Key Person Insurance

Key Person (or Keyman) Insurance is part of successful business planning. In a nutshell, here are the problems that you could experience after losing a key employee, without the protection of Key Person Insurance:

  • The weakening of your company’s credit rating. Your key person is akin to your firm’s “right arm.” Banks, investors, and financial analysts will be concerned with your business’s future, when your key person is lost. Likewise, suppliers and customers will need reassurance that your operations will continue without interruption.
  • The distraction of your other employees. The sudden loss of a key person is shocking to your other employees, who typically lose confidence in your business’s financial viability. Morale deteriorates; deadlines are not met; personal conflicts increase — all contributing to higher employee turnover.
  • The requirement to meet your prior financial commitments. You must fulfill financial promises made to the key person’s family — such as salary continuation or deferred compensation.
  • The need to find, hire, and train a replacement key person. You must bear the financial cost (both in time and dollars) associated with this difficult process.
  • The lost business opportunities. Without Key Person Insurance, your cash reserves are exhausted meeting the above needs. This leaves insufficient funds to invest in new business opportunites, and business growth is at risk.

Please keep in mind that there are a number of possible reasons for the loss of your key person. Insurance can protect you in multiple scenarios. For example, unexpected death is an unfortunate reality. Another consideration is the Family and Medical Leave Act (FMLA). A key employee may rightfully need to take advantage of the FMLA. The key employee, however, may be unable to return.

All in all, your key person’s value is an important consideration, when determining your financial assets and business continuity.

Key Person

Key Person Insurance is not easy to calculate. After all, there is no simple mathematical formula to determine the worth of a key person. However, over the years, business owners have used the following methods to estimate the worth of a key person to their company—and to appreciate the value of Key Person Insurance to protect against loss.

  • “Multiple of compensation” This method assumes that the value of a key person is accurately reflected in his or her total compensation package. The multiple that is used (for example: 2x annual compensation) will depend on the type of business and the estimated difficulty in finding a qualified replacement key person. This method is perhaps the easiest way to estimate potential loss to the firm and determine the appropriate level of keyman insurance.
  • “Contribution to profits” This method estimates the impact that a key person has on the company’s net profit. The firm first calculates the expected profit from a normal return on capital (e.g., the net book value of assets). Profit in excess of this normal return is assumed to result from the efforts of the key person employees. An estimate is made of the percentage of profit attributable to each key person. This percentage is then multiplied by total excess profit, to determine the dollar amount of excess profit from each key person. This sum is then multiplied three times the number of years needed to find and train a competent replacement for the key person. The amount of Key Person Insurance is determined accordingly.
  • “Cost of replacement” This method totals the direct, out-of-pocket costs involved in finding, hiring, and training a replacement keyman, as well as the estimated loss-of-opportunity costs. This total is used as the guide for purchasing keyman insurance coverage.

Many factors determine which method would be right for you, including your type of business, your industry, and the age of your firm. It is critically important to bring in an accountant or financial advisor that specializes in business valuation to determine the value of your own key personnel.

In general terms, a key person is considered to represent 15-20% of the value of a business, if the firm can find a competent successor key person in a reasonable amount of time. However, if the business is likely to fail or be placed in serious jeopardy upon the loss of a key person, then the factor rises to 20-45%. Key person insurance protection becomes a clear concern, in this light.

Please consult with a qualified professional to protect against the loss of your key employees.