Key Person Insurance Guide
Protecting Your Business Against the Loss of a Key Individual
Every business depends on people, but some people have a particularly significant influence on its financial success.
It might be the founder who holds the major client relationships.
It could be a salesperson responsible for a large proportion of revenue.
It might be a technical specialist whose knowledge would be difficult to replace.
Or it could be a director whose experience, contacts and leadership are central to the company's continued operation.
What would happen to the business if that person suddenly died or became seriously ill?
Key person insurance is designed to help businesses manage the financial consequences of losing somebody whose contribution is particularly important.
This guide explains what key person insurance is, who might be considered a key person, how businesses can estimate the amount of protection required and how this differs from other forms of business protection.
What Is Key Person Insurance?
Key person insurance is protection arranged to help a business financially if an important individual dies or, where included within the policy, suffers a specified critical illness.
Unlike personal life insurance, where the objective is generally to protect an individual's family or dependants, key person protection is primarily designed to protect the business.
The business may own the policy and receive the benefit following a valid claim, depending on how the arrangement has been structured.
The objective is to provide financial resources while the business responds to the loss of an important person's contribution.
What Is a Key Person?
A key person is someone whose absence could create a significant financial impact on the business.
This could include:
a founder;
director;
shareholder;
senior manager;
salesperson;
technical specialist;
professional with specialist qualifications;
employee responsible for major customer relationships; or
another individual who makes a substantial contribution to the business.
A key person does not necessarily need to own the company.
An employee can be just as important to the financial performance of a business as one of its shareholders.
How Do You Identify a Key Person?
A useful exercise is to imagine that each important person disappeared from the business tomorrow.
Then ask:
Would revenue fall?
Would important clients be at risk?
Would projects be delayed or cancelled?
Would specialist knowledge disappear?
Would the business need to recruit somebody urgently?
Would suppliers, customers or lenders become concerned?
Would the company struggle to meet its financial commitments?
If the absence of one individual could create significant financial disruption, there may be a key-person risk.
Key People Are Not Always the Highest Earners
Salary alone does not determine whether somebody is a key person.
Consider a relatively small company where one employee manages relationships with several of the company's largest customers.
That employee may not be the highest-paid person in the business.
But if their absence could result in customers leaving and revenue falling significantly, their financial importance to the business could be substantial.
Key person protection should therefore focus on economic impact rather than job title or salary alone.
Why Can Losing a Key Person Be So Expensive?
The financial consequences can extend far beyond the person's salary.
A business could potentially experience:
reduced turnover;
reduced profits;
loss of clients;
delayed projects;
recruitment costs;
training costs;
temporary staffing costs;
disruption to operations;
pressure on cash flow;
difficulty servicing borrowing; and
reduced confidence among customers, suppliers or lenders.
The precise impact depends on the role the person performs.
An Example of Key-Person Risk
Imagine a small company with three directors.
One director is responsible for most of the company's new business and maintains relationships with its largest customers.
If that director died unexpectedly, the company might not immediately lose every customer.
But over the following months, revenue could decline.
The remaining directors might need to spend time maintaining those relationships rather than performing their usual roles.
A replacement may need to be recruited.
The new person may need training and time to establish themselves.
During this period, the company's expenses continue.
Key person insurance is designed to provide financial support to the business while it deals with circumstances such as these, subject to the policy terms.
What Does Key Person Insurance Cover?
The exact cover depends on the policy arranged.
Key person protection may involve life insurance, critical illness cover or an appropriate combination depending on the circumstances.
The insured events, definitions, exclusions and policy terms vary between insurers.
The important point is that the protection should be designed around the financial risk the individual represents to the business.
Key Person Life Insurance
Key person life insurance is designed to provide a benefit following the death of the insured individual during the policy term, subject to the policy conditions.
The proceeds could potentially provide the company with financial resources while it adapts to the loss.
This does not replace the person.
Instead, it can provide financial breathing room while the business decides what happens next.
Key Person Critical Illness Cover
Death is not the only event that can remove somebody from a business.
A key person could survive a serious illness but be unable to work for a significant period.
Where appropriate critical illness protection has been arranged, a benefit may be payable if the insured individual is diagnosed with a condition covered by the policy and meets the required definition.
Critical illness policies do not cover every illness or diagnosis.
The precise policy definitions are important.
What Could a Key Person Insurance Payment Be Used For?
The appropriate use will depend on the circumstances facing the business.
Funds could potentially help with:
temporary loss of profits;
recruitment;
training a replacement;
temporary management support;
maintaining cash flow;
meeting ongoing operating expenses;
servicing business borrowing;
maintaining customer relationships; or
providing time to reorganise the company.
There is no requirement that every business will use a payment in the same way.
How Much Key Person Cover Does a Business Need?
This is one of the most important questions.
There is no universal amount.
Simply choosing a large round figure does not establish whether the business is appropriately protected.
The calculation should begin with the financial consequences of losing the individual.
Consider the Person's Contribution to Profit
One approach is to consider how much of the company's profit is attributable to the key individual.
If their absence could significantly reduce profits, the business may want enough protection to help compensate for that disruption while a replacement is found or the company reorganises.
The appropriate calculation depends on the business and insurer requirements.
Consider the Person's Contribution to Revenue
Revenue can also be relevant.
A salesperson or relationship manager may be directly responsible for substantial turnover.
However, turnover and profit are not the same thing.
A business with high revenue but relatively small margins may have a different protection requirement from another company generating the same turnover with much higher profitability.
The financial impact should therefore be considered carefully.
Consider Replacement Costs
Replacing a key person can be expensive.
Potential costs include:
recruitment agency fees;
advertising;
salary packages;
temporary staff;
training;
professional qualifications; and
time spent by other employees helping the replacement.
A replacement may also take months before becoming fully effective.
Those costs can form part of the protection calculation.
Consider the Time Needed to Recover
Ask how long the business would realistically need to adjust.
Could another employee immediately take over?
Would recruitment take several months?
Would the new person need specialist training?
Would customer relationships need to be rebuilt?
Would the company need to change its strategy?
The longer the expected disruption, the greater the potential financial exposure.
Consider Business Borrowing
A key individual may also be important to the company's ability to service debt.
The business might have:
a commercial mortgage;
business loans;
equipment finance;
development finance; or
other commercial borrowing.
If losing the key person would materially reduce the company's income, existing borrowing can increase the financial risk.
Key Person Insurance and Commercial Mortgages
Consider a business purchasing its trading premises using a commercial mortgage.
The lender may assess the company's financial strength and the people responsible for running it.
If one individual is particularly important to generating the income required to service the mortgage, their death could create both operational and financial problems.
This does not mean key person insurance automatically repays a commercial mortgage.
Rather, business borrowing can be one of the financial risks considered when deciding whether key person protection is appropriate.
Key Person Insurance and Business Loans
The same principle can apply to other business borrowing.
If the business has taken finance to:
expand;
purchase equipment;
acquire another company;
refurbish premises;
increase working capital; or
fund another business objective,
the debt may continue even if an important person dies.
Protection planning can consider how the company would manage that liability if revenue subsequently declined.
Is Key Person Insurance the Same as Business Loan Protection?
Not necessarily.
The objectives can be different.
Key person insurance primarily considers the financial impact of losing an important person.
Business loan protection focuses on the liability created by business borrowing.
The same individual and policy might sometimes be relevant to both discussions, but the financial needs should be identified separately.
Is Key Person Insurance the Same as Shareholder Protection?
No.
This distinction is particularly important.
Key person insurance protects the business against the financial consequences of losing an important individual.
Shareholder protection deals primarily with the ownership consequences of a shareholder dying or experiencing another event covered by the arrangement.
The same individual might be both a key person and a shareholder.
But those are two separate risks.
A Director Can Be Both a Key Person and a Shareholder
Imagine two people own a company equally.
One of them is also responsible for most of the company's sales.
If that person dies, two problems can arise.
First, the business loses somebody responsible for significant revenue.
Second, there is the question of what happens to that person's shares.
Key person protection could potentially address the first problem.
Shareholder protection arrangements could potentially address the second.
One policy should not automatically be assumed to solve both.
Is Key Person Insurance the Same as Relevant Life Insurance?
No.
Relevant Life Insurance and key person insurance have different objectives.
Key person insurance is generally designed to protect the business financially.
Relevant Life Insurance is generally an individual life insurance arrangement established by an employer for an eligible employee, subject to the relevant requirements.
The intended beneficiaries and reasons for arranging the policies are different.
Is Key Person Insurance Personal Life Insurance?
No.
Personal life insurance is generally arranged to provide financial protection for individuals and their families.
Key person insurance is arranged because the business has a financial interest in the continued contribution of the insured individual.
A business owner could therefore potentially have personal life insurance and separately be insured as a key person within their company.
Who Owns the Key Person Policy?
Policy ownership is an important part of the arrangement.
Where key person insurance is intended to protect a company, the policy may be established so that the business owns the policy and is intended to receive the proceeds following a valid claim.
However, the appropriate structure depends on the circumstances.
Ownership, purpose, taxation and the relationship between the business and insured person should be considered when establishing the arrangement.
Does the Key Person Need to Consent?
Insurance applications involve personal information and underwriting relating to the person being insured.
The individual will therefore normally need to participate appropriately in the application and underwriting process.
They may need to provide information about:
health;
medical history;
occupation;
lifestyle;
smoking or nicotine use; and
other relevant circumstances.
Medical Underwriting
Key person protection can involve medical underwriting just like personal life or critical illness insurance.
Depending on the circumstances, the insurer may:
offer standard terms;
adjust the premium;
request further information;
request medical evidence;
apply particular terms where appropriate;
postpone consideration; or
decline the application.
Different insurers may assess the same circumstances differently.
Accurate Disclosure Matters
Insurance applications should be completed accurately.
The insurer relies on the information provided when deciding whether and how to offer cover.
Incorrect or incomplete information can affect a future claim.
Questions should therefore be answered carefully and accurately.
Can More Than One Person Be Protected?
Yes.
A business may depend on several key people.
For example, a company might rely heavily on:
its managing director;
its sales director; and
a specialist technical employee.
The financial impact of losing each person could be different.
Protection requirements should therefore be considered individually rather than simply giving everyone identical amounts of cover.
What About Small Businesses?
Key person protection can be particularly relevant to smaller businesses.
A large organisation may have several people capable of performing similar roles.
A small business may have only one person with a particular skill, relationship or responsibility.
The smaller the team, the greater the potential concentration of risk.
What About a One-Person Limited Company?
If the company depends almost entirely on one director, the business may clearly have significant dependency on that individual.
However, the purpose of any proposed business-owned protection needs to be considered carefully.
There is little value in arranging insurance without first understanding what financial problem the company would actually face and what would happen to the business if the individual died or became seriously ill.
Personal protection may also be particularly important because the owner's household could depend on income generated by the company.
What About Family Businesses?
Family businesses can have additional complexities.
The same individual may simultaneously be:
a director;
shareholder;
key employee;
family member; and
main household earner.
It is important to separate the different risks.
The business may need key person protection.
The shareholders may need succession planning.
The family may need personal life insurance and other protection.
Each objective should be considered separately.
Key Person Insurance and Business Succession
Key person insurance can provide money following a valid claim, but money alone does not create a succession plan.
Businesses should also consider practical questions.
Who would take over management?
Who has access to important systems?
Who knows the major customers?
Who understands the company's finances?
Who can authorise payments?
Who can continue important projects?
Insurance can provide financial support, but operational planning remains important.
Tax Treatment of Key Person Insurance
Tax treatment is an important consideration but should not be assumed.
Whether premiums receive particular tax treatment and how policy proceeds may be treated can depend on factors including:
the purpose of the insurance;
policy ownership;
relationship between the insured person and business;
policy term;
company circumstances; and
tax rules applying at the time.
Tax rules can change and individual circumstances matter.
The company's accountant or tax adviser should therefore be involved where appropriate.
Don't Arrange Key Person Cover Purely for Tax Reasons
The starting point should be the financial risk facing the business.
Insurance should be structured around that need.
Any potential tax treatment should then be considered with appropriate professional advice rather than being the sole reason for arranging the policy.
How Long Should Key Person Cover Last?
The appropriate term depends on the business and the individual's role.
Consider:
how long the person is expected to remain important to the company;
retirement plans;
business succession plans;
outstanding borrowing;
expected business growth; and
whether dependency on the person is likely to reduce.
A policy designed for today's business should still have a clear purpose throughout its intended term.
What Happens if the Key Person Leaves the Business?
Circumstances can change.
A key employee might resign.
A director might retire.
Responsibilities might be redistributed.
The business might be sold.
If the person is no longer financially important to the company, the original reason for the protection may have changed.
The policy should therefore be reviewed rather than simply left untouched.
What Happens if the Business Grows?
Growth can make existing protection inadequate.
Suppose a key person was originally responsible for a business generating relatively modest profits.
Several years later, the company has grown substantially and that person's contribution has increased.
The original amount of protection may no longer reflect the potential financial loss.
Review Key Person Protection Regularly
A review can be particularly useful after:
substantial revenue growth;
significant profit changes;
taking new borrowing;
purchasing business premises;
recruiting senior staff;
directors changing;
shareholders changing;
major new customer relationships;
business acquisitions; or
changes in the role of the insured person.
Business protection should evolve alongside the company.
Don't Automatically Replace Existing Cover
An existing policy may have been arranged when the insured person was younger or had a different medical history.
Replacing it means new underwriting based on current circumstances.
The new policy may have different premiums, exclusions or other terms.
Existing cover should therefore be reviewed carefully before replacement.
Never Cancel Existing Protection Before Replacement Cover Starts
A new application does not guarantee acceptance.
Additional medical underwriting may be required and the insurer may offer different terms from those originally expected.
Existing protection should generally remain in place until replacement cover has been accepted, has started and the consequences of replacing the original policy have been understood.
A Key Person Protection Review in 10 Steps
Step 1: Identify Important People
Determine which individuals the business depends upon financially.
Step 2: Understand Their Contribution
Consider revenue, profits, clients, management responsibilities, knowledge and specialist skills.
Step 3: Estimate the Financial Impact
Consider what could happen financially if that person suddenly disappeared from the business.
Step 4: Consider Replacement Costs
Estimate recruitment, training and temporary staffing costs.
Step 5: Consider Lost Revenue or Profit
Assess how business performance could be affected during the disruption.
Step 6: Review Business Borrowing
Consider whether reduced revenue could affect the company's ability to service debt.
Step 7: Review Existing Protection
Check whether the business already has relevant insurance and what it was originally designed to achieve.
Step 8: Consider Life and Critical Illness Risks
Determine which insured events create a significant financial risk for the business.
Step 9: Coordinate With Professional Advisers
Where appropriate, insurance planning should be coordinated with the company's accountant, tax adviser and solicitor.
Step 10: Review Regularly
Revisit the arrangement as the company, key people and financial circumstances change.
Key Person Insurance Checklist
When considering whether your business needs key person protection, ask:
Who does the business depend on?
Who generates significant revenue or profit?
Who maintains important client relationships?
Who holds specialist knowledge or qualifications?
How difficult would each person be to replace?
How much could recruitment cost?
How long could the disruption last?
What business borrowing exists?
Would losing this person affect the ability to service that borrowing?
What insurance already exists?
Has the business grown since existing protection was arranged?
Could serious illness create as much disruption as death?
These questions help identify the financial risk before deciding what type and amount of protection may be appropriate.
Speak to Cambs Ely Mortgages About Key Person Insurance
Key person protection starts with understanding the business rather than simply choosing an insurance policy.
We can discuss how your business operates, which individuals it depends on, the potential financial impact of losing them, existing protection and business borrowing before considering appropriate protection options.
Where necessary, protection planning can also work alongside your accountant, solicitor or tax adviser.
Cambs Ely Mortgages provides mortgage and protection advice to business owners and company directors in Ely, Cambridge, Cambridgeshire and across England, with remote appointments available.
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Important Information
The information contained in this guide is intended for general educational purposes and does not constitute personalised financial, insurance, legal, accounting or tax advice.
Key person insurance policies vary between insurers. Cover, definitions, exclusions, premiums, underwriting decisions and policy terms depend on the insurer, policy and circumstances.
The appropriate ownership and structure of business protection can have legal, accounting and taxation implications. Appropriate specialist advice should be obtained where required.
Tax treatment depends on the purpose and structure of the arrangement, individual and business circumstances and the rules applying at the relevant time. Tax rules can change.
Do not cancel existing protection until any replacement cover has been accepted, is in force and the consequences of replacing the existing arrangement are understood.