In many cases it is hard to put an exact monetary value on how important a key person is to a given business. Valuing a key employee is an important first step to getting the right plan in place.
Most of the requests we receive are based on the amount of funds being borrowed by the company via loan or some other arbitrary amount that was determined by an investor. In an effort to provide you with the understanding of who this all works, we’ve provided one of many resources below to help you make sense of it all.
Valuing A Key Employee: The Many Methods
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.
In many cases the amount of key employee 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.
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
- 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.