Key Person Cover
This is protection against the financial consequences to a business that would otherwise result from the death or serious illness of someone who (normally) is employed by the business. Effectively, it is loss of profits insurance.
A key person could be defined as “anyone with specialist skills or knowledge, or with particularly important areas of responsibility, whose loss to a business would adversely affect its profitability”.
Such a person cannot easily or quickly be replaced and, whilst it is said that no one is irreplaceable, a business can suffer significantly during the time that it takes to find that replacement.
Key person cover is designed to give businesses a cash injection in order that profits are effectively maintained while the best replacement is found.
How much cover should be provided?
A business needs to consider how much the loss of profits would be if the key person died or suffered a serious illness. They should also think about including costs such as, recruitment, training, and loss of goodwill.
They should also consider how long the cover needs to be in place for. How long will it realistically take to find a replacement?
Traditionally, a multiple of salary method has been used when deciding on the necessary amount of cover for a keyperson. This relies on two assumptions: firstly, that it will take the business a number of years to recover and, secondly, that the keyperson’s salary in some way reflects their impact on profits.
Between two and ten times salary is a guideline, so if the key person’s salary is £30,000 p.a. and the company believe that it will take five years to recover its position, then a sum assured of £150,000 is needed.
Another method is to look at the key person’s salary in conjunction with the business’ total wage bill and their gross profits:-
Example of key person cover
Company A’s gross profits= £5,000,000 p.a.
Company A’s total wage bill= £1,000,000 p.a.
The keyperson’s salary= £30,000 p.a.
Multiply the profits by the keyperson’s salary and divide the figure by the total wage bill:
(£5,000,000 x £30,000) ÷ £1,000,000 = £150,000
If this cover needs to be in place for 5 years, then our sum assured would be
£150,000 x 5 = £750,000
What should the term of the plan be?
This depends on the business and the keyperson. Term assurance plans would be more suitable where:
- Tax relief on the contributions is required.
- The keyperson may not remain key in the future.
- The keyperson is working on a project.
- The keyperson will be key through to their retirement.
- The keyperson may not stay in the business long term.
It is not uncommon for short term plans of say five years to be set up on a renewable basis.
A whole of life plan may be more suitable if the keyperson is an owner of the business.
How should the plan be set up?
Whether its life cover, critical illness cover or permanent health insurance that is needed on the key person, it is the business that will want to receive, and therefore control, the benefits. Key person plans are therefore set up on a life of another basis.
What about underwriting?
As with all life of other plans, insurable interest will need to be shown. The business will need to be able to demonstrate that the level of cover is reasonable in relation to the contribution that the key person makes to the profits of the business.
What is the tax situation?
If a term plan has been affected, then HMRC may allow the company to obtain tax relief on the contributions if:
- There is an employer/employee relationship between the life assured and plan owner.
- The plan is to meet loss of profits only.
- The plan’s term is no more than 5 years.
- The proceeds of any plan that has obtained tax relief on the contributions will be taxable as a trading receipt.
We advise businesses taking out any form of key person insurance to speak to their local Inspector of Taxes to clarify their individual tax situation.