Have you considered key person insurance?

01 November 2010, at 12:00am

DYLAN JENKINS urges practices to identify who is “key” to the business and ensure the appropriate protection is put into place

MANY businesses overlook the obvious reality that certain members of staff are key to profitability and therefore the ultimate success of the operation.

They could be difficult to replace because their specific skills or client relationships are all but unique. Their death or injury could have a drastic effect on cash flow and damage profitability – but don’t panic as there are solutions. This month I aim to provide a brief overview of the benefits that “key person” insurance can bring and look at the potential tax implications if a policy is taken out. 

Losing a key member of staff due to unforeseen death or illness can be a tragedy for a business, but with a less emotional eye any personal loss can also turn to financial loss as well. Staff morale could be drastically affected, causing delays to the normal running of the business, which can result in a loss of goodwill, or even a loss of clients. In addition, recruiting and training a replacement member of staff can prove costly.

It is well known that the British royal family forbids senior members from flying together in case an accident should destroy the “brand” and heritage for ever. The 2010 Polish Air Force crash painfully showed the inherent dangers of concentration risk by letting a number of key people travel together.

Key person insurance is one way that businesses can protect themselves from the financial implications of these unfortunate circumstances, but it is often overlooked. In most cases this is because many organisations do not understand what it is or how it can be used. 

What is key person insurance?

Key person policies are designed to offset any negative impact on profitability to a business following the loss of a member of staff who is essential to its running, through death, serious illness or an accident. It should be noted, however, that this type of policy only covers unforeseen problems and cannot be used if the person simply decides to leave.

It is often thought that key person insurance only applies to directors or partners. This is not the case, but who can be covered will vary depending on your business. The policy can apply to anyone whose loss would have an immediate impact on profits, such as a senior practice manager or a specialist surgeon.

Some organisations have key person policies that pay out on death but do not cover critical illness, which can be just as great a risk. Consider, for example, what would happen if the managing director (MD) of a small company had a stroke and was incapacitated. It could cause a loss of confidence among clients with whom the MD had a close relationship. However, if the business had included critical illness cover as part of its key person policy, it would have been able to make a claim and use any proceeds to compensate for the loss of profitability whilst the MD was incapacitated.

Identifying a key person

In order to identify individuals who are key to the business, start by considering who creates and drives your business. This will vary, depending on your practice and any areas of speciality, but in addition to directors, partners and senior staff, this might also include individuals in client relationship or practice management without whom the business could lose clients or profits.

There are all sorts of reasons why an individual can be essential to a business. Perhaps he or she is responsible for a certain niche area that brings a lot of revenue into your practice, has specialist skills it would be difficult to replace or has built up significant client relationships over a number of years that are key to the success of the business.

Even when key personnel have been identified, whether or not key person insurance is the best way to proceed will depend on how the case is viewed by HM Revenue and Customs (HMRC).

Tax issues

Depending on the terms of agreement, payouts under key person policies may also qualify for tax relief. HMRC decides on a case-by-case basis which payouts are eligible but unfortunately there are no official guidelines issued on this matter. However, past cases indicate that tax relief is most likely in the following circumstances:

  • the only relationship between the business and the key person whose life is being insured is that of employer and employee (except in the case of shareholding directors);
  • the policy covers loss of profits only;
  • the term covered under the policy is reasonable – periods of five years, and sometimes up to 10 years, are generally deemed acceptable;
  • the employee being insured does not hold a significant shareholding in the company.

Tax relief will not usually be available if the policy is intended as security for a loan or is on the life of a proprietor.

These are general guidelines, so in order to clarify the situation for an individual business, it is important to talk to the local inspector of taxes.

If the staff member to be insured is unlikely to be defined as a key person under these rules, it may prove more tax efficient to look into other policies, such as shareholder protection policies, as key person policies which do not qualify for relief can incur corporation tax of up to 40%, leaving considerably less money in the pot to cover the losses incurred.

Therefore, in all cases professional advice is vital to ensure that the most appropriate type of policy is taken out and the cover is appropriate for the organisation’s unique circumstances.