If you’re a business owner, you may have wondered whether your company needs to provide life insurance to cover the loss of a key person should they die unexpectedly. Consider the example of a 15-employee equipment parts distribution business. Of 6 regional salespeople, one—Jack—was responsible for 40% of new business each year. When Jack unexpectedly died, the company’s revenues dropped by 25% the following year.
Jack was clearly a key person for the business, one whose loss had a severe negative financial impact on the company. Many businesses rely on people like Jack—employees whose value to the company would be difficult or expensive to replace. For a restaurant,it may be the chef; for a legal practice, the rainmaker. For almost every small to medium sized business, the key persons include the owners.
Key person life insurance can help a company survive by helping to minimize the organizational loss and fiscal strain that can follow the death of a key employee and by helping to assure that:
- Business loans or investments can be repaid. When a key person dies (especially an owner), a lender may have the right to call the loan.
- Credit can be maintained. At the death of a key person, lenders may become reluctant to lend new money to the business or refinance outstanding loans. The life insurance can help the firm maintain its credit rating by allowing it to pay its bills in a timely manner in spite of the death. It may also demonstrate to the lender that the firm is well managed.
A replacement can be recruited and trained. Months may pass before a qualified candidate can be found.
- The business can help offset lost sales and profits if a key person dies. Insurance proceeds can help offset the future loss in revenue that will probably occur, at least temporarily, when a key person dies.
- Stock can be repurchased. If the business is a corporation, any common stock owned by the key employee can be repurchased with the insurance proceeds. This can enable a partner to buy out a deceased partner’s share.
How Much Insurance?
There are a number of valuation techniques that have been developed to determine how much key person insurance is appropriate. Several of the more popular techniques are described below. No one method is best; a business owner may want to use a combination of these methods.
Method #1: Multiple of salary valuation.
The key employee’s value is estimated based on a multiple of current compensation. Frequently, a multiple of three to five times his/her salary is utilized. If the key person’s salary is $75,000, the amount of insurance might be $375,000 ($75,000 x 5).
Method #2: Replacement Cost.
First, figure out how much additional salary is being paid to the executive above the compensation for the routine duties of the position. For example, if his/her salary is $80,000 but the routine part of the job amounts to approximately $25,000, the additionalskills are then worth approximately $55,000.
Second, estimate how many years it would take to find and fully train a replacement to handle these extra duties. Assume two years and add in the recruiter’s fee – generally about 25%. Third, add the above factors – recruiter’s fee and additional skills ($13,750 + $55,000). Fourth, multiply the above factor ($68,750 x 2 years equals $137,500 of life insurance).
There are other valuation techniques—your insurance professional can help you determine the best method. Because it is simple and sensible, some business owners consider simply insuring one year’s profits.
Buying key person life insurance may be a relatively small expense—one you hope you’ll never have to collect on. But failure to invest in a key person policy—and then having a key person die—can mean enormous expense. Your company can absorb small expenses; big expenses can absorb your company.
Please be advised that this document is not intended as legal or tax advice. Accordingly, any tax information provided in this document is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer. The tax information was written to support the promotion or the marketing of the transaction(s) or matter(s) addressed and you should seek advice based on your particular circumstances from an independent tax advisor. AXA Advisors, LLC and AXA Network, LLC do not provide tax advice or legal advice. This article is provided by Robert McFarland. Robert McFarland offers securities through AXA Advisors, LLC (member FINRA, SIPC) 1525 VALLEY CENTER PKWY SUITE 100 BETHLEHEM, PA 18017 and offers annuity and insurance products through an insurance brokerage aff iliate, AXA Network, LLC and its subsidiaries. AXA Advisors does not provide tax or legal advice. Rockland Financial Group is not a registered investment advisor and is not owned or operated by AXA Advisors orAXA Network.