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Key person insurance

7 minute read

As a business owner it’s important for you to know what key person insurance is, how it works, and if you need it

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Key person insurance

As a business owner, you’ll be acutely aware that your company’s success relies on the talent, dedication, and expertise of your employees. But what would happen if a key employee suddenly became unable to work or even passed away?

According to a survey conducted by Legal & General in 2021, only 13% of UK small business owners have key person insurance in place, yet the loss of a key employee can have a significant impact on your business, both financially and operationally. This is where key person cover comes in.

In this article, we’ll provide you with a comprehensive guide to key person insurance, including what it is, who needs it, how it works, and how to get started with it.

What is key person insurance?

Key person insurance is a type of life insurance policy designed to protect businesses against financial loss in the event of the death or disability of a key employee.

It is also known as key person cover, keyman insurance, keywoman insurance, key person protection, key employee insurance, or simply, business life insurance.

The key person insurance policy pays out a lump sum to the business in the event of the death, diagnosis of terminal illness, or disability of the insured key employee. This lump sum can help the business cover expenses such as to replace lost revenue, lost profits, hiring and training a replacement to take on the key person’s role, paying off debts, and maintaining business operations.

Did you know?

A 2019 report by Aviva found that the average amount of key person insurance cover taken out by UK businesses was £1.4 million. However, this varied significantly by industry and business size.

What businesses need key person insurance?

Any business that relies heavily on the skills, knowledge, and experience of one key person’s contribution should consider taking out business protection. This includes small businesses, startups, and large corporations.

If your key employee’s sudden absence due to serious illness, for example, would cause significant financial harm to your business, then you should consider taking out key person insurance cover.

Examples of businesses that may need this type of insurance include those that:

  • Depend on a few key people to generate a significant portion of business revenue
  • Rely on a key individual to maintain relationships with clients or suppliers
  • Have a key man who possesses specialist skills or knowledge that are difficult to replace
  • Are in a high-risk industry where accidents or illnesses are common

Who is a considered a key person?

A key employee is someone whose contribution to the business is significant enough that the business would suffer a financial loss if they were to die or become disabled. This can include anyone from the CEO to someone with specialist skills such as a specialised technician or even a salesperson. Essentially executives, managers, salespeople, and other employees who have a critical role in the business’s operations.

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How does key person insurance work?

Key person insurance works in a similar vein to other types of life insurance. The business takes out a policy for a particular person, pays the premiums, and is the beneficiary of the policy, should something happen to the key person e.g. if the person insured dies or becomes disabled, the business receives a lump sum payment, paid directly from the insurance company.

The amount of the payment depends on the cover amount and the policy’s terms and conditions. The cover amount is typically based on the key employee’s salary, the estimated cost of hiring and training a replacement, and the business’s expected losses during the transition period.

According to the Association of British Insurers, the UK insurance industry paid out £2.2 billion in claims for life, critical illness, and income protection insurance in 2020. While this includes insurance policies for individuals, it demonstrates the financial impact of unexpected events and the importance of having adequate insurance coverage in place.

Who can take out key person cover?

In a business, key person insurance can be taken out by the business owner or another designated person, such as a director or executive. The policyholder will typically be the business itself, and the key person being insured will be named as the life assured.

How much does key person insurance cost?

The cost of key person insurance varies depending on factors such as the coverage amount, the key employee’s age and health, and the insurer’s underwriting standards. Generally, the younger and healthier the key employee, the lower the premiums.

A financial advisor or insurance broker can help you as the business owner or designated person determine the most appropriate type and level of key person insurance coverage for your specific needs.

4 types of key person insurance

There are several types of key person insurance, each designed to meet different business needs. The four most common types include:

1. Term life insurance

Term life insurance provides coverage for a specified period, usually between 10 and 30 years. If the insured key person dies during the policy’s term, the business receives a lump sum payment. If the key employee does not die during the term, the policy expires, and the business does not receive a payment.

2. Permanent life insurance

Permanent life insurance provides coverage for the insured person’s lifetime, as long as the key person insurance premiums are paid. Unlike term life insurance, permanent life insurance has a cash value component that can be used to fund the policy or be withdrawn by the policyholder.

3. Disability insurance

Disability insurance provides coverage in the event that the insured key employee becomes disabled and is unable to work. The policy pays out a monthly benefit for a specified period, to the business, typically up to two years.

4. Critical illness insurance

Critical illness cover provides coverage in the event that the insured key employee is diagnosed with a critical illness, such as cancer, heart attack, or stroke. The policy pays out a lump sum payment, which can be used to cover medical expenses, lost income, or other costs associated with the illness.

Key person insurance vs. business continuation insurance

Key person insurance is often confused with business continuation insurance, but the two are different. Business continuation insurance, also known as buy-sell insurance, provides funds to buy out a deceased or disabled partner’s share of a business.

Key person insurance, on the other hand, provides funds to the business to cover the financial losses associated with the death or disability of a key employee.

How to get started

Getting started with key person insurance involves several steps, including:

  1. Identifying the key employees who need coverage
  2. Determining the appropriate coverage amount
  3. Choosing an insurer and policy type
  4. Applying for coverage and undergoing underwriting
  5. Paying premiums and maintaining the policy

How to determine the cover amount

How much cover your business needs will come down to your individual circumstances. But, roughly speaking, the coverage amount should be enough to cover the business’s financial losses in the event of the key employee’s death or disability.

Some factors to consider when working out the coverage amount include:

  • The key employee’s salary and benefits
  • The cost of hiring and training a replacement
  • The business’s expected losses during the transition period
  • The business’s debts and other financial obligations

A qualified insurance professional can help you determine the appropriate coverage amount based on your business’s unique needs.

Benefits of key person protection

The benefits of key person insurance include:

  • Financial protection for the business in the event of the key employee’s death or disability
  • Peace of mind for the business owner, stakeholders, and key employees
  • The ability to attract and retain talented employees
  • The ability to obtain financing or investment capital

Risks of not having key person insurance in place

The risks of not having key person insurance include:

  • Financial losses to the business in the event of the key employee’s death or disability
  • Difficulty in hiring and training a replacement
  • Damage to the business’s reputation and relationships with clients and suppliers
  • Loss of business income and profits

Conclusion

Key person insurance is an important type of coverage that can provide financial protection for businesses in the event of the death or disability of a key employee.

By identifying the key employees who need coverage, determining the appropriate coverage amount, and choosing the right insurer and policy type, you can ensure your business is prepared for unexpected events that could have a significant impact on your operations. With the help of a qualified insurance professional or financial adviser, you can find the right key person insurance coverage to meet your unique needs.

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FAQs

What are the disadvantages of key person insurance?

The disadvantages of key person insurance would mainly focus on the cost. It can be fairly expensive, especially if the person is older or high-risk. This may have an impact on businesses, especially smaller ones or start-ups. However, the benefits of having key person insurance are extensive and its something that can save you a lot of money in the future.

How is key person insurance taxed?

For an employee, the premiums will usually be a tax-deductible expense, however, the actual pay out will generally be taxable as it will be viewed as a trading receipt.

How is key person insurance calculated?

Generally, to calculate key person insurance, there would be a number of things to consider such as, the cost of finding a replacement, training and paying them. If any temporary hires are made in the meantime, this would also need to be taken into account, as well as any loss of profit. There are numerous online calculators that can assist you when you’re figuring this out.


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