What is key person insurance and why do you need it?

At a glance

• Small businesses often don’t have key person insurance
• Firms can use the insurance to cover any business issues that result from individual’s absence
• Getting advice on the right cover at the right price, and on tax considerations, can help to ensure continued business success

A lot of small businesses insure their premises, equipment and machinery. But strangely, they often don’t protect against the more important risk of key individuals dying or having serious health problems. Key person insurance addresses this critical issue by paying a cash sum if that happens.

A typical policy pays three to five years of that person’s salary if they die or have a critical illness. Firms can use the insurance to cover any business issues that result from the individual’s absence. This can include lost revenue, but also cover cash flow and costs such as recruitment and training – buying you time to get the best possible replacement, which is essential to continuity and future success.

Who is a key person?

A key person is someone whose death, critical illness or disability would seriously impact business profits.

Tony Müdd, Divisional Director, Development and Technical Consultancy at St. James's Place, says: “People sometimes get tied up about what that means and whether each individual is key to the business. They might think it means the business would fail or flounder without them. But the reality is few people are irreplaceable.

“So the value of key person insurance is less about replacing profits and more about covering the cost of an interim replacement if no employee could fill that role immediately, and recruitment and other incidental costs to help you take time finding and/or training the right permanent replacement.

“The policy doesn’t necessarily insure a large amount. You might think you need £1 million to cover your top individual. But you could be better off insuring, say, five individuals for about £200,000 each.”

There could be lost revenue, for example, if some clients only wanted to deal with that individual. But that would likely only be a short-term problem once they realise you’re arranging a permanent replacement.

A key person need not be a director or shareholder. It might not even be an employee - for example, it could be a contractor or anyone else the business has an insurable interest in.

Key person insurance is only directly available to limited companies - not the self-employed. Partnerships can use key person cover, but that requires a more complicated arrangement involving trusts.

Also, if the business is unlikely to continue without that individual - for example, where it’s just one employee or a husband-and-wife team – key person cover would not make sense. Any claim is paid to the business, but there may be no business to pay to. So personal life insurance and critical illness policies are more suitable.

How to calculate key person insurance

Insurers have different quoting methods for key person insurance premiums and benefits. The most common is based on salary multiples, but some use more complicated formulae. To calculate a more specific or accurate amount, you need advice to help you establish the actual value that could be lost.

How easy would it be to replace the individual? How long might it take? What profit might you lose short term? Do you have succession plans and junior staff members ready to step into the role? Or would you need to hire an interim replacement, or outsource a specialised part of the role? What health issues does the individual have? How long do you want the contract to last?

“Often, people stick to a term of five years,” says Tony. “Sometimes they go to retirement age. But as people approach retirement, they tend to become less valuable to employers as others in the organisation learn their key skills. Your adviser will help you calculate the point at which you may no longer be ‘key’.”

It can be a humbling conversation for the individual. But it’s important, because the longer the term, the more expensive the premiums.

Tax implications for key person insurance

The tax rules on key person insurance are complex. The business can claim a corporation tax deduction on premiums if it meets certain criteria.

Tony says that payouts are generally treated as business revenue, which is taxable. But this is not always the case. If it’s taxable, you will need to gross up the payout to make sure the net figure still meets your needs. We can help ensure you take the right approach from a tax perspective.

How we can help

When deciding who to insure and for how much, talk to us. We can help you get the right cover at the right price to ensure your continued business success, and advise you on the tax considerations.

The levels and bases of taxation and reliefs from taxation can change at any time and are dependent on individual circumstances.

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SJP Approved: 03/10/022