Updated: Dec 10, 2019
A company's success often relies heavily on a small group of its employees. Losing the services of a member of the executive team or a crucial team member with specialized skills can jeopardize the continuity of the business. These essential individuals are often referred to as "key persons."
What Is Key Person Insurance?
Key person insurance compensates a business for financial losses that would arise from the death or disability of a key member. In many cases, it provides the funds necessary to allow the business to continue operations where it may otherwise fail. A key person insurance policy (life insurance or disability insurance) is paid for by the company, insures the key person, and names the company as the beneficiary.
Key person insurance provides business owners, shareholders, employees and customers with the peace of mind of knowing the business will continue operations following the loss of a critical employee. The benefits provided can:
Help offset revenue loss
Finance the recruiting and training of a replacement
Help maintain business financial viability during a change
Generally, the benefits under a life insurance or disability insurance policy are received income tax-free by the business. Premiums paid for life insurance or disability insurance for key person purposes generally are not tax deductible.
However, life insurance ownership poses a risk for alternative minimum tax (AMT) consequences for C corporations.
Life insurance proceeds are included in the corporation's AMT calculation
Increases in life insurance policy cash values are included in the corporation's AMT calculation
What Is A Key Person's Value?
It is often difficult to put a precise dollar amount on the value a key person brings to a business or organization. There are three generally accepted methods to estimate value:
Multiples of Compensation Multiples between 2x and 10x are often used in estimating value. The nature of the key person's services should be taken into account, with top executives and key engineers being insured for a multiple at the top of the range.
Cost of Replacement This method factors in all facets of locating, hiring, and training a replacement. It includes recruiting costs such as advertising for the open position, payment to a recruiter, and an allowance for training and incentive compensation required to attract the desired candidate. This method is generally used when skilled applicants are plentiful and the business does not anticipate a lengthy search for a replacement.
Contribution to Profits This method multiplies the estimated revenue generation potential of the key person by the amount of time it will take to locate, hire, and train a replacement. This is the most commonly used method for salespeople. An average of sales revenue generated in the past 3 to 5 years is used. This number is multiplied by the number of years that will elapse before the revenue generation is replaced.