Every business has at least one person whose sudden absence would cause serious damage — yet most businesses have no financial plan for that scenario.
Ask any business owner what would happen if they were suddenly unable to work — through illness, injury, or death — and the answer is usually a long pause followed by a vague hope that things would somehow work out.
They rarely do.
Key person insurance exists to bridge the gap between a crisis and a catastrophe. It provides a lump sum to the business when a critical individual dies or is diagnosed with a critical illness, giving the company the financial breathing room to recruit, restructure, and survive.
Yet despite being one of the most straightforward and cost-effective forms of business protection, it remains dramatically underused. Research from the Federation of Small Businesses suggests that fewer than one in five small businesses have any form of key person cover in place.
What Key Person Insurance Actually Covers
Key person insurance is a life insurance policy taken out by the business on the life of a key individual. The business pays the premiums, the business is the policyholder, and the business receives the payout.
The “key person” is anyone whose death or incapacity would have a material financial impact on the business. This might include:
• The founder or managing director
• A senior salesperson who generates a disproportionate share of revenue
• A technical expert with specialist knowledge that cannot be easily replaced
• A relationship manager whose personal connections hold key client accounts together
The policy pays out a lump sum on the death of the key person, or — if critical illness cover is included — on diagnosis of a specified serious illness. The business then uses the funds however it needs to: hiring a replacement, covering lost revenue, repaying loans, or stabilising operations.
Why Businesses Need It
The death or serious illness of a key person creates multiple simultaneous problems:
Revenue loss.
If the key person is responsible for client relationships or sales, revenue can drop immediately. Clients may lose confidence, delay projects, or move to a competitor. The longer the gap before a replacement is found, the greater the damage.
Recruitment and training costs.
Finding and training a replacement for a senior or specialist role can take months and cost tens of thousands of pounds. During that period, the business is operating below capacity.
Loan and facility risks.
Many business loans and banking facilities are personally guaranteed by the directors. If a guarantor dies, the lender may call in the loan or reduce the facility. Key person insurance can provide the funds to repay the loan and protect the business from a sudden cash crisis.
Loss of confidence.
Suppliers, lenders, investors, and clients all need reassurance that the business can continue. A key person payout demonstrates that the business planned for this eventuality and has the resources to manage the transition.
How to Calculate the Right Level of Cover
There is no single formula for calculating key person cover. The appropriate amount depends on the individual’s contribution to the business and the likely cost of replacing them. Common approaches include:
Multiple of salary.
A simple starting point is five to ten times the key person’s annual salary. This provides a lump sum to cover recruitment costs and lost productivity during the transition period.
Revenue-based calculation.
For individuals who directly generate revenue (such as a lead salesperson or founder with key client relationships), the cover should reflect the revenue at risk. If the individual generates £500,000 of annual revenue and it would take twelve months to find a replacement, the cover should be at least £500,000.
Profit-based calculation.
An alternative is to calculate the profit contribution of the key person and multiply by the number of years it would take to replace them. This approach focuses on the net financial impact rather than gross revenue.
Loan cover.
If the key person has provided personal guarantees for business borrowing, the cover should be sufficient to repay those loans in full.
In practice, many businesses use a combination of these approaches. The goal is to ensure the payout is large enough to stabilise the business without being excessive.
Tax Treatment of Key Person Insurance
The tax treatment depends on the purpose of the policy:
To cover loss of profits.
If the policy is taken out to protect the business against lost profits resulting from the key person’s death, the premiums are usually deductible as a business expense. However, the payout will be taxable as a trading receipt. HMRC guidance (BIM45525) sets out the conditions that must be met.
To repay a loan.
If the policy is specifically to repay a business loan on the death of a key person, the premiums are generally not tax-deductible, and the payout is not taxable. This is because the policy is a capital protection measure rather than a revenue expense.
For shareholder protection.
If the policy is part of a shareholder or partnership agreement — designed to fund the purchase of the deceased’s shares — the premiums are not deductible, and different rules apply. Cross-option agreements and business trusts are typically used in these arrangements.
The tax position can be complex, and it is worth taking advice from an accountant or tax adviser to ensure the policy is structured correctly.
Key Person Insurance and Estate Planning
Key person insurance is a business protection tool, but it has direct implications for estate planning:
Business valuation.
The death of a key person can reduce the value of the business — which in turn affects the estate’s value for IHT purposes. Key person insurance helps maintain business value, which benefits the shareholders (including the deceased’s estate).
Buy-sell agreements.
Key person insurance is often used alongside shareholder agreements to fund the purchase of a deceased shareholder’s shares. This ensures the surviving shareholders retain control of the business whilst the deceased’s family receives fair value for the shares.
Business Property Relief.
Shares in qualifying trading companies are eligible for Business Property Relief (BPR) at 100 per cent, effectively removing them from the estate for IHT purposes. However, BPR only applies if the business continues as a going concern. Key person insurance helps ensure the business survives — and that BPR remains available.
Common Objections — and Why They Are Wrong
“We cannot afford the premiums.”
Key person insurance is surprisingly affordable. A £500,000 policy for a healthy 45-year-old typically costs between £30 and £60 per month. Compare this to the cost of losing a critical team member with no financial cushion.
“Nobody is irreplaceable.”
Perhaps not permanently. But the gap between losing someone and finding a capable replacement can last six to twelve months. During that period, the business is vulnerable. Insurance buys time.
“We will sort it out later.”
This is the most dangerous objection of all. Insurance becomes more expensive with age, and it may become unavailable if the key person develops a health condition. The best time to arrange cover is when everyone is healthy.
Getting Started
1. Identify your key people. Who, if they disappeared tomorrow, would cause the most damage to the business?
2. Calculate the financial impact. Use the approaches above to estimate the right level of cover.
3. Take advice on tax treatment. Get the structure right from the start.
4. Put the policy in place. Work with a specialist broker who understands business protection.
5. Review it annually. As the business grows, the level of cover should grow with it.
Key person insurance is not glamorous. It does not generate revenue or win new clients. But when the worst happens, it is the policy that keeps the business alive — and that is worth more than any sales campaign.
The Legacy Wills Company works with business owners to ensure their personal and business affairs are fully protected. Book a free discovery call to discuss your business protection needs.