Key person insurance: protecting a business against losing someone vital

Key person insurance is a policy an employer takes out for its own benefit, against lost profits. HMRC's description covers the death, critical illness, sickness, accident or injury of an employee, director or other key person.

Legal & General calls it a business insuring itself against the money it may lose if a key person dies, or becomes critically ill if the business chose that cover.

Who owns and pays for the policy?

A company has its own legal identity, so it applies for the policy and owns it. At Legal & General and Royal London, the company usually pays the premiums and receives the money from a valid claim.

The key person is the life insured. At Legal & General, they fill in their personal and medical details and sign the application. Royal London points out there's no need for a trust, because the company owns the plan and receives the proceeds.

Partnerships in England, Wales and Northern Ireland can't own a policy, because they have no separate legal identity. Legal & General says a partner who is the key person could take out a plan on their own life instead. It would be written in trust from the start for the other partners.

What happens if the key person leaves?

If the key person leaves or retires, Legal & General gives the business three options. It can stop paying the premiums and let the policy lapse, or keep paying to the end of the term. It can also assign (transfer) the policy to the key person, who can then carry on paying.

A key person is anyone whose death or disability would seriously affect the company's future profits. Royal London adds that some companies have several key people and others only one.

Legal & General defines a key person as someone whose skill, knowledge, experience or leadership helps keep the business financially successful. Its examples include a chairman, managing director, marketing manager, computer specialist and sales manager.

They don't have to own shares. Royal London says the size of a shareholding isn't necessarily a good guide, because an employee with no shares could easily be key to the business.

To insure someone, the business must show insurable interest: that it would lose profits if that employee died or became terminally or critically ill. Legal & General says this isn't usually difficult to show.

It pays for the money a business loses when a key person dies, or becomes critically ill if the business chose that cover. Legal & General lists the main ways a key person's death could cost the business:

• lost profits, or the cost of recruiting or training a replacement
• important personal or business contracts lost because the key person isn't there to maintain them
• loss of goodwill, which could affect raising capital or attracting new investors
• customers and suppliers losing confidence in the business
• outstanding loans or ongoing loan repayments

Once the company has the money, it decides how to use it. Royal London's examples are paying off company debt, or covering the company's needs while it reorganises or recruits a replacement.

After a critical illness claim, Royal London notes, the key person may come back to work. The money could then pay a temporary replacement or make up lost profits.

There's no fixed formula: the amount follows what the business stands to lose. Royal London says there are no specific rules for valuing a key person, but the business must show insurable interest. Legal & General suggests starting from the effect on profits and the cost of hiring a replacement.

Our key person insurance calculator puts the main methods side by side on your own figures. Legal & General and Royal London describe three main ways to size the cover:

1. A multiple of profit Royal London calls this the main method, and its normal multiple is 5 times net profit. Where there's more than one key person, the profit is split by their contribution. Higher multiples may be justified for a fast-growing business.
2. A multiple of salary Legal & General and Royal London both put life cover at up to 10 times the key person's salary or earnings, the cost of finding, training and paying a replacement. For critical illness cover, Legal & General uses a lower figure and Royal London up to 5 times gross salary. Salary here includes benefits in kind (non-cash perks). Royal London adds that a shareholding employee's pay may not reflect their worth to the business.
3. The loan at risk Where the cover protects borrowing, both insurers base it on the loan that would have to be repaid if the key person died. With several key people, Royal London says the loan is divided between them.

Legal & General also has profit formulas: up to 2 times the key person's share of gross profit, or up to 5 times their share of net profit.

Its third formula divides the key person's salary by the total payroll, then multiplies by gross profit and a recovery period of up to five years. Legal & General routinely uses an average of the last two years' profit figures in all of these.

For a start-up, Royal London says you calculate the working capital at risk (day-to-day running money) and the key person's share of it. With two key people, it says one joint life plan that pays on the first event may be better than two single plans. Its example is a company owned by two 50% shareholders that has borrowed money.

• Earnings, death (Legal & General) 10 times
• Salary, life cover (Royal London) 10 times
• Salary, critical illness (Royal London) 5 times
• Net profit share (Legal & General) 5 times
• Net profit (Royal London) 5 times
• Gross profit share (Legal & General) 2 times

Cover multiples in Legal & General and Royal London key person guidance

	Multiple
Earnings, death (Legal & General)	10 times
Salary, life cover (Royal London)	10 times
Salary, critical illness (Royal London)	5 times
Net profit share (Legal & General)	5 times
Net profit (Royal London)	5 times
Gross profit share (Legal & General)	2 times

Most figures are upper limits ("up to"). Royal London's 5 times net profit is its "normal multiple". Legal & General gives no fixed figure for critical illness, only a lower one than for death. Salary and profit are different bases, so compare bars with the same basis.

Financial evidence and increasing cover later

Larger amounts need more evidence. On Royal London's Business Menu Plan, life cover up to £2,500,000 usually needs only the application form.

Above that, Royal London usually asks for a financial questionnaire. Above £4,000,000 it wants corroborative evidence: audited accounts for the last 2 years and proof of income, such as a P60. These limits include any cover the key person already has, or has applied for, with any insurer.

Businesses change, so Aviva's business change benefit lets the policyholder add cover without further medical questions once the policy has run for six months. One event that counts is a rise in a key person's value or salary, with a copy of the financial accounts as evidence.

The new policy must start within 180 days of the change, and before the oldest person covered turns 55. The extra cover is capped at the lowest of the original cover amount, £200,000, or the rise in salary, loan or share value.

Legal & General offers three key person policies: life insurance, life insurance with critical illness cover, and key person income protection. The employer owns and pays for each one, so any lump sum or monthly benefit goes to the employer.

Legal & General notes that a critical illness diagnosis can affect a business in the same way as a death, so adding critical illness cover may be suitable. At Aviva, life cover and life with critical illness cover both include terminal illness cover.

Aviva's Business Life Insurance Options can be used for key person, shareholder or partnership, and business loan protection, with terms of up to 50 years. It can cover one or two people but pays the cover amount only once, and the policy ends after a claim.

With level cover (an amount that stays the same), Aviva lets the business take a claim as up to five equal yearly instalments instead of a lump sum. It has to choose this at the start. Aviva sets no maximum for life cover only. With critical illness cover, the limit is £3,000,000 without total permanent disability cover.

Key person income protection

Key person income protection pays the business a monthly benefit instead of a lump sum if illness or injury stops the key person working. At Legal & General and Royal London, the business chooses a deferred period (the wait before payments start) of 4, 8, 13, 26 or 52 weeks.

Legal & General makes the first payment 4 weeks after the deferred period ends, and 8 weeks is the shortest deferred period for driving jobs. At Royal London, the key person must also meet its definition of incapacitated. The business can use the money to make up lost revenue, pay a temporary replacement or fund the key person's sick pay.

Royal London's policy runs for 5 to 20 years and pays out for 1 or 2 years. It covers up to 75% of the gross profit that comes from the key person, to a maximum of £250,000 a year.

Our reviews of Aviva, Legal & General and Royal London have more on each insurer.

Sometimes. HMRC's Business Income Manual says the premiums are deductible where the policy meets two conditions:

1. The sole purpose is to protect trading income HMRC's manual says the sole purpose must be the trade purpose of meeting a loss of trading income if the business loses the key person's services. Covering a capital loss (a fall in the value of assets) doesn't count.
2. Any life policy is term insurance For life policies, the cover must be term insurance that pays only if the person insured dies within the term, with no other benefits. HMRC adds that the term shouldn't run past the time the employee is useful to the company.

Premiums on whole life or endowment policies, and on critical illness or accident policies with an investment element, aren't deductible. HMRC's manual treats them as capital expenditure.

Whether the purpose test is met is a question of fact. HMRC says it turns on evidence of what the company's directors, or the owners of an unincorporated business, were trying to achieve.

HMRC lists two possible signs of a non-trade purpose. One is a policy that covers directors who are major shareholders but not other employees. The other is benefits above the sick pay or other benefits that similar businesses typically give staff of the same status.

HMRC's example is a director whose death would significantly affect the value of the company's shares. One purpose of that policy may be the non-trade purpose of protecting the value of the director's shares, and so of their estate.

Legal & General says the tax treatment of a company's premiums is likely to depend largely on the 'Anderson principles', along with HMRC guidance. These come from comments by the former chancellor Sir John Anderson in 1944. They aren't binding in law, so Legal & General recommends the business asks its local inspector of taxes in each case.

Its general rule is that tax relief should be available where the key person's shareholding is less than 5%. Where a policy is meant to repay a loan, Legal & General says the premiums are unlikely to be allowable expenses.

For unincorporated businesses, HMRC says endowment premiums paid as a condition of long-term finance aren't deductible as a cost of getting the loan. For a partnership, Legal & General says there's no tax relief on the premiums and the payout isn't taxed.

Is the payout taxed?

Where both conditions are met, HMRC's manual treats the payout as income of the trade. For companies that's under section 103 of the Corporation Tax Act 2009, and for unincorporated businesses section 106 of ITTOIA 2005.

As a general rule, HMRC says that if a policy doesn't meet both conditions, the premiums can't be deducted and the payout isn't taxed as trading income. But it also says it can't give any assurance that a future payout will be left out of trading income.

Legal & General warns that it isn't right to assume a payout will be tax-free just because the business gave up Corporation Tax relief on the premiums.

A payout can also affect Inheritance Tax. Legal & General notes that the money tends to raise the value of the business, so if the key person was also a shareholder, their estate is worth more. If the shares pass to someone other than a spouse or civil partner, and business relief isn't fully available, any Inheritance Tax bill may rise.

Key person cover pays the business. Relevant life cover pays individuals such as the employee's family, and shareholder protection can help the remaining owners buy a shareholder's stake.

A relevant life insurance policy is an employer's life policy on a single employee. HMRC's rules restrict who can benefit to individuals and charities. It pays a lump sum if the employee dies before an age set in the policy, which can be no later than 75.

Our relevant life insurance calculator compares the cost of a relevant life policy with paying for cover through salary.

Shareholder protection is about ownership rather than trading profits. NFU Mutual says it can help the surviving owners buy the insured shareholder's interest in the firm and keep control of the business.

Before you apply, gather the figures the insurer will check, write down why the business wants the cover and match the setup to the business. The insurers' key person guides we checked point businesses to a financial adviser. Legal & General tells businesses to speak to their adviser, and Aviva's product guide is for adviser use only.

1. Gather the last two years' accounts and income proof Legal & General routinely averages the last two years' profit figures in its formulas. Royal London asks for audited accounts covering the last 2 years and proof of income, such as a P60, for life cover above £4,000,000.
2. Separate profit cover from loan cover Both insurers size loan cover on the debt that would have to be repaid. Legal & General says premiums on a policy meant to repay a loan are unlikely to be allowable expenses.
3. Record the trade purpose of the policy Whether the purpose test is met is a question of fact, based on what the directors or owners were trying to achieve. HMRC lists cover for directors who are major shareholders, but not other staff, as a possible sign of a non-trade purpose. It also says the term shouldn't run past the employee's usefulness to the company.
4. Match the policy setup to your business structure A company applies for and owns the policy itself, so Royal London says there's no need for a trust. A partnership in England, Wales and Northern Ireland can't own a policy. Legal & General says a partner could take out a plan on their own life instead, in trust for the other partners.

The quote form on this page is for personal life insurance, such as cover for your own family alongside any business policy. Our guides to business life insurance and life insurance for the self-employed explain the other cover available to business owners.

• Business life insurance: Relevant life cover, key person cover and other business policies.
• Relevant life insurance: Life cover a company pays for on behalf of a director or employee.
• Is life insurance tax deductible?: When premiums can be claimed as a business expense.
• Critical illness cover: How a lump sum on a serious diagnosis works.