in purpose.

Three consequences follow from that value existing. The company holds an asset whose guaranteed portion is contractual and whose growth above that portion depends on dividends the insurer declares each year and never guarantees. The company can borrow against the asset without selling it, on the insurer's terms and at the insurer's rates, and interest accrues whether or not the company services it. And the company carries a line on its statements that a lender and a buyer will both read, which the next section takes up.

None of that changes what the contract is. It is an insurance contract and not a portfolio holding, and a company measuring it against a portfolio of securities as a way to grow surplus is comparing two things that answer different questions. What the accumulated value provides is access to capital inside a contract the company already needed for another reason. Where that other reason is absent, the living value is being bought on its own, and that is the case the rest of this page examines.

What does that living value cost the company each year?

It costs the difference in premium, and the difference is far from marginal. A participating contract funds an accumulating cash value as well as the amount payable on death, so for the same death benefit the annual outlay is a multiple of what a term life insurance contract charges, every year, for as long as the funding schedule runs.

That difference has to be judged against what the company would otherwise do with the same dollars. Retained earnings left in a portfolio are taxed as investment income each year and can reduce access to the small business rate, and that is the argument owners are usually shown. Retained earnings spent on equipment, inventory or a second person who can run the plant produce a return the company controls, and that is the argument owners usually never see. Ask a CPA to price all three uses over the same horizon.

The early years are where the comparison is sharpest. A participating contract in its opening years holds a value well below the premiums paid into it, because acquisition costs and the cost of insurance come out first, and a company that stops paying in that window recovers little. A term life insurance contract in the same window has cost a fraction as much and has bought the same protection. A company that cannot commit to the whole schedule should not begin one.

Why should a contract funded for a living purpose be sized on that purpose?

Because sizing on the key person exposure produces the wrong contract. The death benefit needed to cover a replacement search and a called loan has almost nothing to do with the amount of capital a company wants held inside a contract, and a design that solves one of those numbers will miss the other by a wide margin.

Work the two numbers separately and the design follows. If the company wants capital held inside an exempt contract, the sizing question is how much surplus it can commit each year and for how many years without straining working capital, and the death benefit that results is whatever the insurer issues for that funding. If the company wants a key person exposure covered, the sizing question is the four costs set out above, and term life insurance answers it. Folding the two into a single contract sized by neither calculation is how a company ends up overinsured on one measure and short on the other.

A further reason argues for keeping the two purposes apart on paper. A contract the company describes as key person coverage and funds as a capital arrangement raises a question at an audit and a second question during diligence on a sale, because the stated purpose and the funding do not match. A short memorandum naming what the contract is for, prepared with the CPA when the application is made, answers both questions years later at no cost.

When does a key person arrangement create a shareholder benefit?

When the person insured is also a shareholder and the roles are not documented. Where a corporation pays a premium on coverage that benefits a shareholder personally, the Canada Revenue Agency can treat the payment as a benefit conferred on that shareholder under Income Tax Act s.15(1), and the assessment usually arrives years afterwards.

The trap is ordinary because in a small company the key person and the owner are frequently the same human being. The company insures its founder, describes the contract as key person coverage, and names the founder's spouse as beneficiary, or transfers the contract to the founder once the arrangement has done its work. Each of those steps has a defensible version and a version that is not defensible, and telling them apart is an accountant's work on the actual documents. This page takes the separation of the two arrangements no further, because key person coverage compared with shareholder coverage already does it.

Settle three things in writing before the application is signed. Who owns the contract, who pays the premium and who is named as beneficiary, confirmed by the company's CPA against s.15(1) on the facts as they stand. What the contract is for, in one paragraph, kept with the policy. And what happens to the contract if the insured person leaves, is bought out, or the company is reorganised, which is a question for a lawyer or a notary and belongs in the shareholders agreement.

What do a lender and a buyer each see on the balance sheet?

A lender sees an asset and coverage on the person the loan depends on, and may want the contract assigned as security. A buyer sees value inside the company that forms part of what is being purchased, and will want to know whether it leaves with the seller.

For the lender, the assignment is the part worth reading before it is agreed. A collateral assignment is registered against the policy and restricts what the company can do with the value while the facility runs, which includes the advances the company may have been counting on. The day the company wants to reach the value is a poor day to learn that the lender's consent is required. Ask for the assignment wording at the term sheet stage and have the CPA and the lawyer read it together.

For the buyer, the value is a negotiation and often a discount. A contract insuring a person who is leaving is worth less to the purchaser than its statement value, and taking it out before closing is a disposition measured against the adjusted cost basis under Income Tax Act s.148(9), with its own tax consequence. Accumulated value inside an operating company can also affect whether the shares meet the tests that apply on a sale. Both questions belong to the CPA, years ahead of an offer.

What happens when the key person simply leaves?

Most key people leave alive. They resign, they retire, they are bought out, or they go to a competitor, and a contract written for a death answers none of it. A term life insurance contract in that situation is cancelled and the cost stops. A participating contract in that situation becomes a decision the company now has to make.

The choices are all imperfect and they all carry a tax dimension. The company can keep the contract and continue paying, which turns a key person arrangement into a corporate capital arrangement it may never have chosen. It can surrender the contract, which is a disposition that can produce income to the corporation, measured against the adjusted cost basis under Income Tax Act s.148(9). It can transfer the contract to the departing person, which is also a disposition and raises s.15(1) where that person is a shareholder. Each route belongs to the CPA.

Departure is the commonest ending and it is the one the illustration never shows. An arrangement that held up for a person expected to stay twenty years reads differently in year six, when they accept an offer elsewhere. Decide at the outset what the company will do in that event, write it down, and have the answer checked against the shareholders agreement by a lawyer or a notary. A company that has decided in advance is choosing. A company that has not is reacting.

Who this suits, and who it does not

This page suits an incorporated owner who has been shown a participating contract described as key person coverage and wants the drawbacks stated before the application. It suits a company with surplus, a measured exposure and a CPA already in the file. It applies with most force where the exposure carries an end date.

It applies with less force to a company whose exposure carries no end date, because a permanent problem is one of the few places a permanent contract earns its premium on the coverage alone. It applies with less force again to a company holding no surplus beyond its working capital, since a funding schedule it cannot complete is worth less than no contract at all, and the early years punish an interruption hardest. Those companies can settle the term life insurance now and return to the rest when the balance sheet supports it.

It does not suit a reader who wants the arrangement endorsed. Participating whole life insurance is an insurance product and it is not an investment, and a corporation funding one for a living purpose is holding capital in a form that is illiquid in the early years, taxed on disposition, and visible to everyone who reads the statements. Those are the facts. What they are worth depends on figures this page does not have.

Answer two questions before the product question. What would this company actually lose if the person were gone on Monday, expressed as an amount and a number of months. And does the company hold surplus it intends to keep for decades, separate from that loss. An owner who can answer both can evaluate any arrangement put in front of them. The framework for an incorporated owner sits across the business owners section.