What does key person insurance provide?
Key person insurance can compensate the business for the loss of two different qualities:
- business profitability (revenue purpose), and
the capital value of the business (capital purpose).
Key person insurance proceeds can replace the lost profit or capital value that the key person would have generated. The funds can be used to stabilise the business until a suitable replacement person is found who is capable of being trained to have the same key skills.
Reduction of business profitability (revenue purpose)
Losing a key person can cause revenues to go down, and business costs to increase. Key person insurance proceeds can be used to:
- replace the revenue the key person would have generated, or
- pay the extra costs the business incurs in finding a suitable replacement.
In either case, the profitability of the business can be maintained, and the business stabilised, when key person proceeds are available.
- Some other areas of business profitability that can be affected are:
- Sales/ revenue – the loss of a key person directly responsible for sales can result in a fall in sales until a replacement is found and the replacement person starts to generate similar sales results.
- Recruiting costs – the costs incurred by a business to locate, attract and recruit a suitable replacement can be considerable and will lower business profit.
- Training costs – the replacement key person may require expensive specialist training.
- Destabilisation – a key person is an integral member of the business. The loss of a key person can also indirectly affect the business revenue. Short-term internal reorganisation can cause remaining staff to take on extra duties. The extra pressure put on those people may prevent them from performing to their usual standard. In addition, the remaining staff may feel insecure about their future and the future of the business more help. Other businesses with which the business deals may also have the same misgivings. This type of destabilisation can have a profoundly negative effect on the business revenue.
What to consider
The aim is to determine:
- the loss of profit and/or
- the cost of replacing the key person
One way to value the loss of a key person to the business is to multiply their remuneration (salary, bonus, commission and super) by 4 to cover the cost of recruitment and training of a good candidate in a short period of time. Also as a guide, consider how much of the business revenue was contributed by the key person? 50%, 20%, etc? Or, consider what effect the loss of that key person would have on the profit/ revenue of the business, and how long it would be before a replacement can be found and trained to produce the same results? How would the key person be replaced? What role did they key person play? What position would need to be filled? What is the annual salary cost of the replacement?