by Michael Cocco, CFP®, AXA Advisors
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 six 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.
Insuring a key person can spell the difference between the failure and survival of a business. Take another example: Tom and Art were partners. When Art died, his wife Betsy took over his share of the business. Because the business did not provide key person insurance, Tom could not buy Betsy out. Their constant disagreements created an unpleasant working atmosphere and they lost almost half of their employees—and clients. Eventually, Tom let Betsy buy him out at a far lower value than he would have received at the time of Art’s death, had they both been covered.
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. The life insurance proceeds can help pay off that loan.
• Credit can be maintained. At the death of a key person, lenders may become re¬luctant 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. Then it may take time to train him/her to the point where the replacement is as competent as the predeces¬sor. There may also be a recruiter’s fee to pay. So the life insurance proceeds buy time for the business.
• 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.
Who Needs Key Person Insurance?
With key person life insurance, the business owns the policy, pays the premiums and is the beneficiary. Many businesses buy permanent (cash value) life insurance, although term policies can also be used. As with any insurance, premiums will vary based on the age, physical condition, and health history of the insured.
Does your company need key person insurance? That depends on your company’s structure and business continuation plan, as well as the amount of financial hardship potentially faced without a key person.
Not all businesses need key person insurance. In large companies, there may be less likelihood that a single individual or small group is indispensable to a company’s continued success. In one-person firms, however, the business will almost certainly not survive without the principal, no matter how much money is available.
Some partnerships, such as a medical practice, will most likely have a greater need for key person coverage during their early years. As the partners’ pensions, profit-sharing, and net worth grow, insurance may become less necessary for the practice’s survival. For businesses primarily concerned about outstanding loans, many lenders offer and even require credit insurance. In such cases, key person insurance might be redundant.
For most small- to medium-sized businesses, however, key person insurance should be considered. To determine whether your business needs this coverage, think about what would happen if an owner or key employee were no longer a part of the business. How much would you lose in revenues, goodwill, or expertise? How much would it cost to replace these lost assets?
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 additional skills 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.
Michael Cocco is a certified financial planner with AXA Advisors in Nutley. He may be reached at firstname.lastname@example.org or (973) 667-8650.
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