A comprehensive look at Key Person Insurance
Many clients that I advise on business protection confuse key person insurance and shareholder protection. They seem to think that each policy is the same. The truth is that these are similar products i.e. each of these are life insurance but the difference is where the sum assured goes in the event of a claim and the reason each was taken out.
Key Person Insurance is designed to offer a lump sum or regular monthly income cash injection into a business to mitigate any loss that would occur from either the death or long term illness of anyone the contributes to the profit of a business.
Therefore looking at key person insurance, how it is set up and how it works falls into 3 areas.
1 – Identifying a key person.
2 – Working out how much cover is required.
3 – Setting the policy or policies up in the right manner.
This post will hope to uncover the 3 areas above and it will also look at the tax side of things. But in most cases the premiums will not be tax deductible. However that doesn’t mean that you don’t need it. The effects of a business losing a key person can often cause a business to fail thus the need needs to be looked at not the tax side of things.
Key person video
Who is a key person?
What cover is required and how to set it up.
Click play to watch the video explaining more about key person insurance
The video below explains more about key person policies, who they can help, how they could help you and how they work.
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.
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 business. 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 plays a 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 of 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.
Whats the tax position for key person insurance
Premiums are allowable and sums assured received are trading receipts if:
– The sole relationship is that of employer and employee.
– The insurance is intended to meet loss of profits arising from the employee’s loss of services.
– The policy term reflects how long an individual can be deemed to be key to the business – this is generally short term 5 years or less.
– The employee owns 5% or less of the shares in the company.
Each case is different and clarification from the local inspector of taxes would be recommended. Typically tax relief is not allowed as in nearly all cases the key person being insured is a major shareholder of the business. The tax position is as above and comes from the Anderson Rules. Just because the policy may not qualify for tax relief does not mean that the company should not take key person insurance. It just means they will not get tax relief on the premiums.
Whether tax is paid on the proceeds of a plan depends on the reason for the cover. If the policy is used to cover the loss of profit or to pay for a replacement the the sum assured would be treated as revenue and taxed with corporations tax.
If the benefit is used to repay a loan the benefit will be treated as capital and is not subject to tax. We can increase the sum assured to cover any tax liability.
So what are the next steps?
Make setting up the cover a priority.
I’m sure like most company directors you are extremely busy. You have a million things to do and most of them need doing today. Stop and think for a second on how your business would cope with the loss of profits that would occur if you lost your sales manager along with all their contacts they have built up over the years. Or the other company director who is in charge of marketing and brings in 40% of your profits through creating joint ventures and partnerships.
Setting up key person will take a small amount of time. We will need to speak to you initially via the phone for 10 to 15 minutes. After that we can liaise with your professional connections such as your accountant. Quotes will be provided and then once we get the go ahead we will deal with the key person directly not taking any of your time up.
Once terms have been offered we will fill in any trust documentation for you making the process easy and straight forward.