How Much Insurance Should a Business Purchase on its Key Employee?

A common method of calculating the economic effect of the loss of a key employee is the discount approach. This technique applies a percentage discount to the fair market value of the business. The discount approach requires an appropriate discount factor. Some authorities believe that if the business will survive the loss of the key employee and, in time, will hire a competent replacement, an appropriate discount factor is 15 to 20 percent. But if the business will fail at the death of a specified key person, or will be placed in jeopardy from the loss of the key employee, an appropriate discount factor is from 20 to 45 percent. The officers of the company and the firm’s accounting and legal advisors, however, should determine the exact discount factor.

Consider the following questions when determining the discount factor:

  • How long will it take the replacement to become as efficient and productive as the lost key employee was?
  • How much will it cost to locate, situate, and train a replacement, and will the new employee want a higher salary?
  • Is the replacement likely to make costly mistakes during the training period?
  • Will the loss of the employee result in a loss of clientele?
  • What percent of the firm’s current net profits are attributable to the key employee?

While there are other methods of calculating the value of a key employee’s contribution to a corporation, the discount approach illustrated below, courtesy of NumberCruncherTM Software, is a quick and effective method that sidesteps many of the difficulties posed by alternative methods.

Keep in mind that regardless of what approach is used to calculate the value of a key employee, a life insurance carrier will limit a business’ insurable interest to the loss which the business would sustain in the event of the death of the employee. For financial underwriting purposes, the amount of death benefit that a life insurance carrier will issue is usually evaluated based on multiples of compensation for the number of years needed to replace the person and recover the losses. Generally, a maximum death benefit of five to ten times the key employee’s compensation is permitted.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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