Some partnerships will most likely have a greater need for key-person coverage during the early years. As the partners’ pensions, profit-sharing and net worth grow, insurance may become less necessary for the survival of the practice. For businesses primarily concerned about outstanding loans, many lenders offer and even require credit insurance. In such cases, key-person life insurance might be redundant.
For most small- to mid-size businesses, however, key-person life 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 your business. How much would you lose in revenue, goodwill or expertise? How much would it cost to replace those lost assets?
How Much Insurance Do You Need?
There are a number of valuation techniques you can use to determine how much key-person life insurance is appropriate. Two of the more popular techniques are described below. No one method is best, and a business owner may want to use a combination of 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 salary is used. If the key person’s salary is $75,000, the amount of insurance might be $375,000 ($75,000 times five).
Method 2: Replacement cost. First, determine how much additional salary is being paid to the executive above the compensation for the routine duties of the position. For example, if his salary is $80,000, but the routine part of the job amounts to approximately $25,000, the additional skills are then worth about $55,000.
Second, estimate how many years it would take to find and train a replacement to handle these extra duties. Assume it’s two years and add in the recruiter’s fee—generally about 25 percent. Then add the above factors: the recruiter’s fee and additional skills ($13,750 plus $55,000). Finally, multiply the above factor ($68,750 times two years equals $137,500), which equals the amount of life insurance you should have.
There are other valuation techniques, and your insurance professional can help you determine the best method. Because it’s simple and sensible, some business owners consider simply insuring one year’s profit.
Buying key-person life insurance may be a relatively small expense—one you hope you’ll never have to collect. 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, but big expenses can absorb your company.
Minh Tran is director of storage acquisitions for The Jenkins Organization Inc., a Texas-based commercial real estate and development company. To reach him, call 832.859.2425; e-mail email@example.com; visit www.jenkinsorg.com.