It really depends on what stage of development your business has reached as to whether you need keyman insurance or key person insurance.
In a relatively small business losing one of your Key personnel, whether it be a Director of the company, or your Sales Manager, can seriously impact upon the profitability of your business.
In a more established business the impact may not be so severe.
So what is a Key Person?
That varies depending on your business.
A Key Person might have a specific skill set, for example, a Computer Programmer would be Key in an IT Solutions business if he was the only one. They could be Key because of their experience & Contact network in your marketplace giving the edge to your business.
But whatever the reason, what they have in common is that losing them can be very damaging to your business. The business could be hit by a loss of profit, reduced sales, coupled with increased costs for recruitment & training of a replacement. In addition business plans can be seriously disrupted, possibly leading to long recovery times.
You should also remember that if there are Directors loans held with the business that these will also become repayable in the event of the Directors death.
So what can I do to protect my business?
First you need to identify who is a Key Person, and there may be more than one of course. You then have to calculate how Key they are in Financial terms. This can be quite difficult to quantify of course. You then set up a keyman Insurance or key person insurance policy (or policies) that will to pay out to your business in the event that the Key Person Dies, becomes Critically Ill, or is unable to work long term due to sickness or incapacity.
So what happens if my Key Person dies?
I'll assume that you have already set up a Key Person (keyman) life insurance plan, written on the life of the key person. The plan is owned by the business, which also pays the premiums. Any payout is therefore paid to the business, which could use the money to, for example, Head Hunt a new recruit or train a replacement.
The main features and benefits of Key Person Life assurance schemes are:
- They provide benefits based on an employee’s earnings, and the contribution to profitability of the business.
- Benefits will be paid as a lump sum, if the Key Person or keyman dies whilst in service to a company. The payment can be phased over more than one payment in some circumstances.
- Benefits are paid directly to the business as the plan owners
- Lump sum benefits are regarded as a trading receipt, which can therefore be liable to taxation
- The premium for a Key Person Life Assurance scheme may be acceptable as a deductible business expense, although this is not automatically the case. You would need to show that the scheme was necessary to the business. Your accountant will help with this.
So how much Life cover do I need to have on my Key Person?
There are several ways to calculate this, and for some businesses the process of arriving at a cover level may need to be quite complex. Fortunately for most businesses a simple “rule of thumb” approach works well enough.
1) Multiple of Salary basis – a figure of 8 to 10 times the Key Persons salary could be deemed appropriate. This should cover loss of profits, the cost of a temporary replacement, and recruitment. This works well enough for smaller salaries (e.g. up to £50,000 pa) but the numbers get a little large, and hard to justify beyond that.
2) Payroll basis – sometimes this is used as it seems a little more scientific. I'm not sure if that might just be advisers trying to make it seem more complex! For this you do need a few numbers from the business. The equation is as follows: Cover = (A/B) x C x D
A= Key Persons Salary, B = Total Payroll, C = sales turnover, D = the number of years it will take the business to fully recover from the loss.
So let's assume that they earn £50,000, and the total payroll is £250,000. The sales turnover is £1Million pa and you estimate it will take 4 years to recover lost ground and make up the initial lost sales & profits.
£50,000/£250,000 = 0.2.
0.2 X £1M = £200,000
x 4 years = £800,000, so you need a life cover policy for £800,000
3) Profits basis – If you have a good idea of the share of profits attributable to the Key Person this also works well. I would normally suggest 2 x the Gross profit that they generate, or 5 x the Net profit.
My Key Person is knocking on a bit, this is going to cost us too much isn't it?
It might do, but you have to weigh the cost against the benefit if something did happen. Don't forget the premiums might be able to reduce your taxable profits, so it isn't costing quite as much.
The GOOD News is that your Key Person is unlikely to be as important in a few years time, as your business grows and you become less reliant upon one person. You therefore only need to take out a shorter term policy, which keeps the cost down.
It is usual to take out policies over 5 years, rather than say 20 years. The risk of you dying within the term is therefore lower and the premiums are also lower.
The policy must be set up on a Renewable basis, which means after 5 years you can automatically extend for another 5 years if necessary. The premiums at that time will reflect the increased age of the Key person, but if he is in ill health he will still be accepted.
The following figures (correct at time of writing July 2014) are based upon £200,000 of Level Life cover on a 5 year Renewable contract.
- Non-smoker aged 30 - £10.20 per month
- Non-smoker aged 40 - £15.40 per month
- Non-smoker aged 50 - £32.10 per month
But what if my Key Person gets ill?
A very good question. Whilst the worse case scenario is of course the death of a Key Person, the impact upon your business is not necessarily reduced in the event of sickness or incapacity of that same person.
During the absence of a Key Person due to illness or incapacity the business can still suffer the same issues as if they had actually died, but will have the additional cost of possibly continuing to pay salary & benefits to the absentee too.
So how can I protect my business?
You can include the option of Critical illness cover within the policies that you set up. Critical illness cover pays out the whole Sum Assured if the Key Person is DIAGNOSED with any of the Critical Illnesses specified in the policy. The proceeds can then be used for any necessary business purpose.
Policies vary between provider but all policies must cover the a minimum specified list of diseases to be designated as a Critical Illness policy. This minimum will include the following:
- Cancer
- Coronary Artery Bypass Surgery
- Heart Attack
- Kidney Failure
- Major Organ Transplant
- Stroke
- Multiple Sclerosis
In addition most companies cover a range of other illnesses, including some specific to their own policies, the list varying between providers. It is therefore important to seek the advice of your Financial adviser in order to find the most suitable policy.
How much Critical illness cover do I need?
The impact on the business of a Critical illness may be lessened by the eventual recovery of the Key Person. This, coupled with the reality that Critical Illness policies are more expensive than life cover only policies, would lead to a lower Sum Assured. I would recommend roughly half the level of cover that you would select for life only cover.
Using the Multiple of Salary basis I would recommend around 4 to 5 times Gross Annual Salary, or £200,000 to £250,000 for someone earning £50,000.
The following figures (correct at time of writing July 2014) are based upon £100,000 of combined Life & Critical illness cover on a 5 year Renewable contract.
- Non-smoker aged 30 - £18.44 per month
- Non-smoker aged 40 - £33.50 per month
- Non-smoker aged 50 - £77.29 per month
The plan is owned by the business, which also pays the premiums. Any payout is therefore paid to the business, in order to subsidise the ongoing salary costs for the absentee.
My Key Person is knocking on a bit, this is going to cost us too much isn't it?
It might do, but you have to weigh the cost against the benefit if something did happen. Don't forget the premiums might be able to reduce your taxable profits, so it isn't costing quite as much.
The GOOD News is that your Key Person is unlikely to be as important in a few years time, as your business grows and you become less reliant upon one person. You therefore only need to take out a shorter term policy, which keeps the cost down.
It is usual to take out policies over 5 years, rather than say 20 years. The risk of you suffering an illness within the term is therefore lower and the premiums are also lower.
The policy must be set up on a Renewable basis, which means after 5 years you can automatically extend for another 5 years if necessary. The premiums at that time will reflect the increased age of the Key person, but if he is in ill health he will still be accepted.
My Key Person might be off sick long term, and I've checked the Critical illness policy terms and they don't cover this unless it is a specified illness. Now What?
This can be a big problem as you have no idea how long it might be before they return. Fortunately we can also set up a Key Person Income Protection policy, again written on the life of the key person. This covers them for long term absence due to sickness or incapacity, and is not restricted to specific illnesses.
The plan is owned by the business, which also pays the premiums. Any payout is therefore paid to the business, in order to subsidise the ongoing salary costs for the absentee.
The main features and benefits of a Key Person income protection scheme are:
- The scheme provides a regular income for the Key person who is unable to work due to illness or injury. Additional expenses such as pension contributions and employer’s National Insurance contributions can also be covered.
- The maximum benefit allowed under a scheme is usually around 70% of usual salary/dividends, usually based on a 3 year average.
- Benefits are paid to the company as gross income.
- Premiums are tax deductible as a business expense for the company and are not taxed as a benefit in kind for the employees
It is usual to take out policies over 5 years, sometimes 10, rather than say 20 years. The risk of you being off work within the term is therefore lower and the premiums are also lower.
It is also usual to restrict payout for 12 months or 60 months in the event of a claim.
The following figures (correct at time of writing July 2014) are based upon a 5 year term with a monthly payout of £2,500. First payment would be made after 6 months, and continue for 60 months. The initial payment period can be reduced if necessary (or increased) and this would alter the premium.
- Non-smoker aged 30 - £14.38 per month
- Non-smoker aged 40 - £22.48 per month
- Non-smoker aged 50 - £46.00 per month
Darren Amos
Financial Planning Designer
If you would like to contact Darren to find out more about keyman life insurance, key person income protection or critical illness cover then you can contact him via the red box (either to the right of or below this article depending on the device you are using).
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