Looking after no.1

Ask any business what its most important resource is and most will acknowledge that its their employees. However, many are still unaware of the true value of the key people within the company and what effect their absence would have on the balance sheet.

One of the major stumbling blocks for businesses is that they still underestimate the impact of the loss of a key individual on the company. While the exact impact will vary from business to business, there can be substantial costs involved, from finding a replacement to a loss of profits relating to their absence. Lenders and investors may wish to call in loans, which could lead to problems for the business going forward.

But according to bruce Bulgin, partner at Chadney Bulgin IFAs, many companies should be able to afford key person cover. 'It can be difficult to communicate effectively to business owners the necessities of getting cover. But in our experience a number of businesses have been favourably surprised at the cost of cover,' he says.

In any company there will always be certain individuals whose loss would be keenly felt by the company and it is important that the business is protected against this eventuality. These individuals can be covered by a key person protection policy. This is based on a life, or a life and critical illness (CI) assurance policy which is used to protect a business in the eventuality that the insured is no longer around to fulfil their role.

Identifying key people

However, working out who to insure or how much cover is needed is not an exact science for either insurers or IFAs. The key individuals within a company can usually be identified as those whose absence would have a detrimental effect on the finances of the business. Bulgin says: 'You have to get businesses to work out what would be their position if certain people were not there, and find out who would be the most damaging person to lose.'

In a high proportion of cases the key person is not the managing director. It could be anyone within the company who has specific skills or contacts whose expertise means that they are valued as a key person.

Mark Preston, senior life and disability underwriter at Scottish Equitable Protect, says: 'In terms of who needs protecting in a business, the chief executive officer and managing directors are the most obvious to insure, but it could also be the sales or finance director. It depends on the industry the business is in. For example, in a high-tech medical company the chief scientist may not necessarily be a director, but they may be just as important to replace in terms of their impact on revenue, lost profits and replacement costs. It is often only when IFAs sit down to assess the financial evidence that the key skills of individuals within the company are drawn out.'

Rosalind Pearson, research and planning manager at Swiss Life, agrees. 'The job title of the key person will depend on the business. So, in large companies the finance director may be a key driver, but a lot of smaller companies may not have a finance director and in this case it tends to be the more creative types who shape the business. It could be anything from top salespeople, IT people developing new software, or even design companies with a top designer,' says Pearson.

There are four key areas of business protection. A common requirement is to provide security against a loan. In this situation the business must take out security against the loss or incapacity of a key person which could damage the company's ability to repay the loan. The sum assured depends on the size of the loan and when the bank or venture capitalists want the money repaid.

Ronnie Martin, protection director at Legal & General, says: 'Cover needs to be taken out on a level term, or on a decreasing term if the loan is being repaid on a capital interest basis. The choice of cover is life or life with CI, although life with CI is more expensive. In terms of assessing a sum assured it is the easiest one to do.'

John Lawson, senior technology manager at Standard Life, says: 'In the case of business loans, banks usually insist some life cover is taken out on one of the main drivers in the business ' in small companies this will usually be the managing director. If the loan is worth up to £500,000 the bank may insist the cover is equal to the loan. If it is for more than this they may not ask for the full amount on the grounds that if the company is that big, the loss of one key person should not be as crucial.'

When assessing how much cover is needed for loan protection it is important to take into account the standing of the business. Preston says: 'It is a good idea to look at whether it is currently profitable, and if you look at projections when it will next become profitable. If the insurer is happy with this, they will often cover the full amount of the loan.'

Knock-on effects

Another important factor to consider when assessing a company's requirements is the effect on profitability caused by the loss of one of the key drivers. Once the key person has been identified their loss must be calculated in monetary terms.

Diane Saunders, proprietor of the Leeds-based IFA of the same name, says: 'If the company is projecting the future growth of the business on the back of the sales, finance or even managing director, you need to protect the company against the impact of that loss. Things to work out include the calculated loss to the company and in smaller companies the cost of buying out the spouse of a major shareholder if they were to die. There is also the cost of bringing someone else in to do the job of the key person and maybe to train them up. There are no hard and fast rules ' each company will be different.'

Most insurers work from formulas designed to gauge the impact of the individual on the company. Martin says: 'It can be calculated as a multiple of salary, and around 10 times salary is generally accepted as an acceptable level. Or it can be calculated by looking at the gross profits attributable to the individual. We use a formula to calculate this. This is key person divided by total payroll, multiplied by gross profit, multiplied by the time period ' typically four to five years. So, a £50,000 salary divided by a £2m total payroll, multiplied by gross profits of £4m, multiplied by a period of four years would give a sum assured of £400,000. Five years is the typical period of time needed to train someone up to that level.'

Protecting investors

Another important area of business protection is that of investor and shareholder protection. Insurers calculate the most effective sum assured by looking at the percentage interest the director has in the business and then apply it to the business' value. Martin says: 'The value of the business can be reached by looking at business plans for the next few years. In small and medium-sized companies key person cover can help the remaining partners buy out their interests if they need to and is often written under trust. The price of cover varies according to age, although it usually runs until retirement.'

This can be especially important for small companies where the loss of a major shareholder could destabilise the business.

Other investors may demand cover is in place to insure their interest is protected. Preston says: 'Venture capitalists will usually ask for the key person to be covered. But it is not always for the full amount of the capital because they are often shareholders as well, and at the end of the day they will still see some return on their investment.'

Another important factor to take into consideration is the cost of replacing a key person ' that is hiring someone and then training them up to the same level as their predecessor. Preston says: 'Replacement cover has to be looked at in terms of salary ' 10 to 15 times salary is not uncommon. But more emphasis should perhaps be placed on lost profits due to the key person's absence, which could be around five times income or two times gross. Certain insurers restrict the levels of CI cover compared to the amount of life cover because in theory the insured could return to work if they are not dead.'

Cover can normally be arranged for sums assured of up to £500,000 before the insurer will ask for additional information. Martin says: 'For between £500,000 and £1m they may be asked to produce a business assurance questionnaire, which gives more details on the business and why the cover is required. For amounts over £1m they may be asked to produce three years' accounts.'

Pearson says that if IFAs help fill in business assurance questionnaires, it can help the client see the value of cover and makes it more likely the insurer will agree to the sums assured. 'Filling in these forms helps the underwriters make a decision, but in certain circumstances we would also ask for audited accounts and loan agreements to check the relevance of the requested sum assured,' says Pearson.

Businesses are becoming more aware of the need to protect themselves against the loss of a key person and they are often receptive to the idea of business protection. Key person protection offers IFAs a lot of scope to give advice and it can be easier to sell than individual policies as businesses have so much to lose.