Many company owners see the benefits of taking out a life insurance product to protect their families in case the worst happens. But what happens if, as an owner-manager, you become seriously ill and are unable to carry out your contract work?

This is where keyman insurance comes in. This type of cover will protect your business if you suffer a serious health event, or even a terminal illness. It is similar to critical illness cover, but is taken out by – and benefits – the business itself.

In this guide, we examine what keyman insurance is, how it works, and how it would be used in practice by a small limited company.

What is Keyman insurance?

Keyman insurance will protect a business from the financial impact it would suffer if a key staff member became seriously ill, was diagnosed with a terminal illness, or passed away.

The cash lump sum realised by such a policy could be used to keep the business running until the key person is replaced, or to implement measures to mitigate the loss of a pivotal member.

In some cases, the company would be able to use the funds to settle any outstanding tax or business liabilities, before shutting the business down if it is no longer a viable concern.

For obvious reasons, the cover is also known as ‘Key Person Insurance’, or ‘Key Person Protection’.

It is a term insurance product, meaning you will typically take out cover for a fixed term, such as 5 or 10 years.

How does it work in practice?

Your limited company may decide to provide key person life cover or life and critical illness cover. It depends on the scope you require.

The definition of a ‘key worker’ varies wildly – it may be the founding owner, the primary key earner (such as a professional contractor), or someone else who has unique knowledge or skills.

The policy is owned by the company, and premiums are paid by the business as an allowable business expense, reducing your Corporation Tax bill.

If the key person becomes seriously ill (as defined by the terms of the insurance), or dies, the company will be the beneficiary of a cash lump sum.

Are the premiums tax-deductible?

Yes, in most cases, your company can offset the cost of premiums against Corporation Tax if you have chosen a term policy (brokers often recommend a term of 5 years or less).

Importantly, the cover must be in place to protect the company from a trading loss, not a capital loss. HMRC also states that “…the insurance term should not extend beyond the period of the employee’s usefulness to the company.”

When you are working out the level of cover your business needs, you should bear in mind that, if the policy pays out, then the incoming cash lump sum will be subject to Corporation Tax.

Whole of life and endowment policies (rather than fixed term policies) are seen as ‘capital’ expenditure by HMRC, and would not qualify for tax relief.

You can access the official guidance in BIM45525.

Is keyman insurance right for your business?

This largely depends on how your business operates and how reliant you are on specific people. If a key team member died or was seriously ill, would it have a severe impact on the business? How replaceable is that person? Can your business afford the premiums?

Keyman insurance – an example

Westbourne Coders Limited is a small web development company based in West London. It provides highly specialised support to some of the largest online gaming firms.

One of its founders, John, is widely regarded as one of the best in his field and is a key selling point when pitching for new business. There are two other directors and several support staff.

Clearly, if something happened to John, the business would suffer a significant financial hit – both in terms of ongoing revenue, as well as gaining future contracts. It would take time to find a replacement, and several people may be needed to fill the gap.

The company decides to take out a keyman death benefit on John’s life of £500,000.

Unfortunately, John suffers a major heart attack several years later and will not be able to work again. The plan pays out £500,000 to Westbourne Coders Limited. 19% of this must be set aside to pay Corporation Tax.

The remaining £405,000 is used to pay for contract staff to continue the work John was doing for several clients. Two new developers are subsequently hired to replace John. The premium pays for lost potential earnings, training, and hiring costs.

Other things to bear in mind

You may be required to take out keyman cover as a condition of securing a business loan.

Make sure you seek professional advice before taking out a keyman insurance policy, as there may be a more suitable option for your situation, such as relevant life insurance (paid for by the company) or critical illness cover (paid for personally).