Key Person Insurance: Protecting Your Business From Losing Someone Vital

Key person insurance is a policy your business takes out on the life of someone whose skills, contacts or leadership drive its profits. If that person dies, or is diagnosed with a serious illness if you add that cover, the policy pays the business a lump sum to cover lost profit, recruitment and debts while it recovers.

Most small businesses insure their premises, their vans and their stock. Far fewer insure the people who actually make the money. Yet in many small firms, losing one director, one top salesperson or one technical specialist would do far more damage than a fire.

Key person insurance gives the business cash at the moment it needs it most. This guide explains who to insure, how much cover makes sense, how HMRC treats the premiums and payouts, and where key person cover fits alongside other business protection. For an overview of every type of cover, see our UK protection guide.

What is key person insurance and how does it work?

The business is the policyholder, pays the premiums and receives any payout. The key person is the life insured. The money belongs to the business, not to the person or their family, and the business can use it for whatever helps it survive.

Feature	How key person insurance works
Who pays	The business
Who is insured	A director, partner or employee vital to profits
What triggers a payout	Death, and serious illness if critical illness cover is added
Who receives the money	The business
How it pays	Usually a lump sum
Cash-in value	None. It is pure protection

Because the business is the beneficiary, key person cover is not usually written in trust. That is the main difference from relevant life cover, which pays the person’s family and must be in trust.

Who counts as a key person?

A key person is anyone whose death or long-term absence would cause a real financial loss to the business. Job title matters less than impact. Ask yourself who you would struggle to replace and what would happen to income while you tried.

Typical key people include:

• Founders and directors who lead the business, win the work or hold the relationships with lenders and suppliers
• Sales leaders whose personal contacts bring in a large share of revenue
• Technical specialists with skills, qualifications or knowledge that few others in the business have
• The person a contract depends on, where a client has agreed to work with you because of a named individual
• Owners who have personally guaranteed business borrowing, where their death could prompt a lender to review the facility.

Key person insurance tends to suit small and medium-sized businesses where a few people make a big difference. It suits less well where the business could easily cover a loss from reserves, or where the person’s role is easy to fill quickly.

How much key person cover do you need?

There is no single formula, and insurers will ask you to justify the amount. In general terms, businesses build the figure from three parts.

Lost profit

Estimate how much gross profit the business would lose if this person was no longer there, and for how long. That might be the profit from the clients they manage, or the work that would stall without them. The period is usually the time it would realistically take to recruit and settle in a replacement.

Replacement costs

Add the cost of finding and training someone new. That might include recruitment fees, a higher salary to attract the right person, temporary cover, and time other staff spend filling the gap.

Loans and debts

If the person’s death could lead a lender to ask for a loan to be repaid, or if a director’s loan account would need repaying to their estate, you may want cover for those amounts too. Bear in mind that cover for capital purposes like loan repayment can affect the tax treatment, which we cover below.

Part of the valuation	Questions to ask
Lost profit	Which income depends on this person? How long until a replacement is fully effective?
Replacement costs	What would recruitment, temporary cover and training cost?
Loans and debts	Which borrowing could be called in? Is there a director’s loan to repay?

Is key person insurance tax deductible?

Sometimes. HMRC sets out its approach in the Business Income Manual at BIM45525. Premiums are normally deductible as a trading expense only if:

• the sole purpose of the insurance is the trade purpose of meeting a loss of trading profit
• it is term insurance, not whole of life or a policy with an investment element
• the term does not run past the period the person is likely to be useful to the business.

The key rule to remember is this: if the premiums are deducted, the payout is taxable as a trading receipt. If the premiums are not deductible, BIM45525 says the payout is not generally taxed as trading income, though HMRC treats that as a separate question.

	Premiums deducted	Premiums not deducted
Effect on yearly tax	Reduces the business’s taxable profit	No effect
Tax on the payout	Taxable as a trading receipt	Not generally taxed as trading income
When it applies	BIM45525 conditions are met	Conditions not met, or the business chooses not to claim

This is a decision to make with your accountant before the policy starts, and to record clearly. Some businesses prefer to claim the deduction each year. Others would rather not claim the deduction, as the payout is then not generally taxed as trading income, although HMRC gives no guarantee of this. That matters most when the amount is large.

When does HMRC say the purpose is not a trade purpose?

BIM45530 explains that whether the sole purpose test is met is a question of fact, based on what the directors were trying to achieve. HMRC gives examples where there may be a non-trade purpose:

• the cover is only on directors who are major shareholders, and not on other staff who matter to the business
• the benefits go beyond what comparable staff would get, such as sick pay
• the real aim is protecting the value of the person’s shares or their estate.

The manual refers to a tax case, Beauty Consultants Ltd, where premiums on policies linked to the directors’ own interests, and a policy with a dual purpose, were held not to be wholly for the trade. In practice, that means cover set up to repay borrowing secured on a director’s home, or to protect share value, is unlikely to be deductible. Where a group policy covers some people for trade reasons and others not, HMRC says a reasonable split can be made.

Should key person cover include critical illness?

You can choose life cover only, or life cover with critical illness, which pays out on death or on diagnosis of a listed serious illness, whichever happens first.

	Life only	Life with critical illness
Pays out on	Death during the term	Death or diagnosis of a listed serious illness
Cost	Lower	Higher
Protects against	Permanent loss of the person	Permanent loss, and a long absence through illness
Things to check	The term and amount	The illness definitions and how they apply to the business

A serious illness can take a key person out of the business for months, with much the same effect on profits as a death. If that would hurt your business, critical illness cover is worth pricing. As with personal critical illness cover, definitions vary between insurers, and cancer, heart attack and stroke are always covered by insurers that follow the ABI minimum standards. Check the deductibility position with your accountant for this cover too.

Can key person insurance repay a business loan?

It can. Because the payout belongs to the business, the business can use it to repay or reduce a loan if that is what it needs. Some businesses include their borrowing in the amount they insure for exactly this reason.

We do not arrange a separate business loan protection product. Where loans matter, we look at whether to build them into the key person amount. Bear in mind BIM45525 and BIM45530: cover taken out to repay capital, rather than to replace lost profit, is less likely to meet the sole trade purpose test, so ask your accountant how it affects the tax.

How does key person insurance compare with other business cover?

Cover	Who receives the money	What it is for
Key person insurance	The business	Lost profit, recruitment and debts
Relevant life cover	The person’s family, through a trust	Personal life cover paid by the company
Shareholder protection	The remaining owners	Buying a deceased owner’s shares
Personal income protection	The person	Replacing their own income when they cannot work

These do different jobs, and many businesses need more than one. Key person cover protects the business. It does nothing for the person’s family or for who ends up owning their shares.

What affects the cost of key person insurance?

Insurers price key person cover in the same way as personal cover:

• the key person’s age, health, family history and whether they smoke or vape
• their job and any hazardous activities
• the amount of cover and the length of the term
• whether critical illness cover is included
• guaranteed or reviewable premiums.

Insurers will also want to see that the amount is justified by the person’s value to the business, so have your figures ready.

What are the most common key person insurance mistakes?

1. Insuring only the owners. The person whose loss would hurt most may not be a shareholder at all.
2. Guessing the amount. Without a clear method, the cover may be too low to help or hard to justify.
3. Not agreeing the tax treatment first. Deducting premiums makes the payout taxable, so plan for that.
4. Mixing up business and personal cover. Key person cover pays the business, not the family.
5. Setting the term too long. For deductibility, the term should not run past the person’s useful period to the business.
6. Never reviewing it. As the business grows or people change roles, the cover can quickly fall out of date.

How Option Finance helps with key person insurance

We help business owners look at protection alongside their mortgages and business finance, so the cover fits the real risks. We will:

• help you identify who your key people are
• work through a sensible valuation with you
• compare key person cover from leading UK insurers
• explain the difference between life only and life with critical illness
• share the details with your accountant so the tax treatment is agreed up front
• review your cover as the business changes.

If you are a director looking at a mortgage too, our company director mortgage guide explains how lenders assess you.

How we are paid. There is no fee for our protection advice. We are paid by commission from the insurer you choose. If we are arranging your mortgage, protection advice is included at no extra cost.

Frequently asked questions

Speak to Option Finance about key person insurance

If losing one person would put your profits, your contracts or your borrowing at risk, key person cover is worth a conversation. We will help you work out who to insure and how much, and we will work with your accountant on the tax.

Book a free initial consultation using the enquiry form below. See also our UK protection guide, shareholder protection guide and relevant life cover guide.