My Complete Guide to Key Person Protection Insurance
I advise many businesses on various different forms of business protection insurance. Many are confused as to what key person often referred to as keyman insurance is and how it is treated for tax reasons. Others try to use it to protect shareholders, when it is in fact there to protect the business to ensure that it can continue with the effect of death, critical illness or long term illness occurring to a key person.
In brief there are 3 types of key person insurance. These are life insurance for a key person, critical illness protection for a key person and income protection insurance for a key person. Each policy has it’s own benefits. Which is the best for one business or another will depend on many factors the budget being one of these. This page will hope to be a complete guide to key person insurance.
If you have any suggestions or questions then feel free to contact me. You can read the whole page or jump top specific areas using the menu to the right.
Does Your Business Have a Key Person Insurance Need?
Key Person Definition
Anyone whose loss, either permanent or temporary would affect the companies ability to maintain turnover and generate profit.
As a business owner you know what you need to make your business a success. Suitable premises, machinery or tools, and your computer systems may all be important. But have you protected what is probably your most important asset – your people? Protection insurance can’t stop the unthinkable from happening, but it can make dealing with the consequences easier. Without adequate business protection you could end up risking everything you’ve worked so hard to achieve
Consequences of no Keyman Insurance
The consequences of what could happen should a key person die or become unavailable to work through illness or injury can make you think about what might happen:
- Without the leadership of you or your key person your employees may decide it’s time for them to move on.
- Customers may choose to go elsewhere.
- Sales could fall.
- New products could be delayed.
- It could create a lack of confidence from your lender, suppliers, customers and your other employees
- Bank loans and overdrafts could be called in.
- Suppliers may demand payment up front.
How Likely is it that a Key Person will need to Claim?
Likelihood of a Critical Illness – Likelihood of at least one partner or director getting a critical illness before age 65 Source CIBT02 Based on 1971-2003 population data and experience, published in SIAS paper Exploring the critical path, 2006. Males standalone, extended cover, including own occupation total and permanent disability.
Likelihood of Death – Likelihood of at least one partner or director dying before age 65 Source www.actuaries.org.uk. Based on mortality data from TMNOO (temporary assured lives, male non smokers, 1992-2002) at five plus years duration.
How to Identify a Key Person?
Methods of Calculating Key Person Cover
Who is a Key Person?
A key person is an individual whose skill, knowledge, experience or leadership contributes to the continued financial success of the business.
A key person’s title could fall into almost any category of your business such as:
- Managing Director
- Marketing Manager
- Computer Specialist
- Sales Manager
Questions to Ask Yourself
Although the number of key individuals may vary from one business to another, there will always be at least one key person in any given usiness. The obvious choice of key person will normally be some or all of the partners or members in the business.
However, clients should also consider the impact on the business of losing someone who may not have any financial stake in the business but nevertheless playsa fundamental role in its success. Questions that you should ask yourself could include
- How easily could the business replace their expertise?
- Would their absence affect business expansion plans or ongoing projects?
- Would the business be in danger of losing customer orders?
- Would it result in a loss of goodwill or hardening of suppliers’ credit terms?
- Would the business miss their administration or management contribution?
- Are there any loans or overdrafts dependent upon the key person?
Methods of Calculating Key Person Cover
Calculating the cover – Once you have identified those individuals key to the business, the next step is to establish the level of cover required. There are no hard and fast rules when assessing the financial value of a key person. Each key person must be dealt with on their own merits. There are several options available to guide you in assessing a reasonable amount of cover, and these are outlined below.
Multiple of Profits– This is the primary method of calculating the key person’s worth. As key person cover is concerned with protecting the profitability of the business, considering profit is a sensible first step. The normal multiples are:
2 x gross profit or 5 x net profit
The profit may need to be split where there is more than one key person. Higher multiples may be justified for a rapidly expanding business.
Multiple of Salary – Where the key person is an employee rather than a partner or member, a multiple of gross salary, including benefits in kind, can give a useful indication of the amount needed to bring in a replacement. Up to ten times gross salary may be considered.r a rapidly expanding business.
Proportion of Salary Roll – proportionate An alternative for employees is to calculate the key person’s contribution to turnover. The formula used would be. It will usually take at least a year to train and recruit a replacement, but in some cases it could be argued that three or even four years is more appropriate.
Key Person Tax Treatment
About Tax – If certain criteria are met (see “What are the Anderson Rules?” below) it is possible for a business to receive tax relief on premiums under a keyperson policy. The relief is obtained by treating the premiums as an allowable business expense, which means that they can be offset against business profits for corporation tax purposes.
The taxation treatment of any policy proceeds (i.e. payment of life cover or critical illness benefit) will often depend on whether the premiums were tax deductible. Usually, if tax relief has been allowed on the premiums then any proceeds received are treated as trading receipts and charged to corporation tax. Conversely, if premiums are not tax deductible then any proceeds are typically free of tax.
If a business is eligible for tax relief on premiums, it cannot elect to waive this right in order to receive taxfree benefits.
A business should always ask its local Inspector of Taxes to confirm the likely tax treatment, of any proposed keyperson cover, before proceeding. I have sample letters that can be used as templates for this.
The Anderson Rules – These are not rules at all but a set of principles that formed part of a statement made in 1944 by Sir John Anderson, Chancellor of the Exchequer.
The principles form the basis on which a local Inspector of Taxes will decide whether keyperson cover premiums qualify as an allowable business expense. There are three conditions that have to be met:
- The sole relationship between the business and the keyperson must be that of employer and employee. Relief will not be allowed if the keyperson has a significant stake in the business.
- The life policy is intended to meet loss of profits resulting from the loss of the keyperson’s services.
- The policy is a short-term assurance (although ‘short-term’ is not defined, most tax inspectors will allow relief for terms of up to 5 years).
What Next – How to Apply for Key Person Cover?
Direct or Financial Adviser
One option is to use price comparison websites and go it alone. You can use the information above that may help some of you get suitable cover. However I would suggest using a business protection adviser like myself. The benefit of this is that they can identify your situation and recommend the most suitable solution for you.
I make the process as straight forward as possible and fill in all the paperwork for you. If I deem it suitable to put the policy in trust I do this as part of the service for free. You will find the quotes I provide both competitive and explained in straight forward jargon free language.