Managing the risk that could ultimately threaten your company’ sprofits
A vital part of any business is the people who work there. But what if something happened to one of the key personnel in your business, for example, if an important member of staff died unexpectedly or became unable to work due to a serious illness. This could have a considerable impact on the core operations, sales and profit of your business.
Key person insurance is cover that pays out for loss in the event of either death or disability of the important individuals within a business and is designed to protect or compensate the business.
Is your business at risk?
Small and medium-sized businesses could be particularly at risk. However, there is a solution – insurance that would replace the lost profits caused by the loss of a key person. Typically, the liability of any such insurance is the estimated cost of the loss, for example, in business or revenue lost, and/or the replacement of that individual.
Key personnel to consider
The people who create the business and steer it in the
The people without whom your business would lose sales and profits
Directors, partners and shareholders
Integral managers, or key IT development specialists or development operators
Types of cover
There are various types of insurance policy that can be used for this purpose. There might be a short-term need for cover, for example, during an important project. In this situation a term assurance policy may be the most appropriate solution. However, if the key person is likely to remain with the business for an indefinite period of time, whole-of-life assurance may be more appropriate.
Companies and sole traders can affect policies on employees. But partnerships in England and Wales are not a separate legal entity, so where the key person cover is for an individual partner, the policy can either be taken out jointly by all the partners, in which case it becomes a partnership asset or, alternatively, the key partner could take out a policy and place it in an appropriate trust for the other partners.
Insuring a key person
The required level of insurance taken out has to be justifiable. Factors to be taken into account when estimating the required level of cover will include the profits that will be lost if the services of the key individual are no longer available, the expected cost of recruiting and training a new person and the length of time before that replacement is likely to be fully established.
In the event that a loan may be called in on the death of the key person, the amount of the loan and the effect this would have on the profitability of the business will also need to be assessed.
To calculate the sum insured, it is generally acceptable to use the individual’s earnings, including bonuses and company perks, multiplied by a factor of five to ten times earnings. Alternatively, a multiple of profits may be used, which would not typically exceed two years’ gross profits or five times annual net profit, divided by the number of key people being insured.
The tax implications of this type of insurance vary. Often, the premiums for key person insurance will be allowed as a business expense for corporation tax purposes, but certain conditions will need to be met.
Where the policy proceeds are taxable, the tax payable will be linked to the type of underlying policy. Payments under a key person term assurance policy will be treated as a trading receipt and subject to corporation tax.
Bearing in mind that the policy has been taken out to replace lost profits and those profits would have been liable to tax, this approach makes sense.
However, the payout from a whole-of-life policy is treated differently, as it is considered a capital item. As these policies are deemed ‘non-qualifying’ for life assurance purposes, they will be taxed as the company’s income.