What Is Key Person Insurance?

Most businesses insure their premises, their stock and their vehicles, yet the asset that actually generates the profit is often a handful of people. Key person insurance (sometimes called keyman insurance) fills that gap. It is a policy the company takes out on the life, and frequently the critical illness, of an individual whose sudden loss would do real financial damage, paying the business a lump sum to weather the disruption.

Crucially, the company is the policyholder and the beneficiary: it applies for the cover, pays the premiums and receives the payout. This is general information about how the cover works, not personal advice.

What the payout is for

The money is intended to buy the business time and stability while it recovers from losing someone central. In practice it is used to:

• Replace the profit or turnover lost while the person is absent or being replaced
• Fund the cost of recruiting and training a successor
• Repay or service a business loan that a lender required to be covered
• Reassure banks, investors and major customers that the business is stable
• Provide working capital to keep the company trading through the shock

Lenders increasingly require key person cover before advancing finance to an owner-managed business, because the loan effectively depends on one or two individuals continuing to run it. Sizing the cover is part art, part arithmetic.

There is no single formula for the sum assured, but three approaches are common. The multiple-of-profit method estimates the share of gross profit the individual generates and multiplies it by the years the business would take to recover. The multiple-of-salary method, often five to ten times remuneration, is a simpler proxy. And the loan-cover method insures the outstanding business borrowings the person underpins. Many businesses take the highest of the three, then review it as the company grows, because cover fixed years ago is often far too low today. The term is usually set to a defined period, linked to a loan, a growth plan, or the years until the key person expects to retire, which keeps premiums affordable, since the risk being insured is temporary rather than lifelong.

How it differs from shareholder protection

The two are complementary, not alternatives. Key person insurance keeps the business running after the loss of vital talent; shareholder protection deals with what happens to the deceased owner’s shares. A well-protected company often has both, because losing a founding director creates both problems at once, a hole in the day-to-day running and an unresolved question over ownership.

Adding critical illness cover broadens the protection considerably. A key person is statistically more likely to survive a serious illness than to die from it, yet a stroke, cancer or heart attack can keep them out of the business for a year or more. A policy that pays out on critical illness as well as death means the company receives support when the person is alive but unable to work, often the more probable and more prolonged scenario. It is also worth distinguishing key person insurance from a relevant life plan, which some directors confuse it with: a relevant life plan is a death-in-service style policy the company pays for to benefit the individual’s family, whereas key person cover benefits the business. The two solve different problems and are frequently held side by side.

Tax, structure and getting it right

The tax treatment turns on the facts. Following HMRC’s long-standing “Anderson” guidance, premiums on a policy insuring an employee may be deductible against corporation tax where the cover is short-term, meant purely to make good a loss of trading profit, and the person is not a substantial shareholder. Where that test is met and premiums are deducted, the payout is generally taxed as a trading receipt. Policies on owners or shareholders, or with a capital purpose, are usually treated differently, often with non-deductible premiums but a tax-free payout. Because the treatment is genuinely fact-specific, it should be confirmed with your accountant before you rely on it.

Our guide to key person insurance works through the structuring in more depth, including how the sum assured is calculated and how the policy dovetails with wider protection. Because the right cover depends on your people, your borrowings and your profits, it is worth reviewing it as part of a broader look at business exit and succession planning. You can arrange a free, no-obligation match with an independently vetted, FCA-regulated specialist through Vetted Wealth. This is information and a matching service, not personal advice.

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