There are four
categories of loss for which key person insurance
can provide coverage:
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Losses related to the extended period when a key
person is unable to work, to provide temporary
personnel and, if necessary to finance the
recruitment and training of a replacement.
-
Insurance to protect profits. For example,
offsetting lost income from lost sales, losses
resulting from the delay or cancellation of any
business project that the key person was
involved in, loss of opportunity to
expand, loss of specialized skills or knowledge.
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Insurance to protect shareholders or partnership
interests. Typically this is insurance that
enables shareholdings or partnership interests
to be purchased by existing shareholders or
partners.
-
Insurance for anyone involved in guaranteeing
business loans or banking facilities. The value
of insurance coverage is arranged to equal the
value of the guarantee.
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Who is
defined as a key man (person)? |
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A key
person can be anyone directly associated
with the business whose loss can cause
financial strain to the business. For
example, the person could be a director
of the company, a partner, a key sales
person, key project manager, or someone
with specific skills or knowledge which
is especially valuable to the company.
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Taxation |
With both
key man life and disability insurance,
the business secures the policy on the
life of the key person. It will own the
policy, pay the premiums and be the
beneficiary in the event the key
employee dies or is disabled. The
premium payments made by the company are
not tax deductible but in most cases,
the proceeds received are income tax
free. Death benefits on life insurance
owned by a C Corporation may be subject
to the corporate Alternative Minimum Tax
(AMT).
Proceeds on key-man policies in an
S-Corporation are essentially trapped in
the corporation. Any distribution of
that cash to surviving S-Corporation
shareholders – or to the estate of the
deceased shareholder – triggers a
taxable event.
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In
many cases it is hard to put an exact monetary value
on how important a
key person is to a given business and how much key
man insurance coverage is required. The goal when
valuing a key person for life and disability
insurance is to get the correct amount of coverage
based on the specific needs of the business
but that also corresponds to the realistic loss
associated with the death or disability of the key
employee from the insurance company’s viewpoint.
There are several valuation methods commonly used to
determine the proper amount of key man insurance
needed from both the business and insurance
companies perspective. These valuation methods
include: the replacement cost method, the
contribution to earnings method and the multiples of
income approach. A brief explanation of each
valuation method follows below:
Replacement cost method.
The amount of key man insurance needed is based upon
what it would cost to replace the key executive. The
replacement cost of a key person is determined by
the salary and other ongoing expenses required
in hiring, training and completely replacing the key
employee or executive. Costs associated with
decreased or lost revenue may also be factored in
when determining a key employee’s replacement cost.
Contributions to earnings method.
The contributions to earnings method is calculated
based on the percentage contribution the key
employee makes to the company’s bottom line profit.
For example, a top salesperson in a small business
may contribute 50% or more of the sales of the
company directly resulting in half of the company’s
profits. In this case, the actual value of half of
the company’s annual profits would be multiplied by
the number of years needed to train an equivalent
replacement.
Multiples of
income method.
The multiple of income method is the simplest most
common form of determining the value of a key
employee. Most insurance companies use a multiple of
5-7 times current salary including benefits as a
general guideline. Of course, depending on the
specifics of the position, a higher or lower
multiple may be justified. An example of the
multiples of income approach would allow $1,000,000
of key man insurance on an executive making $200,000
in compensation and benefits assuming a 5 times
multiple. |
