How much key person life insurance does my business need? Valuing key employees is important, but it is usually also quite difficult. What is the exact monetary value a key employee or owner brings to your business?
This figure is commonly based on a loan amount the company is acquiring or perhaps another arbitrary amount an investor has calculated. While the amount of coverage should address the specific needs of the company, the insurance company's primary goal in valuing a key person for life and disability insurance is to determine the realistic loss associated with the death or disability of such employee.
Often businesses request an amount of key man life insurance that is not reasonable or even available from life and disability insurance companies. The insurance amount must be justifiable - not simply equal to the amount of funds being borrowed from a lender.
To determine the amount of key person life insurance that will meet the needs of both the business and the insurance provider, there are various valuation methods. These valuation methods are listed in detail as follows:
The Multiples of Income Method
The simplest and most common method used to determine the value of a key executive or business owner is the multiples of income method. Insurance companies typically base the amount of key person insurance needed on a multiple of five to seven times the employee's current salary compensation and benefits.
For example, using a multiple of five:
- $1,000,000 would be the amount of insurance needed for a key person with a salary package totaling $200,000.
The Replacement Cost Method
With this valuation method, the estimated cost of replacing the key employee determines the amount of key man insurance needed. To calculate this replacement cost, not only salary, but also the expenses needed to recruit, hire, train and bring the new employee up to the same level as the former one must be included. Additionally, there should be added to this the expected decline in revenue following the death or disability of a key person.
The Contributions to Earnings Method
The percentage contribution the key employee adds to the company's bottom line profit is the basis of the contributions to earnings method. For instance, a small business may have one top salesperson that is contributing the bulk of the company's sales, thereby generating a major portion of the company's revenue. To use the contributions to earnings method, the actual value of that portion of the company's yearly profits would be multiplied by the number of years required to sufficiently train one or more replacement employees.
Jim Cahill, CLU