KEY PERSON INSURANCE
1. WHAT IS KEY PERSON INSURANCE? ... 2
2. THE NEED FOR KEY PERSON INSURANCE ... 2
3. TYPES OF KEY PERSON INSURANCE ... 2
3.1 Personal Accident Insurance ... 3
3.2 Life Assurance ... 3
3.2.1 Term Life ... 3
3.2.2 Whole of Life ... 3
3.3 Critical Illness Cover (CIC) ... 3
3.4 Permanent Health Insurance (PHI) ... 3
3.5 Combined Plans ... 3
4. TAX TREATMENT OF KEY PERSON INSURANCE ... 4
4.1 The Sole Relationship is that of Employer and Employee ... 4
4.2 The Insurance is Intended to Meet a Loss of Profit Resulting from the Loss of the ... 4
4.2.1 Life Contracts Which Acquire a Surrender Value ... 4
4.2.2 Life Contracts with Conversion Options ... 4
4.2.3 Life Assurance Solely Designed to Protect Loans ... 5
4.3 The Contract is Annual or Short Term Insurance ... 5
4.4 Tax Treatment of Benefits ... 5
4.4.1 Term Assurances Where Tax Relief Has Been Given on the Premiums ... 5
4.4.2 Term Assurances Where Tax Relief Has Not Been Given on the Premiums ... 5
4.4.3 Whole of Life and Endowment Assurances ... 5
4.4.3.1 On Death or Claim ... 5
4.4.3.2 Surrender of the Plan ... 5
4.4.3.3 Maturity ... 5
4.4.4 Endowment Policies Undertaken to Repay Loans ... 6
4.4.5 Permanent Health Insurance (PHI) ... 6
4.4.5.1 Premiums ... 6
4.4.5.2 Benefits ... 6
5. FINANCIAL UNDERWRITING ... 6
1. WHAT IS KEY PERSON INSURANCE?
Key person insurance is the provision of a protection to a business against the death and/or disability of a key employee. We have separate notes available which explain the protection of shareholders and partners interests in their businesses.
What makes a key employee is a subjective matter. A sales person who is responsible for the bulk of a company’s income would be defined as a key employee, likewise a design or research individual that is working on key new product areas would, again, qualify. There are, however, many other fields in which an employee may be defined as being of special worth to the business.
2. THE NEED FOR KEY PERSON INSURANCE
Clearly, the need for key person insurance is the protection of the business against unforeseen circumstances. No business would carry on without ensuring that their premises, computers and software etc were protected by insurance. Statistically, it is just as likely that the staff who generate the income etc for the business will suffer an illness or injury which could be far more damaging to the health of the firm than the destruction of inanimate objects.
The death or disablement of a key person can lead to:
Interruption or loss of existing and potential product sales. Loss of confidence from existing or new suppliers.
Loss of confidence from the bank.
Loss of competitive edge afforded by innovation or design expertise. Special projects delayed or not completed.
Additional strain on remaining staff who have to cover for the missing key person. Lowering of staff morale.
Large recruitment costs and head-hunting fees to find a replacement.
All these factors make it imperative that well run businesses insure their key staff, as well as their other assets.
3. TYPES OF KEY PERSON INSURANCE
3.1 Personal Accident Insurance
Where a key person is going abroad, or it is felt by the employer that they undertake hazardous pursuits, it is possible to insure the key person against death and permanent disablement by way of an accident. The occurrence must, however, crystallise within, say, 30 days of the accident happening.
3.2 Life Assurance
Life assurance is the most common form of key person insurance. The individual dies and the agreed sum assured is paid out. Life cover can be undertaken in two main ways:
3.2.1 Term Life
The life cover is taken out for an agreed period of, say, 5 years. If the key person dies within the term of the policy then the proceeds are paid to the company.
3.2.2 Whole of Life
A whole of life insurance provides the potential for continued cover of the key person for the remainder of their life. There are many types of whole of life plan (see our note on whole if life insurance), however, key person insurances are normally taken out on a “maximum sum assured” basis. This is, in effect, up to a 10 year term of premium payments followed by a review where the premiums are reassessed according to the new age of the insured. Typically after review premiums are 3 to 6 times higher than for the first 8 to 10 years of the plan.
3.3 Critical Illness Cover (CIC)
CIC insurance pays out the benefits upon the confirmed diagnosis of an illness/condition that is listed in a range of life threatening illnesses. The main benefit to a business would be in the circumstances of perhaps a heart attack, where the key person was unable to work, but likely to survive for a considerable period.
3.4 Permanent Health Insurance (PHI)
PHI benefits to a company are usually paid after the key person has been ill for a waiting period of 3-6 months. The benefit is usually paid for no more than 3-5 years.
3.5 Combined Plans
It is possible to “mix and match” the above benefits within a single plan. It is possible, for example, to insure a key person against death for £500,000 whilst, at the same time, provide £200,000 of CIC or £20,000 of PHI cover within the same arrangement.
4. TAX TREATMENT OF KEY PERSON INSURANCE
The tax treatment of key person insurance goes back to a statement in the House of Commons in 1944 by the then Chancellor, Sir John Anderson.
It is made clear within the guidelines that the tax treatment of key person insurance will be subject to the agreement of the Local Inspector of Taxes. Having said this, as a general rule, if the local Inspector agrees to grant relief on the premiums, then the proceeds are usually taxed as a trading receipt. Conversely, if the Local Inspector has disallowed the premiums as a trading expense, then the proceeds of any claim should be received tax free.
Please note it does not matter whether a business has been claiming tax relief on premiums and getting away with it. Until the Local Inspector agrees to the tax treatment of the premiums and benefits, then no certainty of tax treatment is achieved.
The following are further requirements that have to be met if the premiums for the key person insurance are to be agreed by the Local Inspector as an acceptable trading expense.
4.1 The Sole Relationship is that of Employer and Employee
It is generally felt that where the key person has more than a 5% stake in the business, the tax relief on the premiums will be disallowed. This is because the premiums are not being paid “wholly and exclusively for the purposes of the trade” (Section 34 Taxes Act 1988). On the key person’s death/disablement, his estate will benefit due to the proceeds of the insurance possibly increasing the value of the business. Whilst this may dismay Capital Directors who would prefer tax relief on their premiums, remember that it is most unlikely that any premiums paid by the company will be treated as a P11D benefit for a Capital Director so key person insurance can, in some circumstances, “double-up” as share protection as well.
4.2 The Insurance is Intended to Meet a Loss of Profit Resulting from the Loss of the Employee’s Service
This requirement affects the following types of plan: 4.2.1 Life Contracts Which Acquire a Surrender Value
Whole of life and endowment plans usually generate surrender values, which mean that their sole purpose is not to protect against a loss of profit. As such, the premiums would normally not be an allowable business expense.
4.2.2 Life Contracts with Conversion Options
If the conversion options allow for the plan to be converted to a form of insurance, which could acquire a surrender value, then the premiums would be unlikely to obtain tax relief.
4.2.3 Life Assurance Solely Designed to Protect Loans
Where key person insurance is taken out to protect a loan, business relief on the premiums would not usually be granted, as a loan is a capital liability not a loss of profits. A typical example of this would be where the lender insists on assigned life cover and the insurance, therefore, is a security for the loan and hence cannot be argued as being a protection against loss of profits. 4.3 The Contract is Annual or Short Term Insurance
This element of the requirements is very subjective. As a general guideline, Local Inspectors will usually approve straight term assurance plans up to 10 years, however, term plans with options to extend beyond this period will not usually have their premiums agreed as a tax deductible business expense.
4.4 Tax Treatment of Benefits
Once the local Tax Inspector has agreed the treatment of the premium, you can usually expect the proceeds to be treated as follows:
4.4.1 Term Assurances Where Tax Relief Has Been Given on the Premiums
The proceeds would be taxable as a trading receipt. In these circumstances, it is sometimes possible to arrange for the proceeds to be paid out over a number of trading years to reduce the tax burden.
4.4.2 Term Assurances Where Tax Relief Has Not Been Given on the Premiums
Assuming that no surrender value is payable under the plan, the proceeds are usually paid tax free.
4.4.3 Whole of Life and Endowment Assurances
Where a plan generates a surrender value, the tax on the proceeds is as follows: 4.4.3.1 On Death or Claim
The surrender value prior to claim less any premiums paid. This is usually negative, hence, no tax to pay.
4.4.3.2 Surrender of the Plan
The surrender value less any premiums paid. This is usually negative, hence, no tax to pay. 4.4.3.3 Maturity
4.4.4 Endowment Policies Undertaken to Repay Loans
Where the loans are to purchase land or buildings for the sole purpose of carrying out the firm’s trade, then tax arises only on the excess of proceeds over the loan which the endowment is secured upon.
4.4.5 Permanent Health Insurance (PHI) 4.4.5.1 Premiums
The tax treatment of premiums follows the principles previously outlined in these notes. 4.4.5.2 Benefits
Irrespective of the treatment of the premiums, benefits are usually taxed as a trading receipt.
5. FINANCIAL UNDERWRITING
To obtain the insurance, you must prove that the company will suffer a loss should the key person die. Whilst this would not be a problem for a relatively small sum assured, it may be difficult to gain acceptance for a substantial amount of cover. Insurance companies need to assess the risk of a “Lord Lucan” claim and hence will want full disclosure of accounts, salaries and related factors.
Finally, of course, no insurance company will insure you if they think you might claim! For larger insurances, extensive medical information will be required including an AIDS test, blood tests, ECG, medical, etc.
6. KEY PERSON OR SHARE PURCHASE INSURANCE
It is important for capital shareholders to understand the difference between key person and share purchase insurance. Key person protects the business. If, coincidentally, the key person is also a shareholder then careful consideration needs to be given as to whether key person, share purchase or both insurances are required.
Please note that whilst every effort is made to ensure that the information contained within this explanation is correct, these notes are by necessity brief and you should seek further clarification on any plans about which you are at all uncertain about. These notes last updated 03.2012.
