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 he die unexpectedly. Consider the example of a 15-employee equipment-parts distribution business. Of six regional salespeople, only one, Jack, was responsible for 40 percent of new business each year. When Jack unexpectedly died, the company’s revenue dropped 25 percent 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 almost every small- to mid-size business, the key people 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 company didn’t have key-person insurance, Tom could not buy out Betsy. 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.
Understanding Key-Person Life Insurance
Key-person life insurance can help a company survive by minimizing the organizational loss and fiscal strain that follows the death of a key employee and helping to ensure:
Business loans or investments can be repaid. When a key person dies, especially an owner, a lender may have the right to call in the loan. Life-insurance proceeds can help pay off that loan.
Credit can be maintained. With the death of a key person, lenders may become reluctant to lend new money to the business or refinance outstanding loans. Life insurance can help the business maintain its credit rating by allowing it to pay its bills in a timely manner in spite of the death. It also demonstrates 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 to the point where the replacement is as competent as the predecessor. There may also be a recruiter’s fee to pay. The life-insurance proceeds buy time for the business.
The business is indemnified for lost sales and profit 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 enables a partner to buy out a deceased partner’s share.
Who Needs It?
With key-person life insurance, the business owns the policy, pays the premiums and is the beneficiary. Many businesses buy permanent or cash-value life insurance, although term policies can also be used. As with any insurance, premiums vary based on the age, physical condition and health history of the insured.
Does your company need key-person life insurance? That depends on your company’s structure and business-continuation plan, as well as the amount of potential financial hardship without a key person. Not all businesses need it. 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 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 protected]; visit www.jenkinsorg.com.