 In
many cases the amount of key person insurance requested is
dramatically higher than is available from the life and disability
insurance companies. For example, just because a firm is
borrowing $10,000,000 for a project expansion doesn’t
mean the insurance company will willingly write $10,000,000
of key man life or disability insurance. Specific details
will be required by the insurance company to justify the
insurance amount requested. For more information on how the
insurance companies review financial needs of businesses
see, “Underwriting
Key Man Insurance.”
There are several valuation methods commonly used to determine
the proper amount of key person 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.
The key man valuation methods discussed above are not set
in stone. Each case merits specific consideration and therefore
should be reviewed based on their individual circumstances.
If you have questions regarding the amount of key man life
or key man disability insurance needed, please call MEG Financial
at (877) 583-3955 or complete
a simple online
form now.
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