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Dana Sydney
Dana Sydney
Have You Insured Your Company's Most Valuable Resource?
It can mean the difference between the survival and the failure of your business.

February 17, 2011
by Dana Sydney, CLU, CFP

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 percent of new business each year. The company’s revenues dropped by 25 percent the following year after Jack unexpectedly died.

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, 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.

Benefits

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 minimizing the organizational loss and fiscal strain that follow the death of a key employee and assuring that:

  • Business loans or investments are 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. At 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 firm 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 is found. It may then take time to train him or her to the point where the replacement is as competent as the predecessor. There may also be a recruiter’s fee to pay. So the life insurance proceeds buy time for the business.
  • The business is indemnified for 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 enables 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 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 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 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 survival of the practice. For firms 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 CPA firms, however, key person insurance should be considered. To determine whether your firm 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 you can use to determine how much key person insurance is appropriate. No one method is best; a business owner may want to use a combination of methods. Several of the more popular techniques are listed below:

  • Multiple of salary valuation.

    The key employee’s value is estimated based on a multiple of current compensation. Frequently, a multiple of three times to five times his or her salary is utilized. If the key person’s salary is $75,000, the amount of insurance may be $375,000 ($75,000 x 5).
  • Replacement Cost.
    • 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 the routine part of an employee’s job amounts to approximately $25,000, and their overall knowledge and intellectual property they possess makes up approximately $55,000, it will take a company a total value of $80K to replace the key person it lost.
    • 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 percent.
    • Add the above factors — recruiter’s fee and additional skills ($13,750 + $55,000). Finally, multiply the above factor ($68,750 x two years equals $137,500 of life insurance).

Conclusion

There are other valuation techniques with which you as the insurance professional can help your clients 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 can be a relatively small expense, one that hopefully your client will never have to collect on. But failure to invest in a key-person policy and then have that person die can mean enormous expense. Your client’s firm may be able to absorb small expenses, but big expenses can absorb their company.

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Dana Sydney, CLU, CFP, is partner and co-founder of Melville, NY-based Dayton and Sydney, LLC and, is a 10-year veteran of AXA Advisors Dayton & Sydney Wealth Management. He offers securities and investment advisory services through AXA Advisors, LLC (member FINRA, SIPC) and offers annuity and insurance products through an insurance brokerage, AXA Network, LLC and its subsidiaries. AXA Advisors and AXA Network are affiliated companies. Dayton & Sydney Wealth Management is not owned or operated by AXA Advisors or AXA Network.

* The AICPA’s Personal Financial Planning Section is the premier provider of information, tools, advocacy and guidance for CPAs who specialize in providing estate, tax, retirement, risk management and investment planning advice to individuals and closely held entities. The Personal Financial Planning Section is open to all Regular Members, Associate Members and Non-CPA Section Associate Members of the AICPA. If you are a CPA who wants to demonstrate your expertise in this subject matter, become a Personal Financial Specialist Credential holder. Visit www.aicpa.org/PFP to learn more.