Key man insurance
Written by Steve Wentworth
Thursday, 6th May 2010
Introduction
If your small to medium size business relies heavily on one or more
individuals then your business is at serious risk should anything happen to that
individual. Key man (person) insurance is an insurance product which will provide
the business with protection should the worst happened to your key individuals.
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Many small to medium size businesses have started from a small group
of employees who have specialists skills and knowledge fundamental to the running of
the business. Whether this be financial, technical, sales & marketing these skills may
not be transferred to another individual quickly. This therefore leaves the business
relying on one or two key individuals to ensure correct operation, maintaining cash-flow
and keeping a steady growth within the business.
When assessing your business to see if you have any key individuals, it is
important to think how long it would take the business to recover to normal operation if
the particular key man was removed from your day-to-day operations? Does the key person
significantly contribute to the profits of the business? Is there significant cash-flow
to maintain the profits during the period of handover if the key person died or took a
serious illness such as cancer? What would the cost of training a replacement be? These
are all important questions you should be able to answer for your business to ensure the
risk to the business has been managed.
How key man insurance works
Key man insurance can be used to mitigate the risk to the business of
losing a key person within the firm. It would provide a lump sum amount to aid cash-flow
which can then be used to ensure projects continue as planned, provide funds to recruit
and train a replacement. If your key person has taken ill with a serious illness such as
heart attack, stroke or cancer the funds can be used to recruit and train a temporary
replacement whilst still offering your key man a salary whilst they take a timely recovery.
Think of how important this benefit would be to the individual as well as the business.
Lets take a look at an example. Mr Jones works as an Electrical Engineer
for ABC Alarm Systems he is responsible for the design of new alarm systems and is
currently heavily involved on a new high profile project which has buy-in from an number
of customers already. Looking at two examples, one where ABC Alarms Systems have no key
man insurance in place and one where they do: -
ABC Alarm Systems own a policy on Mr Jones' life:
Mr Jones dies -> Policy proceeds paid directly to AAS ->
AAS have funds to maintain profits -> AAS have funds to find and train a replacement
ABC Alarm Systems have no cover:
Mr Jones dies -> Emergency cover needed £ -> Loss of customers/reputation in the market/No confidence from creditors
It would be a good idea for ABC Alarm Systems to contact their local
tax inspector. This will help them to understand tax relief on the policy premiums
and the tax liability on any payments made in the event of a claim.
On a normal Key Person policy, the benefit paid to ABC Alarm Systems
would be treated as a trading receipt. This means it would be subject to corporation
tax at the company’s rate for that financial year. It would therefore, make sense if
the sum assured was based on gross profits so any tax liability at point of claim
will be accounted for.
How much cover is needed?
This would depend on a number of factors, some of which you have
already considered above: -
- Key persons salary
- Total payroll for the business
- Gross profit of the business
- Recovery period (time to return to normal operation)
The following calculation will provide a guide to how much cover would
be required for a key individual in your business: -
Sum assured = (Key Persons Salary / Total Payroll) * Gross Profit * Recovery Period
For example if the key person had a salary of £35,000 and the total
payroll was £250,000 with a gross profit of £350,000 and recovery period of 3 years.
Sum assured = (35000/250000)*350000*3
Sum assured = £147,000
To summarize
This is an insurance product which can protect your business from the risk
of loosing your key individuals who are fundamental to your businesses profits. The lump sum
amount received from a policy payout can ease cash-flow and provide the funds to recruit
and train a replacement.
About the author:
Steve Wentworth formed his firm Wentworth Financial Services in Nov 2007
having been in the industry since Nov 2002. If you require a meeting to discuss
key man insurance or other forms of business protection visit our
business website.
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