Many businesses insure their premises, equipment, vehicles and other physical assets. But for some companies, one of their most valuable assets is a person.
It might be the founder who brings in most of the business, a director with specialist knowledge, a salesperson responsible for major client relationships or an employee whose technical expertise would be difficult to replace.
If that person died or became seriously ill, the financial impact could extend far beyond the cost of recruiting somebody new.
Revenue could fall, clients could leave, projects could be delayed and existing business borrowing could become more difficult to manage.
Key person insurance is designed to help a business protect itself against that financial risk.
Quick Answer: What Is Key Person Insurance?
Key person insurance, also commonly called key man insurance, is business protection arranged on the life of somebody whose death or serious illness could have a significant financial impact on the company.
The business normally owns the policy, pays the premiums and receives the payout following a valid claim.
Depending on the cover arranged, the policy may provide protection if the insured person dies and can potentially include critical illness cover.
The money could then help the business manage the financial consequences, such as lost profits, recruitment costs, outstanding borrowing or disruption while the company adjusts.
The important question isn’t simply whether somebody is senior.
It’s what would happen financially to the business if that person were suddenly no longer able to contribute.
Who Could Be Considered a Key Person in a Business?
A key person isn’t necessarily the most senior or highest-paid person in the company.
The relevant question is how much financial disruption the business could experience if that individual died or was no longer able to perform their role.
A key person could be:
- a founder;
- a managing director;
- a senior salesperson;
- somebody responsible for major client relationships;
- a specialist engineer or technical employee;
- somebody holding important licences or qualifications;
- an employee with knowledge that would be difficult to replace; or
- another person who makes a significant contribution to revenue or profitability.
How Do I Know If Somebody Is a Key Person?
Ask what would happen if that individual wasn’t in the business tomorrow.
- Would revenue fall?
- Could important clients leave?
- Would you struggle to deliver existing contracts?
- Would replacing their expertise take several months?
- Could the business continue servicing its borrowing?
- Would investors or lenders become concerned?
- Would other employees be able to take over their responsibilities immediately?
If losing one person could materially affect the company’s revenue, profitability, debt position or ability to operate, there may be a key-person risk worth considering.
How Does Key Person Insurance Work?
Key person insurance is normally arranged by a business to protect itself against the financial consequences of losing an important individual.
In a typical arrangement:
- The business identifies somebody whose loss could have a significant financial impact.
- The business applies for insurance on that person’s life.
- The individual being insured goes through the insurer’s underwriting process.
- The business pays the premiums.
- The business normally owns the policy.
- If a valid claim occurs, the policy pays the benefit to the business.
The company can then use the money to help manage the financial disruption caused by the loss of that individual.
The exact cover will depend on the policy arranged.
For example, some businesses may arrange life cover, while others may consider adding critical illness protection so that the business could potentially receive a benefit following diagnosis of a condition covered by the policy where the relevant definition is met.
This is different from personal life insurance because the purpose of the policy is to protect the business, rather than provide money directly to the insured person’s family.
What Can Key Person Insurance Help a Business Protect Against?
Key person insurance doesn’t usually reimburse the company separately for individual expenses such as recruitment fees or a particular lost contract.
Instead, following a valid claim, the policy can provide a lump sum that gives the business additional financial resources while it responds to the loss of the insured person.
Depending on why the cover was arranged, the money could help the business manage:
- a reduction in revenue or profit;
- disruption to important client relationships;
- recruitment costs;
- the cost of finding and training a replacement;
- delays to projects or contracts;
- existing business borrowing;
- short-term cash-flow pressures; or
- the wider financial disruption caused by losing an important person.
For example, if a salesperson is responsible for a substantial proportion of a company’s revenue, their loss might affect income while the business recruits somebody new and rebuilds those client relationships.
Alternatively, if a director is central to servicing or securing business borrowing, the company may want protection against the financial pressure that could follow their loss.
The purpose of the cover should therefore be established before deciding how much insurance to arrange.
How Much Key Person Insurance Does a Business Need?
There isn’t a single formula that works for every business.
The appropriate level of cover should reflect the financial loss the company could realistically experience if the key person died or became seriously ill.
There are several ways a business might approach this.
Lost Profit
Consider how much profit the individual contributes to the business and how long it might take to replace that contribution.
For example, if losing a key employee could reduce annual profit by approximately £150,000 and the business expects it could take two years to fully recover, the potential financial exposure could be substantial.
Revenue Contribution
Some businesses may look at the amount of revenue directly associated with the individual.
This can be particularly relevant for senior salespeople, advisers or employees responsible for major client accounts.
However, revenue isn’t the same as profit, so it shouldn’t automatically be treated as the amount of cover required.
Cost of Replacement
Consider what it could cost to:
- recruit a suitable replacement;
- use a specialist recruitment firm;
- pay a competitive salary;
- provide training;
- employ temporary support; and
- absorb the reduced productivity while the new person becomes established.
Business Borrowing
If the key person’s loss could make it harder for the company to service outstanding borrowing, some or all of that debt may also need to be considered.
Worked Example
Imagine a business estimates that losing its commercial director could result in:
- £200,000 of lost profit while client relationships are rebuilt;
- £30,000 of recruitment and training costs; and
- £150,000 of business borrowing that it wants additional protection against.
That represents a potential financial exposure of £380,000.
This doesn’t automatically mean £380,000 is the correct amount of insurance. The appropriate cover will depend on the business, the purpose of the policy, insurer limits and the company’s wider financial resources.
But assessing the actual financial exposure provides a much more useful starting point than choosing an arbitrary lump sum.
Is Key Person Insurance Tax Deductible?
Key person insurance can have tax implications, but businesses shouldn’t assume that the premiums will automatically qualify for tax relief.
HMRC’s guidance explains that premiums may be allowable as a business expense in certain circumstances, including where the sole purpose of the policy is to protect the trade against a loss of trading income resulting from the loss of the key person’s services.
For life insurance, HMRC also sets conditions relating to the type and term of the policy.
The purpose of the insurance therefore matters.
A policy intended to protect trading profits can potentially be treated differently from one arranged partly for another purpose, such as protecting the value of a major shareholder’s interest in the company.
Is a Key Person Insurance Payout Taxable?
The tax treatment of a payout can also depend on the circumstances.
HMRC states that where the relevant conditions for deducting premiums are satisfied, sums received under the policy are treated as income of the employer’s trade.
Where premiums aren’t allowable, the position can be different, although HMRC also makes clear that the treatment of a particular payout is ultimately a separate question.
Tax treatment therefore shouldn’t be assumed when arranging the policy.
If tax treatment is important to your business, you should discuss the proposed arrangement with your accountant or tax adviser alongside your protection adviser.
Key Man Insurance vs Life Insurance
One of the most common questions we hear is:
“Key man insurance vs life insurance what’s the difference?”
The biggest difference is who owns the policy and who receives the payout.
With standard life insurance:
- An individual owns the policy.
- The payout normally goes to their family or chosen beneficiaries.
With key man life insurance:
- The business owns the policy.
- The business pays the premiums.
- The business is usually the beneficiary and receives the payout.
The purpose is not to provide for the employee’s family but to protect the financial stability of the business.
Key Person Insurance vs Shareholder Protection
Key person insurance and shareholder protection are both forms of business protection, but they address different problems.
Key person insurance is designed to protect the company against the financial impact of losing an important individual.
Shareholder protection is designed to help deal with the ownership of shares following the death or, depending on the arrangement, serious illness of a shareholder.
For example, imagine two directors each own 50% of a company and one dies.
The business could face two separate issues:
- The company may lose the deceased director’s expertise, relationships and contribution to profit.
- The deceased director’s shares still need to be dealt with.
Key person insurance may help address the first financial risk.
A properly structured shareholder-protection arrangement may help address the second.
A business can therefore potentially need both types of protection because they serve different purposes.
What If the Key Person Is Also a Director or Shareholder?
A key person can also be a director, founder or shareholder.
However, that can make it particularly important to establish what financial risk the policy is intended to protect.
For example, the company might want protection against lost trading profits if its founder dies.
But if the same individual is also a major shareholder, the business may separately need to consider what happens to their shares.
These aren’t necessarily the same problem and may require different protection arrangements.
The purpose of the policy can also be relevant to its tax treatment, so businesses shouldn’t simply arrange a policy on a director and assume that it will automatically receive a particular tax treatment.
This is an area where protection, legal and tax advice may need to work together.
How Much Does Key Person Insurance Cost?
There isn’t a standard price for key person insurance.
The premium can depend on factors relating to both the person being insured and the cover being requested.
These can include:
- age;
- health and medical history;
- smoking status;
- occupation;
- amount of cover;
- policy term; and
- whether critical illness cover is included.
Generally, a larger amount of cover or more extensive protection is likely to cost more.
The insurer will also assess the individual being insured, which means two businesses requesting the same amount of cover for different key people could receive different premiums.
However, price shouldn’t be considered in isolation.
If losing an individual could expose the business to hundreds of thousands of pounds of lost profit, debt or replacement costs, the more useful comparison is between the cost of the policy and the financial risk the company is trying to protect.
Does Every Business Need Key Person Insurance?
No.
A business with a large team, strong cash reserves and little dependence on individual employees may be able to absorb the loss of one person without significant financial difficulty.
The case for protection can become stronger where the business:
- relies heavily on one or two individuals;
- has concentrated client relationships;
- depends on specialist expertise;
- has significant business borrowing;
- has limited cash reserves;
- would need substantial time or money to recruit a replacement; or
- could experience a material reduction in profit following the person’s loss.
The starting point should therefore be the financial risk, not the insurance product.
Ask what the company would lose, how long recovery could take and what resources would already be available.
If the business could comfortably absorb that risk, insurance may be less important.
If the loss could threaten cash flow, profitability, borrowing or the company’s ability to continue operating normally, key person protection may be worth considering.
What Should I Compare When Arranging Key Person Insurance?
Comparing key person insurance involves more than looking for the lowest monthly premium.
Consider:
Who Needs to Be Insured?
Identify which individuals create a meaningful financial risk to the company.
What Risk Are You Protecting?
Is the concern lost profit, recruitment costs, business borrowing or a combination of risks?
How Much Cover Is Needed?
Base this on the potential financial impact rather than choosing an arbitrary lump sum.
How Long Should the Cover Last?
Consider how long the individual is expected to remain important to the company and the purpose for which the policy is being arranged.
Life Cover or Critical Illness?
Consider which events would create a significant financial problem for the business and what protection is available.
What Are the Policy Terms?
Check the insurer’s definitions, exclusions, underwriting requirements and conditions rather than comparing premiums alone.
How Will the Policy Be Structured?
Ownership, purpose and tax treatment should be understood before the arrangement is put in place.
The aim is to build protection around the business risk rather than simply buying a policy because somebody has been labelled a “key person”.
Oportfolio Insight
When business owners think about risk, they often start with physical assets.
Offices are insured. Equipment is insured. Vehicles are insured.
But for many owner-managed and professional businesses, the most significant concentration of financial risk can actually sit with a small number of people.
A founder may hold the strongest client relationships. A commercial director may generate a substantial proportion of revenue. A specialist employee may have knowledge that would take a year to replace.
That’s why we think the starting point for key person protection should be a simple question:
What would this business look like financially if this person wasn’t here tomorrow?
From there, you can start quantifying the exposure: lost profit, client revenue, recruitment costs, debt and the length of time the business might need to recover.
That provides a much stronger basis for considering protection than simply deciding that every director should have the same arbitrary amount of insurance.
Could Losing a Key Person Affect Your Business?
If your company relies heavily on a founder, director, salesperson or specialist employee, it can be worth understanding the financial impact their loss could have on the business.
At Oportfolio Mortgages, our protection advisers can help you assess the risk, consider how much cover may be appropriate and compare business-protection options based on your circumstances.
The aim isn’t simply to insure your most senior employees.
It’s to identify where your business has a genuine financial dependency on an individual and consider whether protection could help the company manage that risk.
