Key person insurance

Financial loss can mean the cost of recruitment and training a replacement. It could also include the cost of repaying capital under a business loan or director’s loan account.  Some loan agreements stipulate that there is some form of key person insurance in place.  In these cases calculating the figure for a financial loss is relatively straightforward.

However, for rural businesses where replacements are not easy to find, the loss of a key person would directly mean loss of income. This is where key person insurance gives some peace of mind but the policy must be set at the appropriate level.

Where there are a number of employees or partners, businesses must consider what proportion of income is attributable to a key person, and establishing this figure can be difficult. The Chartered Insurance Institute (CII) recommends that underwriters use the proportion of that key person’s remuneration in relation to the business’s overall remuneration pool. For example, for key person insurance based on an individual who earns £60,000, where the remuneration pool is £100,000, they are arguably responsible for 60% of the business’s income. This figure is then applied to a multiple of the business’s income. Again, the recommendation is generally either twice the turnover, or five to ten times net profit.

In this example if the business has a turnover of £300,000, then the “value” of the key person is 60% x £300,000 x 2, which is £360,000. Life only key person insurance cover for a 40 year old for this amount over a 10 year term starts at £25 a month. Costs increase with the addition of critical illness cover in the key person insurance policy. Interestingly if that individual is a smoker, premiums are usually twice as much – often regardless of whether it is an odd festive cigar or an implacable 40-a-day habit.

Regarding the taxation of policies, if premiums are deductible it will normally follow that the proceeds are taxable; and if the premiums are not deductible the proceeds will normally not be taxable. Where the proceeds are likely to be assessable then the sum assured under the policy should itself be increased so that there is sufficient to meet the tax as well as provide the required amount of cover.