Not sure how much key person insurance your business needs?
Key person insurance provides crucial financial protection against the loss of a key employee, offering a lump sum payment to help you replace lost profits, find and train a replacement employee, and generally maintain your company’s strength and success.
Before you can take out key person insurance, you’ll need to work out exactly how much cover your business needs to keep running in the event of the loss of a key person. Let’s take a closer look at how you can calculate the right amount of key person insurance cover for your business.
How does key person insurance work?
- Paying off debts and outstanding loans.
- Finding, hiring and training a replacement employee.
- Replacing profits lost as a result of the key person’s departure.
- In the case of partnerships, buying out a deceased partner’s share of the business from their family members.
- Providing extra collateral when securing future loans for the business.
- Improving the overall financial position and credit rating of the business.
- Funding a smooth transition of ownership or maybe a restructuring of the business.
- Replacing lost goodwill for the business.
- Providing salary continuation to the beneficiaries of the life insured.
Who should I cover with key person insurance?
Just about any business that has employees can benefit from the security of key person insurance cover, but especially any business where the loss of a key person could lead to severe financial consequences. Not only will the loss of a key person reduce your ability to earn a profit, but you also lose all of that employee’s experience, contacts and goodwill that they have gained throughout their working life.
Key person insurance can be used to cover a wide range of important people in a business, including:
- Small business owners
- Business partners
- Company directors
- Key salespeople
- Project managers
- Principal shareholders
- IT specialists
- Heads of product development
This list is far from exhaustive. Anyone with skills or knowledge specific to the operation of your business, or with important business contacts and relationships, can be covered by key person insurance.
How do I work out how much I need?
There are a wide range of factors you need to consider when working out how much key person insurance cover your business needs, and as a general rule, the larger and more complicated your business is, the more factors there are to take into account. In Australia it’s possible to take out key person insurance cover for an amount between $250,000 and $10 million.
- The first step in the process is to work out how much your business is worth – your accountant will be able to explain how you can do this if you’re not sure.
- The size of your business and your current financial position will need to be taken into consideration in your calculations.
- The structure of your business needs to be considered, as you may need to use some or all of the proceeds from the benefit to buy back shares in the company from the family members of a deceased partner or executive.
- It’s also worth pointing out that you’ll need to consider the value of any projects or sales that could be lost with that person, and the overall financial impact their departure could have on your business.
There are three main ways to work out how much key person insurance your business needs: The replacement cost method, the contributions to earnings method and the multiples of income method.
Replacement cost method
This method calculates your cover needs based on how much it would cost your business to replace the key person. This includes not only the salary paid to the employee, but also the cost of finding, recruiting and training a replacement employee to the same standard. In addition, this method allows you to include costs associated with lost revenue caused by the loss of the key person.
Contribution to earnings method
This method involves calculating the necessary level of cover based on the percentage of the employee’s contribution to the company’s profit. For example, a well-established salesperson may be responsible for 60 per cent of the company’s profits, so the amount of cover needed can be determined by multiplying 60 per cent of annual profits by the number of years required to train a replacement to produce the same standard of performance.
Multiples of income method
This is the most popular and probably also the easiest way to determine the value of an employee to your business. A rough guide is to multiply the employee’s current salary (including benefits) by 5-7 times, but this figure can be adjusted based on the person’s importance to the business.
Once you know how much cover will be adequate for your business, it’s time to start comparing key person insurance quotes to find the right policy for your needs. It’s also essential to review your key person insurance policy regularly to ensure that it matches the changing needs of your business.