TH E USE OF I NSU R AN C E I N A B U SINESS E NVIR O NM EN T C H AP TE R 1 0
CHAPTER 10
THE USE OF INSURANCE IN
A BUSINESS ENVIRONMENT
Learning Outcomes
When you have completed this chapter you will be able to
define a key-person in an organisation;
explain what a deferred compensation plan is;
explain the benefits of structuring an employer owned policy in
accordance with the concessions provided by the Income Tax Act;
explain the estate duty implications of a key-person policy;
explain what a preferred compensation plan is and why they are
sometimes used in place of deferred compensation plans;
briefly describe what is meant by a sinking fund;
explain the importance of a buy-and-sell agreement in a business
environment and briefly describe how they work;
describe the operation of a preference share capital redemption
plan;
explain what is meant by contingent liability insurance and how the
plan works.
RSK3701 LI Page 220
Ver 31072011
,TH E USE OF I NSU R AN C E I N A B U SINESS E NVIR O NM EN T C H AP TE R 1 0
10.1 KEY-PERSON INSURANCE
The term key-person is one that is often heard in a business environment, but what makes a
person in an organisation a key-person? If we were to ask the employers of these type of
people to define their reasons for elevating a particular employee to the status of a key-
person, we would end up with a number of different answers.
One usually finds that key-people in any organisation are those who, should they die or
leave, will:
be difficult to replace;
effect the profits of the enterprise;
result in a reduction of sales;
result in costly training of a replacement; or
require a possible change in management.
Once the role of a key-person in an organisation has been established, it becomes possible
to decide on the value of the person. It is often difficult to do this in Rands and Cents and so
the following may assist as a guide.
10.1.1 ESTABLISHING THE VALUE OF THE KEY-PERSON
Where it is not possible to accurately assess the loss that a key-person will mean to an
employer, it is normal to use a multiple of his basic salary to determine the sum insured, for
example, either 5 or 7 times his gross annual salary.
Should this method not be used, it is vital to ensure that, not only the actual loss, but also the
costs that will be incurred in the recruitment and training of a replacement are taken into
consideration.
10.1.2 KEY-PERSON AND DEFERRED COMPENSATION
Premiums payable on the life of an employee by an employer are an allowable deduction if
certain rules and conditions are met. This deduction is then made in terms of Section 11(w)
of the Income Tax Act. What is often forgotten, is that both a key-person and a deferred
compensation policy are employer owned policies. Both these policy provisions, therefore,
need to be considered when deciding on the benefits to be added to a policy. The employer,
who owns the policy and pays the premiums, must be made aware of the implications of
using one policy for both of the above provisions.
Assume the employer has undertaken, in terms of a service agreement, to pay the proceeds
of the policy to the employee’s beneficiaries on death. The employer could then find that the
money that had been earmarked for use in replacing the employee is no longer available.
RSK3701 LI Page 221
Ver 31072011
, TH E USE OF I NSU R AN C E I N A B U SINESS E NVIR O NM EN T C H AP TE R 1 0
10.1.3 THE INCOME TAX ACT
Section 11(w)(ee)(B) of the Income Tax Act, restricts the size of the premium that the
employer may deduct if the policy has a maturity benefit. A deferred compensation policy
needs a maturity value, and so utilising one policy for both purposes will limit the size of the
life cover and benefits available.
In terms of Section 11(w) of the Income Tax Act, there will be allowed as a deduction “an
allowance in respect of any premium which was actually paid by the taxpayer under any
policy of insurance taken out upon the life of a employee of the taxpayer”. In the case of a
company, the deduction will also apply if the policy is on the life of a director.
A point which is often not appreciated by intermediaries and their clients is the fact that,
where a policy premium is allowed as a deduction in terms of Section 11(w), the proceeds of
the policy are fully taxable, on receipt, in the hands of the employer.
Only those portions of premiums that may have been disallowed (or not have been claimed)
at any stage, will be allowed as a deduction (without interest) against the proceeds of the
policy at maturity, when they must be included in the gross income of the employer.
Please note that this will apply whether the employer chooses to claim the tax
deduction under Section 11(w), or not. The only way that an employer can avoid the
payment of tax on the proceeds of a policy, owned by the employer, on the life of an
employee, is to contract for what is commonly known as a "non-conforming" policy.
Where there is an estate duty liability on the proceeds of the policy (for example, in a family
company), it is the practise of the revenue authorities to tax only the net proceeds of the
policy i.e. after any estate duty payable has been deducted.
The impact of taxation on the proceeds of a key-person policy can be severe. A company or
close corporation, for instance, currently (2010) pays tax at a flat rate of 28%. It is advisable
to take this cost into account when determining the level of life cover required on the life of
the key-person.
Taxation Laws Amendment Act, 7 of 2010: Employer-owned policies
Premiums on employer-owned life insurance policies such as key person or deferred
compensation policies will be tax deductible as from 1 January 2011, only if one of the two
following conditions are met.
Condition 1
The premiums are included in the taxable income of the employee or director as a
fringe benefit.
OR
Condition 2
The policy is owned by the employer, paid for by the employer and the employer is to
receive the benefit. If there is a collateral or security cession on the policy then the
premiums may still be claimed as a deduction, unless the cession is in favour of the life
insured, his relatives or dependents.
RSK3701 LI Page 222
Ver 31072011
CHAPTER 10
THE USE OF INSURANCE IN
A BUSINESS ENVIRONMENT
Learning Outcomes
When you have completed this chapter you will be able to
define a key-person in an organisation;
explain what a deferred compensation plan is;
explain the benefits of structuring an employer owned policy in
accordance with the concessions provided by the Income Tax Act;
explain the estate duty implications of a key-person policy;
explain what a preferred compensation plan is and why they are
sometimes used in place of deferred compensation plans;
briefly describe what is meant by a sinking fund;
explain the importance of a buy-and-sell agreement in a business
environment and briefly describe how they work;
describe the operation of a preference share capital redemption
plan;
explain what is meant by contingent liability insurance and how the
plan works.
RSK3701 LI Page 220
Ver 31072011
,TH E USE OF I NSU R AN C E I N A B U SINESS E NVIR O NM EN T C H AP TE R 1 0
10.1 KEY-PERSON INSURANCE
The term key-person is one that is often heard in a business environment, but what makes a
person in an organisation a key-person? If we were to ask the employers of these type of
people to define their reasons for elevating a particular employee to the status of a key-
person, we would end up with a number of different answers.
One usually finds that key-people in any organisation are those who, should they die or
leave, will:
be difficult to replace;
effect the profits of the enterprise;
result in a reduction of sales;
result in costly training of a replacement; or
require a possible change in management.
Once the role of a key-person in an organisation has been established, it becomes possible
to decide on the value of the person. It is often difficult to do this in Rands and Cents and so
the following may assist as a guide.
10.1.1 ESTABLISHING THE VALUE OF THE KEY-PERSON
Where it is not possible to accurately assess the loss that a key-person will mean to an
employer, it is normal to use a multiple of his basic salary to determine the sum insured, for
example, either 5 or 7 times his gross annual salary.
Should this method not be used, it is vital to ensure that, not only the actual loss, but also the
costs that will be incurred in the recruitment and training of a replacement are taken into
consideration.
10.1.2 KEY-PERSON AND DEFERRED COMPENSATION
Premiums payable on the life of an employee by an employer are an allowable deduction if
certain rules and conditions are met. This deduction is then made in terms of Section 11(w)
of the Income Tax Act. What is often forgotten, is that both a key-person and a deferred
compensation policy are employer owned policies. Both these policy provisions, therefore,
need to be considered when deciding on the benefits to be added to a policy. The employer,
who owns the policy and pays the premiums, must be made aware of the implications of
using one policy for both of the above provisions.
Assume the employer has undertaken, in terms of a service agreement, to pay the proceeds
of the policy to the employee’s beneficiaries on death. The employer could then find that the
money that had been earmarked for use in replacing the employee is no longer available.
RSK3701 LI Page 221
Ver 31072011
, TH E USE OF I NSU R AN C E I N A B U SINESS E NVIR O NM EN T C H AP TE R 1 0
10.1.3 THE INCOME TAX ACT
Section 11(w)(ee)(B) of the Income Tax Act, restricts the size of the premium that the
employer may deduct if the policy has a maturity benefit. A deferred compensation policy
needs a maturity value, and so utilising one policy for both purposes will limit the size of the
life cover and benefits available.
In terms of Section 11(w) of the Income Tax Act, there will be allowed as a deduction “an
allowance in respect of any premium which was actually paid by the taxpayer under any
policy of insurance taken out upon the life of a employee of the taxpayer”. In the case of a
company, the deduction will also apply if the policy is on the life of a director.
A point which is often not appreciated by intermediaries and their clients is the fact that,
where a policy premium is allowed as a deduction in terms of Section 11(w), the proceeds of
the policy are fully taxable, on receipt, in the hands of the employer.
Only those portions of premiums that may have been disallowed (or not have been claimed)
at any stage, will be allowed as a deduction (without interest) against the proceeds of the
policy at maturity, when they must be included in the gross income of the employer.
Please note that this will apply whether the employer chooses to claim the tax
deduction under Section 11(w), or not. The only way that an employer can avoid the
payment of tax on the proceeds of a policy, owned by the employer, on the life of an
employee, is to contract for what is commonly known as a "non-conforming" policy.
Where there is an estate duty liability on the proceeds of the policy (for example, in a family
company), it is the practise of the revenue authorities to tax only the net proceeds of the
policy i.e. after any estate duty payable has been deducted.
The impact of taxation on the proceeds of a key-person policy can be severe. A company or
close corporation, for instance, currently (2010) pays tax at a flat rate of 28%. It is advisable
to take this cost into account when determining the level of life cover required on the life of
the key-person.
Taxation Laws Amendment Act, 7 of 2010: Employer-owned policies
Premiums on employer-owned life insurance policies such as key person or deferred
compensation policies will be tax deductible as from 1 January 2011, only if one of the two
following conditions are met.
Condition 1
The premiums are included in the taxable income of the employee or director as a
fringe benefit.
OR
Condition 2
The policy is owned by the employer, paid for by the employer and the employer is to
receive the benefit. If there is a collateral or security cession on the policy then the
premiums may still be claimed as a deduction, unless the cession is in favour of the life
insured, his relatives or dependents.
RSK3701 LI Page 222
Ver 31072011
