Key person insurance is an important form of business insurance. There is no legal definition for “key person insurance”.

In general, it can be described as an insurance policy taken out by a small or medium sized business to protect that business from potential financial losses that could arise from the death or extended incapacity of the member of the business specified on the policy. The policy’s term does not extend beyond the period of the key person’s usefulness to the business.

The aim is also to help protect the profits and facilitate business continuity. Key person insurance does not indemnify the actual losses incurred but provides a fixed monetary sum as specified on the insurance policy upon the insured person either dying or suffering a critical illness as defined in the insurance policy terms & conditions.

An employer may take out a key person insurance policy on the life or health of any employee whose knowledge, work, or overall contribution is considered uniquely valuable to the company. The employer does this to offset the costs (such as hiring temporary help or recruiting a successor) and losses (such as a decreased ability to transact business until successors are trained) which the employer is likely to suffer in the event of the loss of a key person.

A key-person can be anyone directly associated with the business whose loss can cause financial strain to the business. For example, the person could be a director of the company, a partner, a key sales person, key project manager, or someone with specific skills or knowledge which is especially valuable to the company.

Based on a set of principles laid down in 1944 by the then Chancellor of the Exchequer, Sir John Anderson, the premiums paid will be allowed as a business expense for corporation tax purposes provided that:

• The only relationship between the proposer and the life assured is that of employer and employee (except in the case of shareholding directors – see point 4 below).
• The policy is designed to cover loss of profits only.
• The policy’s term does not extend beyond the period of the key person’s usefulness to the business.
• The employee does not hold a significant shareholding (less than 5% is probably insignificant).

If the premium is a permitted allowable expense, then the policy proceeds would normally be subject to taxation. However, there are no hard and fast rules regarding the tax treatment of premiums and benefits, and each case should be referred to the local Inspector of Taxes for guidance.

It is not the case that if the business decides not to apply for tax relief on the premiums, any proceeds will necessarily be tax-free. The taxation decisions rest with HM Revenue & Customs, and there are reported cases where the Revenue has taxed benefits on which the premiums did not obtain tax relief.

However, such policy proceeds should usually escape tax, unless the proceeds are payable in instalments. As above, each case should be referred to the local Inspector of Taxes for guidance before the policy is implemented.

It is therefore very important that the effects of taxation should be considered when setting the sum assured on key person cases.