The Pillars of Success: Understanding Key Employee Insurance
Preparing for the Unexpected
As we discussed earlier, the death of a key employee can also wreak havoc on a business—loss of productivity and profits; wariness on the part of clients, lenders, and vendors; and competitors who may try to take advantage of the company’s perceived weakness. However, a business owner can prepare for such an unexpected event by having enough cash on hand to pay the increased expenses the business would inevitably incur in finding, hiring, and training a suitable replacement.
Some businesses set up a sinking fund, setting aside money on a periodic basis with the hope that there will be enough cash on hand when a key employee dies. However, business owners are often tempted to invade such a fund to meet current obligations and emergencies. Even without withdrawals, when a key employee dies prematurely, the business may not have had enough time to accumulate an amount that would cover unexpected expenses. There is a better solution.
Life insurance on a key employee—whether a family member or outsider—guarantees that the appropriate amount of money is available to the business at the exact time it’s needed to offset the financial loss the business would suffer if that key employee dies prematurely.
How Does It Work?
Here’s how key employee insurance works:
- A key executive agrees to allow the business to purchase a specified amount of life insurance on the employee’s life.
- The business purchases and owns the policy.
- The business pays the premiums and is the beneficiary of the policy.
- If an insured employee dies, the business uses the death benefits to pay for losses incurred or additional expenses that result from the key employee’s death, including the cost and time lag associated with training a successor to an equal level of productivity.
Determining the Appropriate Amount
The appropriate amount of cash will vary from business to business. Placing a realistic figure on a key employee’s value to the business is difficult and inexact, but critical to properly protecting the business. There are, however, two typical methods:
- The contribution to earnings method estimates the employee’s annual contribution to earnings, multiplies it by the number of years the employee is expected to work, and then discounts earnings to its present value.
- The cost to replace the experience method determines the amount the business would have to pay a new person to do the same job. From that amount, subtract the key employee’s compensation. Multiply the difference by the number of years it will take to train a new person—then add hiring costs.
Key Employee Insurance: An Example
Ryan and Jack opened a bakery 20 years ago. They’re both in their mid-fifties and they are beginning to think about retirement. The bakery has 15 employees and grosses $4 million a year. Rebecca started behind the counter ten years ago while she put herself through business school. During the last five years, she has taken on more and more managerial responsibility, putting her marketing skills to work and helping to grow the business. Ryan and Jack recognize her contributions and compensate her accordingly.
Jack and Ryan realize that if Rebecca died unexpectedly, the loss to the business would be extraordinary. They also realize that Rebecca is critical to making their succession plans work. So, with her consent, the bakery purchased a $100,000 life insurance policy for Rebecca’s life. The company is both the owner and the beneficiary of the policy. Now, if she dies, the proceeds from the life insurance policy will provide the bakery with the funds it would need to absorb immediate losses while searching for someone to fill Rebecca’s shoes.