H—Key Person Insurance
Multipurpose key person insurance protects a business from the financial losses that can occur when a key employee dies. Such a key employee could be the owner of the business, or a nonowner employee whose very specialized abilities are critical to the operation of the business and difficult or costly to replace. Adequate amounts of key person insurance are essential in any risk management program.
Since the existence of business debt “signals a need for insurance,” key person insurance can function as a form of commercial loan protection, as well as provide needed funds when a business is to be continued, sold, or liquidated.
Key person insurance is often purchased as an alternative to holding cash by businesses, such as construction companies, that are required to post bonds. Company Owned Life Insurance (COLI) policies are often designed to eliminate the “hit to the balance sheet” by having cash values equal to (or nearly equal to) premiums paid in the early years. These types of policies are rarely available to individual consumers, with life insurance companies limiting them to business
ownership. Key person COLI is also purchased by C corporations as a means of avoiding the excess retained earnings excise tax.
DURING LIFETIME. This protection is provided by having the business obtain insurance on the life of the key employee. As both owner and beneficiary of the contract, the business pays the premiums directly to the insurance company. The contract’s cash values are carried as a business asset, and are available as collateral for securing commercial loans, or for direct borrowing from the insurance company at generally favorable interest rates.
Many guidelines are used in estimating the dollar value of a particular key employee. However, the value can be most easily estimated by using a factor of three to ten times the employee’s salary. Other guidelines that have been employed involve either a determination of the employee’s replacement cost, or an estimation of lost profits or credit.
UPON DEATH of the key employee the insurance company pays the death benefit directly to the business. The funds are treated as an addition to surplus and are received free of any direct income taxes.
The proceeds can then be used for various purposes. Should it be determined that the business will be continued, these can be used to obtain a qualified replacement, replace lost profits, protect its credit position, provide a financial cushion, fund a partial stock redemption or make survivor income payments. If the business is to be sold, then there is money available to fund a full stock redemption. In case of liquidation, the cash will benefit the surviving family by offsetting lost business value.
Key Person Valuation Formulas. No single formula is accepted for valuing a key person or employee. In fact, valuing a key person is much like valuing a business, it is more art than science. Much depends upon the characteristics of the key person (e.g., a sales manager who has a substantial impact upon sales or a financial officer who has access to credit). However, there is little doubt that key persons can have considerable value; and their death or disability can cause substantial financial losses, or even failure of a business. One or more of the following formulas should provide a useful starting point for determining value.
Contribution to Profits. This method evaluates the key person’s contributions to profits and then capitalizes this amount to determine value. For example, assume the business has a book value of $500,000, an expected rate of return on book value for this particular type of business is 8 percent and average profits are $120,000. The excess earnings are $80,000 ($500,000 × .08 = $40,000; $120,000 – $40,000 = $80,000). Assuming the key person’s contribution to excess earnings is 50 percent, capitalization of the key person’s contribution at 12 percent yields a value of $333,200 (.50 × $80,000 = $40,000; 100 ÷ 12 = 8.33 × $40,000 = $333,200). A variation on the contributions to profits method does not capitalize the contribution, but rather reduces the key person’s annual contribution as a replacement is recruited, trained, and becomes fully effective. Using this variation, the key person’s value would be $120,000, assuming annual contributions to profits of $40,000 and 5 years to complete the replacement. The basic method and the variation are calculated as follows:
Average Profits $120,000 Variation
Book Value at 8% $40,000 Year 1 $40,000
Excess Earnings $80,000 Year 2 $32,000
Percent of Contribution 50 Year 3 $24,000
Key Person’s Contribution $40,000 Year 4 $16,000
Capitalization Factor 8.33 Year 5 $8,000
Key Person Value $333,200 Key Person Value $120,000
Business Life Value. This is a variation of the method commonly used to determine human life value. The business estimates its annual loss of earnings if the key person were to die, multiplies that amount by the number of working years to retirement, and then discounts the results by an appropriate interest rate. Assuming annual loss of earnings of $40,000, 15 years to retirement, and 12 percent interest, the value would be calculated as follows:
Loss of Earnings $40,000
Present Value Factor 6.811
Key Person Value $272,440
Multiple of Salary. This method recognizes that the salaries paid to key persons are an indication of their value. Typically a factor of from 3 to 10 times annual salary is used. Assuming an annual salary of $75,000 and a factor of 5, the value would be calculated as follows:
Annual Salary $75,000
Factor 5
Key Person Value $375,000
Discount of Business. This method simply discounts the value of the business to reflect the loss of the key person. Assuming a business value of $900,000 and a discount of 20 percent, the value would be calculated as follows:
Value of Business $900,000
Discount .20
Key Person Value $180,000