Key Person Insurance Explained

This comprehensive guide covers everything small businesses need to know about key person insurance in the UK. We'll explain what it is, how it works, what it covers, how it benefits companies, and help you determine if key person cover is right for your business.

What is Key Person Insurance?

Key person insurance is a life insurance policy taken out by a business on the life of a vital employee or "key person" whose death would financially damage the company. These policies provide a payout upon the key person's death to help the business manage the costs and losses associated with their absence.

The key employee may be a founder, executive, lead salesperson, top technical expert or other individual whose knowledge, relationships and contributions are essential to operations. Losing them unexpectedly can significantly disrupt the business.

Key person insurance provides capital to bridge the gap during this transition. The tax-free lump sum payout can fund the search for a replacement, cover revenue losses, repay debts the key person guaranteed, or keep the business afloat.

How Does Key Person Insurance Work?

Key person insurance functions by having the business take out a life insurance policy on a vital employee or "key person" and paying the premiums. The business is both the policy owner and beneficiary of the plan.
The coverage amount is calculated based on the estimated financial impact if that key person passed away unexpectedly. This factors in expenses like recruitment costs for a replacement, potential lost revenue associated with the individual, business valuation changes, and other impacts specific to the person.

If the insured key employee dies while the policy is active, the insurer pays out a tax-free lump sum to the business as named beneficiary. This payout provides funds to help the company manage the costs and burdens arising from losing such a crucial team member.

The business can then utilize the insurance money to cover recruitment, lost income, debts owed by the deceased key person, and other transition costs in order to maintain operations.

In essence, key person insurance offers financial protection that helps minimize the damage from unexpectedly losing an employee who is highly important to the success and profitability of the company. The policy provides contingency funds to bridge the gap.

What Does Key Person Insurance Cover?

There are a few common costs key person policies can provide funds for:

• Recruitment costs to find a replacement - Advertising, headhunters, onboarding
• Lost productivity until a replacement gets up to speed - Temporary staff, overtime, operational changes
• Lost revenue or sales associated with the individual - Lower sales, delayed projects, unfulfilled contracts
• Repaying outstanding business debts the key person guaranteed personally - Loans, overdrafts, credit cards
• Potential devaluation of the business due to the loss of expertise or relationships
• Funeral and death benefit costs if the business is covering for the deceased

This financial protection can be vital for small companies that rely heavily on just a handful of employees generating revenues, sales relationships, and specialized skills or knowledge.

How Can Businesses Benefit from Key Person Insurance?

There are several advantages key person insurance offers businesses:

• Provides stability at a time of immense disruption and uncertainty
• Allows continuity by funding the ongoing operations and transition
• Offsets potential financial and productivity losses from the key person's absence
• Protects business valuation if a top employee passes away
• Can cover debts personally secured by the deceased
• Premiums and payout are tax deductible and tax-free respectively
• Creates reassurance for customers, vendors and stakeholders about business continuity

Having a plan to insure against key person loss can mean the difference between survival or closure after the loss of an owner or other vital company member.

Who Needs Key Person Insurance?

These businesses are most likely to benefit from key person policies:

• Owner-managed small businesses relying on just 1-2 individuals to operate and generate revenue. The loss of an owner can be catastrophic.
• Companies where a key salesperson generates the majority of revenue. Their relationships drive sales.
• Businesses with limited staff where one person covers multiple specialized roles that would be hard to replace.
• Startups still establishing processes - Loss of initial team members could severely hurt growth.
• Partnerships where a partner's death triggers the need to buy out their interest so the business can continue.
• Companies where a key technical expert's skills and knowledge are not easily transferred.

Essentially any small business highly dependent on a few individuals should consider key person insurance.

How Much Key Person Insurance is Needed?

Determining adequate coverage involves quantifying the potential financial impact if the key person dies. Factors include:

• Cost to find, hire and train a replacement - Look at comparable roles
• Projected revenue losses until a new hire is productive - Estimate deals delayed or lost
• Value of proprietary knowledge and processes that could be lost
• Decrease in valuation - Consult valuation specialists
• Outstanding business debts personally guaranteed - Tally up amounts
• Other costs associated with disruption - Temp staff, operational changes

Add these factors up to quantify the financial risk. Securing coverage equal to this total amount ensures full protection.

How Is Key Person Insurance Taxed?

When it comes to taxes on key person insurance policies in the UK, there are some beneficial tax treatments for businesses:

• Premiums paid by the business are considered a deductible business expense under the "wholly and exclusively" tax rules. This provides corporation tax relief as long as the policy relates to the company's trade.
• The lump sum payout received by the business is treated as a trading receipt. Therefore it is not considered taxable income for the business. No income tax is charged on the amount.
• If the payout amount ends up exceeding the key person's actual economic value to the business, the excess may not be fully tax deductible. This is due to the Anderson principles around tax deductibility. However, most payouts align reasonably with financial loss.
• If the business returns any premiums paid to the deceased's estate, this is considered a deductible business expense rather than a capital loss. So tax relief still applies.
• For partnerships, premiums are split between partners and deducted on their personal tax returns. Payouts received by the partnership itself are not taxed.

In summary, the tax rules in the UK allow businesses to claim meaningful tax relief on key person insurance premiums. The payouts are also received tax-free based on the tax treatment of insurance proceeds. This makes the coverage even more valuable and affordable.

How To Set Up A Policy

To implement key person insurance:

• Determine the cover amount needed as outlined above
• Choose an appropriate policy term length - account for age, retirement plans, etc.
• Select life insurance product - term life is common,
• Name the company as owner and beneficiary
• Undergo individual underwriting on the key employee
• Pay premiums annually or monthly
• Consider coverage for multiple key people

A business insurance broker can walk through implementation details and policy options to protect your key staff members.