guarantee funding when your business needs it the most.
by russ alan prince
your $5 million high-net-worth practice
there are times because of death when key people in a company are lost. key person life insurance provides funds to a business to address the financial losses that can occur when a key person dies.
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revenue losses can be offset, and money can be tapped to help ensure the business remains viable and doesn’t fail – for example, to find a replacement or train someone to take the job of the key person who died.
this is almost always the most cost-effective approach. additionally, key person life insurance pretty much guarantees the money required will be available when needed.
the company buys a life insurance policy for its key personnel. a separate policy is often purchased for each key person. if a key person were to die while the policy is in force, the proceeds from the life insurance would go to the company to be used to enable the company to keep running and possibly find or train a person to replace the key person.
for the most part, the payout from the life insurance policy is tax-free to the company. however, the premiums the company pays for key person life insurance policies are not tax-deductible.
while key person life insurance can be extremely useful for many entrepreneurs, in a study of 513 entrepreneurs, only about three out of five of them had key person life insurance policies on themselves or other critically important personnel. what’s more, nearly three-quarters of the entrepreneurs who lack key person life insurance say their businesses would suffer if they unexpectedly died. in effect, these firms have no financial backup plans in the event they lose a key person.
according to homer smith, managing founder of konvergent wealth partners and co-author of optimizing the financial lives of clients: harness the power of an accounting firm’s elite wealth management practice, “even among those business owners with key person insurance, there is often a big problem. about nine out of 10 of them have not reviewed or revisited their key person insurance within the past three years. that means the insurance could be outdated and insufficient – and no longer be adequate to address the current-day needs of the company and its owners.”
in general, there are three basic ways to calculate how much life insurance to take out on a key person:
- multiples of compensation. this way is based on the all-in compensation a key person earns. that might mean including income, bonuses, the cost of benefits, and any other form of compensation (such as equity grants). then you add the multiplier, which tends to range from two times to 10 times (but can be even more). this approach is relatively easy to implement because it is a straightforward algorithm.
- cost of replacement. with this approach, the amount of life insurance on a key person is a function of what it will cost to find and compensate someone else who is similarly qualified to take the job. finding a replacement includes the cost of recruiting. this method is seen as most viable when there is a large supply of capable applicants and when the cost of recruiting a new key person for the role is not seen as arduous. it is anticipated that a new, high-caliber applicant will be identified and recruited fairly quickly.
- contribution to profits. here, the estimated ability of the key person to add to the bottom line is combined with the amount of time it will take to find a replacement and get him or her up to speed. it is a good way to also help address the losses the company may face without a talented person in the position.
sometimes, in using this approach, it is easy to calculate a key person’s financial contribution (as in the case of salespeople, for example). you can determine the average profits of a salesperson over a period of years. however, this approach can become much more subjective when, say, a company founder is involved.
according to anthony glomski, principal and founder of ag asset advisory family office and co-author of your $5 million high-net-worth practice: guidelines for sourcing and working with the wealthy during the covid-19 crisis and beyond, “for entrepreneurs who rely on specific people to help ensure the continued success of their companies, key person insurance is almost certainly worth looking into. if they already have such insurance in place, but the policy is older, it is probably time to revisit the coverage to ensure it still is structured to give the entrepreneur the financial safety net needed.”