Companies would never leave their most expensive machinery, equipment or other capital assets uninsured. So why do they fail to insure their most valuable assets – their employees? According to research carried out by Legal & General, more than one in two companies said their business would crumble within a year if a key person in the business died or became critically ill.
Key person insurance is a type of business insurance policy taken out on an invaluable company executive or employee. Also known as key man insurance or business life insurance, the purpose of the policy is to help the company offset some of the financial losses brought about by the untimely death of a ‘key’ employee. The following sections will take you through the ins and outs of key person insurance:
- What is key person insurance?
- How does key person insurance work?
- What is covered by key person insurance?
- How much does key person insurance cost?
- How much key person insurance do you need?
- Does my business need key person insurance?
- List of insurance providers
- What about support for the family of the key person?
- Case study
- Final thoughts & FAQ’s
What is key person insurance?
In today’s highly specialised market, individual talents are often the main source of business success. Should anything happen to the firm’s breadwinner, the entire venture would likely suffer significant losses. Sales and profits can plunge, owing to a lack of expertise and an increased workload for other employees. Not only is the company bound to lose revenue, but the costs of hiring and training a successor can also be overwhelming in itself.
Key person insurance can cover a business against this financial risk, helping companies to overcome the costs associated with losing a major contributor to their bottom line. The policy will compensate the firm for any financial losses incurred by the death or incapacity of one of the company’s most prominent members. It’s important to note, however, that policies do not cover the actual losses incurred, but rather compensate a fixed, agreed sum, as specified in the policy.
How does key person insurance work?
The sum insured by the policy is paid out as a lump sum in the event that the person insured dies during the policy term. This capital injection could be crucial in keeping a company afloat if it would struggle to survive without the knowledge, contacts or direction of a significant employee. The sum can resolve cash flow issues caused by lost profit, or cover the cost of hiring and training a replacement.
The policy is owned and paid for by the employer. This means it is the employer who receives the payout following the key person’s death. Some providers will also pay out if the insured person suffers from a critical illness or a long-term disability which means they can no longer work.
Some banks require you to take out key person insurance if you take out a commercial bank loan. The cover serves as a form of business loan protection, ensuring the company does not fail, losing the lender their money, if an instrumental employee is no longer around.
How do you define a key person?
A key person refers to any member of staff who is crucial to a company’s financial success. This is usually the business founder or CEO, but it can also be somebody who defines the company strategy, the sales manager, or somebody with critical skills that the business can’t function without – such as the principal software developer in a software company. Typical key people include:
- the office manager: essential for the daily running of the business
- the web developer: without whom a company’s primary sales platform could go down
- the founder: somebody who knows the entire business inside out and is likely to have most of the fundamental business connections
- the top salesperson: integral for hitting sales targets and making a significant profit.
What is covered by key person insurance?
Unlike other forms of insurance, key person cover often provides an agreed, fixed sum, rather than paying the actual price of individual claims. The policy owner, or the employer, will receive the funds and be able to use the money in the business as they see fit. The employer may use the payout to cover the company in a variety of ways, including:
- making up for lost profits
- paying for recruitment and training for a replacement
- covering the loss of vital business contacts
- losing the confidence of suppliers or customers
- repaying outstanding loans
- making up for the loss of knowledge of the company’s systems, processes and operations.
In the worst-case scenario, the beneficiary can use the cash to pay off the company’s debts and wind the company down. For a small business, such a payout could protect them from bankruptcy.
The events for which an insurer will pay out vary. Broadly, there are two types of cover offered under key person insurance:
- Life only key person insurance: this works similarly to a straightforward life insurance policy, where a person is insured for a stipulated sum of money which is paid out if they die. Usually, terminal illness is covered in life only insurance, too.
- Life and critical illness: many providers offer critical illness cover as an add-on or a separate policy. The insurer will pay out a lump sum if the insured person receives a diagnosis for a critical illness covered by the insurer. Over 70% of claims are for a heart attack, stroke or cancer, which are almost always included. The specific conditions covered will vary from provider to provider, though most providers adhere to the recommendations set out by the Association of British Insurers (ABI) which includes Parkinson’s disease, Alzheimer’s, kidney failure, paralysis and multiple sclerosis, among others.
Employers can also choose to add key person income protection insurance to their policy. In the event of an employee becoming ill or temporarily incapacitated, the plan can help to fund the employee’s salary and also cover the costs of replacing the key person while they recover. This cover does not always extend to critical illness or long-term disability, so you must check with a provider before you purchase a policy.
Does my business need key person insurance?
While over half of businesses claim that they would quickly fold without a key employee, under half of the companies asked have key person insurance. It’s a good idea to evaluate how reliant your business is on your important staff members and consider how your business would fare without them. Larger companies may be better equipped to absorb the loss of key contacts, knowledge or expertise. In smaller businesses with a team of five or ten, this loss may be instantly crippling.
Consider for what portion of your company profits your key personnel are directly responsible. If they’re significant, you should consider investing in a key person insurance policy. It’s also worth noting that many venture capitalists insist that a company or start-up has key person insurance in place before they invest. The same goes for banks, who may not provide you with a loan without a key person policy.
How much key person insurance do you need?
There’s no set rule for working out how much cover you need. It depends primarily on the size of your business, how niche the expertise of the key person is, and the amount of turnover for which they are responsible.
That said, there’s a general rule which can help you figure out an approximation of cover that you need. Firstly, identify the individuals you want to insure. Next, you should try and work out their specific value to your business, by identifying the portion of the net or gross profits for which they are directly responsible. Most insurers suggest insuring the person for twice the amount of gross profit they bring in or five times the net profit.
For example, if your business makes £100,000 of gross profit a year and your key employee is responsible for 40% of the turnover, it would be advisable to insure them for £80,000 (2 x £40,000). If your business has net profits of £50,000 and your employee is responsible for 10%, it is sensible to insure them for £25,000 (5 x £5,000).
Alternatively, you can use one of the key person cover calculators available online as a guide for choosing the right amount of cover.
How much does key person insurance cost?
The price of the policy depends mostly on how long the policy lasts and the level of cover chosen. Employers usually calculate the amount of protection they need based either on the key staff member’s salary, or the turnover they create, as well as how long it would take to recover the lost profits if they could no longer work. Sometimes businesses take into account the costs of replacing the key person, including the replacement’s salary and the time it would take to make back the lost revenue.
The premium you pay will depend on factors relating to the key person insured, such as their age, health and general lifestyle. In this way, it works similarly to life cover. The price will also depend on whether you opt for life cover only, or life and critical illness cover, which will be more expensive. You can also choose to cover more than one person if there are several employees intrinsic to the success of the business.
Another factor which affects the price is the length of the cover. Usually, employers take out cover for five to ten years, and there’s usually no penalty for cancelling the insurance at any time, for example, if the key person were to leave the company voluntarily.
Should I get cheap key person insurance?
Cheaper policies tend not to include critical illness insurance. However, for many companies, the impact of a key person being unable to work physically is the same. It’s therefore well worth considering paying a bit extra to protect your company against financial damage it could suffer if a key staff member can no longer come into the office.
What about key person insurance comparison sites?
When comparing policies on online comparison sites, it’s also crucial to bear in mind that the quotes you see won’t always reflect the final price that you may end up paying. As with life insurance, the policy depends hugely on the specific details you provide about the person insured. The same level and length of cover can vary hugely in price depending on how the insurer assesses their risk, so what looks like the cheapest option at first glance may end up being more expensive once you’ve built up your policy.
How to lower your premiums
Of course, the younger and healthier the person you choose to insure, the lower your premium will be. Other factors include the length and level of cover you opt for. However, some providers will give you the option to take specific action or enrol in a particular programme in return for a lower premium. This is the case with Vitality, who offer the Vitality Programme, which promotes healthy living. If you and your employees enrol and commit to getting active each week, they’ll reward you with Vitality points, regular treats or knock some money off your premium.
Should I use an insurance broker?
Most financial advisers and insurance providers now offer key person insurance. With so much choice, it can be tricky to find the best policy for you. Brokers can help you find better deals with lower premiums and more extensive cover. They have the industry knowledge necessary to compare the intricacies of the different policies offered by various providers.
Brokers often have access to policies that are not available directly to customers, and for reduced prices, too. Often, these low deals absorb the commission taken by the broker as well, making it still a cheaper option for the end customer. The British Insurance Brokers’ Association, BIBA, offers a helpful Find a Broker tool, providing a list of brokers which all adhere to the association’s exacting standards.
How to choose the right policy
When you’re shopping around for key person insurance, you should start by working out the insured sums you require, as we’ve shown above. You will need this to compare policy prices and to see whether insurers provide the amount of cover you need. The next things to consider are whether the provider offers only life cover, or life and critical illness cover.
Finally, it is worth looking into the level of support offered with your policy, and how much the provider can guide you. Losing a key employee is personally devastating, and it can help to have support in place to help you allocate funds and get the business back on its feet during an emotionally exhausting time. Extra support for the company is especially important, too, if the key person insured was usually responsible for business operations and strategy.
What about support for the family of the key person?
While key person insurance is a sensible option for any business which finds itself disproportionately reliant on several employees, it can feel cruel to receive a company payout in the aftermath of a death of a valued colleague. To ensure you are supporting the insured person’s family in their grievance and suffering, many providers offer additional cover to help support the key person’s loved ones. Some policies include other benefits such as medical services to ensure the employee receives the best treatment they can following a difficult diagnosis.
On top of this, companies can invest in relevant life insurance. A relevant life policy is a benefit set up by a company, but the money goes to the staff member themselves or their beneficiaries if they pass away. Typically, the policy will accompany a trust, which both reduces inheritance tax and identifies who the beneficiaries would be – usually the family or dependents of the deceased. Relevant life insurance typically doesn’t cover critical illness, only death or terminal illness. It’s therefore often taken out in conjunction with key person insurance or shareholder protection.
A Dorset-based software consultancy agency celebrated its fifth anniversary at the beginning of the year. Since its founding in 2015, they have grown to become an SME with around 15 employees, turning over £2 million per year. The agency was founded by two friends, one with a knack for business and the other, a highly skilled software developer. While the company has grown to incorporate a multitude of services, 40% of the revenue comes from their bespoke software package, which is almost exclusively managed by the software developing partner.
In March 2020, the software developer and founder discovered they had a terminal illness. The diagnosis came as a personally devastating shock to the remaining founder and the rest of the team. In terms of the business, fortunately, the software developer had insisted several years back that the company invest in key person insurance for them, after realising they were responsible for such a considerable amount of the company’s profits.
Of the £2 million annual turnover the company makes, the software developer was responsible for 40%, or £800,000. Of this £800,000, £500,000 was gross profit. They had therefore taken out a life and critical illness policy with an insured sum of £1,000,000; twice the gross profit brought in by the developer. When the founder received their diagnosis, the remaining founder received the payout from their insurer. They used this money to recover some of the lost profits and recruit and train a new developer.
While the policy could by no means relieve the heavy personal loss felt by the remaining founder and the team, the insurance was able to alleviate the financial pressures for the business following the diagnosis. Having key person insurance in place ensured that the founder’s legacy lived on in a thriving business, and allowed the team left behind to grieve, focusing on the things that matter.
Final thoughts & FAQ’s
The loss of any team member is devastating. While key person insurance can by no means soften the emotional blow, it can alleviate the stresses of keeping your company afloat in a time which should be reserved for supporting the employee and their family.
One of the first rules of business is to protect your assets, and this includes your staff. Underinsuring a company is one of the most common oversights of budding entrepreneurs. If the success of your whole enterprise rests on the brains of one person, it’s well worth considering a key person insurance policy.
Still have questions? Find answers to the most frequently asked questions concerning key person insurance, below.
Is key person insurance a legal requirement?
You are by no means legally required to have key person insurance. In fact, less than half of businesses today have any kind of insurance in place for their most valuable assets – their staff! While there’s no legal reason for you to get it, many banks and investors will not give you money without it, as it acts as a form of loan protection for the lender.
Is key person insurance tax deductible?
The premiums of key person insurance are usually tax-deductible. This means they can be offset against a company’s corporation tax, provided that:
- the payout is used to compensate for the loss of profits following the loss of a key staff member
- the policy has a term assurance of five years or less
- the policy is not convertible.
If the policy is eligible for tax relief, any payout made to the company would be taxed at the usual rate of corporation tax, which is not usually the case. It is worth weighing up whether the money you would save in your corporation tax relief would be worth the reduced sum you would have available from a payout after factoring in corporation tax. If you are planning to claim corporation tax relief for your key person insurance premiums, many advisors recommend raising the sum assured by the key person policy to compensate for what you will lose in tax.
Many companies require cover for over five years. If this is the case, but you want to claim corporation tax relief, you can find term assurance plans which work on a five-year renewable basis. This setup means that businesses can cover themselves beyond five years, while still satisfying the rules given for corporation tax relief stipulated by HMRC.
Is a key person insurance payout tax-free?
As above, it largely depends on whether you have claimed corporation tax relief for your key person premiums. If you haven’t, any key person payout from an insurer is likely to be regarded as capital rather than profit in the business, which means it won’t be taxable. However, each case depends on HMRC’s verdict, so it is best to seek advice directly from HMRC or an accountant.
What’s the difference between key person insurance and shareholder protection?
People often confuse these two policies. While they work in a similar manner, they constitute a different insurance product. A shareholder protection policy provides a payout which shareholders, partners or directors can use to purchase the shares of another shareholder if they pass away or receive a diagnosis for a critical illness. This protection helps the remaining shareholders buy the shares and help the business return to normality if they would not usually have the funds to buy the equity themselves.
If a shareholder passes away, and there is no agreement in place for the distribution of equity, the business can enter a period of uncertainty, which can affect relationships with suppliers and customers. A shareholder protection policy also ensures that the family member of the deceased receives a fair sum of money agreed at the time the shares are purchased.
So, while shareholder protection concerns the ownership of the business, key person insurance protects the business against loss of profits following the death of any member of staff deemed intrinsic to a company’s success.
What other types of business insurance should I consider?
Losing a key member of staff is not the only way a business can suffer financial losses. Starting a business comes with enormous risk, and insurance is the best way to protect your company. Many insurance brokers can help you find a package deal which incorporates the primary forms of business insurance, which is particularly helpful for smaller businesses, or first-time business owners looking for an all-encompassing package.
If you offer a service, one of the most important policies to take out is professional indemnity insurance. This cover protects your business should a client claim that your advice or service has caused them to suffer a financial or reputational loss. It’ll also cover you for costly claims against negligence or a confidentiality breach. Professional indemnity insurance will pay the compensation settlement as well as any legal fees incurred.
Another common commercial insurance to consider is public liability insurance, which protects you against any claims made by members of the public should they sustain an injury or damage to personal property while on your premises. Other policies to look into include employers’ liability, a legal requirement if you have any employees, and office contents insurance. You should also explore directors’ and officers’ liability insurance to protect your management against claims which make them personally liable. For director/officer and company liability you should look at a comprehensive management liability insurance policy.