Tony Granger outlines different ways to provide a value to insure for when a key person dies or becomes disabled.
Whilst most businesses are aware of ‘key person’ assurance, 93% of businesses have no cover in place to protect the business against financial loss on the death or serious illness of a key person (source: Swiss Re survey). This is possibly because businesses are unaware of the extent of financial loss caused to the business if the key person dies or becomes seriously ill or disabled and cannot work.
One does not need to be the business owner to be the key person in it. It could be the head of production or a key salesperson, the loss of whom could cost the business thousands of pounds in lost revenues or replacement costs. If the business cannot absorb the loss, it can insure against it.
Factors to determine key people losses
The loss of the key people will cause costs or loss in one or more of the following:
1. effect on profits;
2. cost of replacement, hiring of a locum, advertising, employment costs;
3. cost of replacing know-how;
4. benefit costs to be met;
5. costs of lost contracts and contacts;
6. value lost from work in progress (e.g. starting again);
7. employee contractual payments;
8. repaying a loan account in the business;
9. repurchasing shares from a deceased estate;
10. intrinsic value of the employee – cost of boosting morale amongst the workforce; and
11. keeping the business going, replacing bank guarantees and loans, liabilities and exposures.
Expected financial loss and costs can be insured against
One can value a key person for life assurance, critical illness, and disability cover in a number of different ways. That figure then becomes the level of cover required and will usually be in a range. The cover required should be indexed for inflation and business growth.
The four methods are:
1. amount of the actual liability;
2. 10 x the salary of the key person;
3. 2 x gross profits x % impact;
4. 4 x net profits x % impact;
Example: Key person cover calculations
Assume that a key person has an annual salary of £30,000 and the company has gross profits of £250,000 and net profits of £75,000. Actual liabilities are £175,000. The key person has an impact of 30% on profits. Cover would then be in the range of:
1. £175,000;
2. £300,000;
3. £500,000 x 30% = £150,000;
4. £300,000 x 30% = £90,000.
The business would probably choose a figure between £175,000 (i.e. actual liability) and £300,000. This would satisfy HMRC’s ‘reasonable amount’ test. Life assurance effected is owned by the company or business.
Taxation aspects
If it is a five years’ term or less, the premiums are generally allowable to the business, but the policy proceeds are taxable. You may therefore have to gross up the sum assured by the tax rate to take taxation into account.
If longer than a five years’ term or whole of life policy, the premiums are not deductible. Any gain on a whole of life policy is taxable, and the term policy proceeds are taxable.
Consider combining shareholder protection with key person cover. Premiums are not allowable, but policy proceeds are tax-free and can be loaned to the company to cover key person loss and costs.
Serious or critical illness or disability key person cover
It may be said that the serious illness of the key person or disability could be worse than one dying, in the sense that the business still has to pay an income to someone who is no longer productive and find a replacement. The business may have to replace a fee earner or revenue producer but be morally bound to keep him or her on the books.
Critical Illness cover and income protection can provide the business/employee with protection if this arises. Then, if the key person subsequently dies, the business is covered.
Practical Tip :
Decide who is key to the business. Review the business exposure to risk of loss if a key person becomes seriously ill or dies. The death of a key person could collapse the business if it is not prepared for.
