Key Person Protection
One of the most valuable assets of your business is its staff: business success or failure depends on them. Some of these people because of their specialised knowledge, skills or contacts, are vital to the profitability of the business. They are often referred to as “key persons” as their death or incapacity could result in the financial performance of the business being adversely affected.
Such an event could lead to a significant fall in profits, perhaps to the inability to repay loans or meet other obligations and, in extreme cases, to the collapse of the business.
One option open to a business to protect against the loss of a Key Person is to ensure that in the event of the death, diagnosis of a critical illness or absence from work due to accident or injury the business receives a lump sum payment or series of payments enable it to cover the loss of profit that would result.
Level of Cover
As noted below there are a number of methods that can be utilised to calculate the level of cover in relation to key person protection:
Payroll-based approach – This is suitable when the recovery period would not exceed five years and the key person’s salary and total payroll are fairly stable, it is arrived at by using the following formula:
|Key person salary||X sales turnover||X expected years to recover|
Salary-based approach – This is suitable when the aim is to find an equally competent replacement, but does not allow for the key person’s contribution to overall turnover. A popular multiple to use is five times the key employee’s total remuneration package.
Profits based approach – suitable when there are few (or only one) key persons. Popular multiples are either two time’s gross profits or five times net profits. Gross profit is taken as total sales less cost of sales. Net profit should be taken before tax.
The levels of cover should be reviewed annually to ensure they continue to reflect the requirements of your business.
Critical Illness and Total Permanent Disability
Just as it is necessary to insure a business against the loss of or damage to physical assets, it is also vital to insure against the serious illness/disability of a key person. This is where key person critical illness cover can help. Key person critical illness cover is designed to pay out a lump sum if a key person is unfortunate enough to suffer from any of the specified critical illnesses but survive for a period of time after diagnosis (normally 28 days).
Critical illnesses usually include cancer, heart attack, kidney failure, multiple sclerosis, major organ transplant and strokes. These are known a core conditions and account for the majority of claims. The comprehensiveness of conditions covered varies enormously and details regarding what will and will not be covered will be fully explained in any supporting literature which you should check to ensure it meets your purposes.
It is usual to include cover for permanent total disability within the contract. The definition of Permanent total disablement does vary and some insurers define it as the life assured being unable to follow his/her normal occupation as a result of sickness whilst others will define it as the life assured being unable to independently perform three or more Activities of Daily Living as a result of sickness or accident.
Critical illness cover, written on the life of a key employee enables funds to be made available to the business in the event of that person’s illness/disability to help in some of the following circumstances:
- Recruitment of a temporary or permanent replacement
- Replace loss of profits arising from the serious illness of a key person
- Tide the business over until the key person is able to return to work
- Pay off a loan or overdraft to reduce the business liabilities
- Contribute to the medical care of the key person or provide financial support for their immediate family.
Tax relief on premiums
Protection against loss of profits is the only type of key person assurance where premiums may be allowed as a trading expense for tax purposes. However, it should be noted that if policy premiums are allowed as a trading expense, then any policy proceeds will generally be taxable. If premiums are not allowed, then the policy proceeds generally escape tax.
In addition to the proviso that the insurance must be to cover loss of profits, the following conditions must be met if premiums are to get tax relief:
The only relationship of the life assured to the company is employee/employer.
The life assured has no significant shareholding – and is not a member of a family that holds shares – in the company. As a guide, tax relief is usually given without question on a shareholding of up to 5%.
The policy provides annual or short-term (up to five years) life or critical illness protection and does not have an investment element or the option to convert to a policy with an investment element.
The level of cover should be reasonable.
Taxation of proceeds
Where all the conditions previously mentioned have been met, any benefits payable under the policy are usually liable to tax as a trading receipt. The level of benefit should be set to take this liability into account.
Where the conditions previously mentioned are not met the policy proceeds are normally regarded as capital receipts and therefore free from tax. Please note that failure to claim relief on the premium, where in fact it was available, does not mean that the benefits will be tax free.
As the tax treatment of each case is considered on its own merits by the HM Revenue and Customs the business must confirm the tax position with its own Inspector of taxes prior to taking out a policy.
Term of cover
In discussing the objectives of the business in relation to key person cover it is appropriate to consider a contract with a term designed to help the business adjust following the loss of the individual concerned.
The term can be selected to fit with a stated business plan, or a period of time that reflects a time line that the individual has within the business (training up a replacement (s) for example).
It is usual to effect a policy or policies over a term that is felt by the business to be sufficient to cover to the point at which the business would have less reliance upon individuals than it does now and a greater ability to continue to be profitable without the input of specific individuals.
Level of Premium
This should be affordable to the business.
Type of Premium
Some companies offer guaranteed or fixed premiums, whilst other plans reserve the right to review premium levels on a periodic basis. There is usually a small additional cost for the advantage of a guaranteed premium.
Waiver of Premium
This option ensures that premiums continue to be paid in the event that the key person is unable to work as a result of accident or sickness. This benefit commences after a specified period of absence, referred to as the deferred period.
The definitions of disability vary considerably. For this particular contract an (own/any) occupation definition is used. Own occupation is defined as any occupation for which the employee is suited by reason of experience and/or qualification. Any occupation is as the name suggests any occupation whatsoever.
This option enables you to effect a further policy, prior to expiry date of your policy, limited to the original sum assured at the then applicable rates, without evidence of health.
Find out more about Key Person Protection by contacting Peter Gray on 01284 773728.