Navigating Key Person Insurance
Risk is something that every business needs to accept - and something every business owner is familiar with. But that doesn't mean that risk shouldn't be managed or shared, with a partner or an insurance company.
All businesses are different, and risk can come from many different sources. That said, one risk common to all businesses (assuming you rely on partners or employees) is the unexpected incapacity of one. The death or disability of a key staff member can cripple any operation. Along with losing a valued member of your management team, you could also be losing a manager’s skill, “know-how” and, important business relationships he or she has cultivated over the years.
The Landscape of Key Person Risk
Although it is impossible to prevent the sudden and unexpected loss of a critical employee, you can share some of this risk with an insurance company through a "key person" insurance policy. Key person, or key man insurance covers your company against the loss of a valued team member’s skill and experience. Essentially, the policy pays out if a covered person dies or becomes disabled. The proceeds can help:
- Provide funds to recruit, hire, and train a replacement;
- Replace lost profits;
- Assure customers that business operations will continue; and/or
- Reassure lenders that funds will be available to help repay business loans.
Generally, the firm owns the policy, the premiums are not deductible, and the death proceeds are received by the company income tax free (although there may be alternative minimum tax (AMT) consequences for businesses structured as C corporations).
What are Key People Worth?
Needless to say, it is not easy placing a value on a key employee. Generally, there are three different approaches used to determine the amount of insurance that is necessary:
- The “multiple” approach uses a multiple of the key person’s total annual compensation, including bonuses and deferred compensation. The popularity of this method may reflect the difficulty business executives have in quantifying a key employee’s value. On the other hand, the disadvantage is that the estimate, typically for five or more years’ annual compensation, may or may not relate to actual needs.
- The business profits approach is a more sophisticated method. It attempts to quantify the portion of the business’s net profit that is directly attributable to the key person and then multiplies that amount by the number of years it is expected it will take for a replacement to become as productive as the insured. For example, if net profit attributable to the key employee is estimated at $250,000 annually, and it is expected that it would take five years to hire and train a replacement, then the policy’s face amount would be $1.25 million.
- The present value approach calculates the present value of the profit contributions of the key employee over a specified number of years. This amount is then used as the face value of the policy. For instance, with an anticipated profit contribution of $250,000 per year for the next five years and a discount rate of 8%, the policy’s face value would be about $1 million. This method assumes insurance proceeds can be invested at a given rate of return and will be expended over a given period of years.
Regardless of which method is best suited for your business, key person insurance is a vital component in protecting your firm from the loss of your most valuable asset — the people who help it grow and prosper.