Financial adviser Lawrence has sensed that there is an opportunity for key person insurance at a new corporate client recently recommend by an accountant.
Smith Jones Financial Planning has set up Sipps for the directors and senior management team, together with death in service and income protection. And as a natural extension of the personal protection discussion, the subject turned to protecting the company against the financial consequences of one of the key people falling seriously ill or dying.
However, this was not a subject that Lawrence had dealt with before in practice and so he turned to Taxbriefs Advantage to get up to speed quickly and efficiently with the up to date position with regard to key person insurance.
Why insure key people?
First of all it gave him some ideas about how to make the case for a company to take out key person cover. The introduction to the section on key person insurance points out that “the success or failure of a business is usually more dependent on its human assets than any other factor”. And also “if it thought necessary to insure the physical assets that produce a company’s profit, then it is reasonable to insure those people who make a vital contribution to profitability”.
Lawrence was then able to access a list of the main types of senior employees in a business and the reason why they might be regarded as key people whose loss would spell significant financial loss to the business.
A particularly good example was the sales director whose contacts and personal relationships with customers might well be crucial in maintaining sales. Most companies have very few genuinely key employees.
The next question is what type of policy to use. The main choice is between term and whole life. Most companies buy term because of the much lower cost. But a few are attracted by whole life, because the policy can be taken over by the employee when they retire. Although this is rightly a very rare solution, the section on key person insurance sets out the tax consequences when the policy is assigned in this way.
The section also discusses the relative merit of taking out a standalone policy for critical illness or combining it with life cover.
What level of cover?
The amount of key person cover that a business should take out on its key people is the subject of a separate subsection. The basic approach is to take out enough cover to make good the financial loss that the business would suffer as a result of the death or serious illness of the key employee. It might be possible to carry out this exercise at a particular time – perhaps if the success of a specific project or sale depended on this person. Generally it is clear that there would be a loss but it is hard to decide how much it would be.
At that point it makes sense to use some kind of rule of thumb. Several approaches are considered and one method of estimating potential loss favoured by some experts is to relate the potential loss to the individual’s remuneration in relation to the total wages bill as a proportion of the company’s current gross profit.
For example, if a company’s gross profits are £10m, the total gross wages bill is £4m and the individual is paid £500,000 a year, the amount of cover needed on this formulaic basis would be £10m x £500,000/£4m. That would mean cover of £1.25m would be needed.
This approach will not work in all circumstances. In particular it would not be suitable for a new company where the profitability has not yet grown sufficiently.
The section on key person cover also considers the issues raised by both medical and financial underwriting and what the life offices are likely to expect in different situations.
Finally there is the tax position and the range of possibilities. There are two main issues for the company. First, how will the premiums be treated, and in particular, will they be deductible? Second, if there is a claim on the policy, how will the proceeds be taxed? The position is not straightforward and it is certainly not the case that if the company does not claim tax relief on the premium, that will necessarily mean that the proceeds will be tax free.
The whole position is made even clearer by a fully worked key person insurance case study. Lawrence found it invaluable preparation for seeing his client and securing the business.
Danby Bloch is editorial director at Taxbriefs
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