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February 19, 2004 at 07:00 PM
How Much Key Employee Life Insurance Is Needed?
It is difficult to put an exact dollar figure on how much key person life insurance is the right amount for the business.
There are some subjective and some formula approaches that can assist in deciding on what the face amount of the policy should be. These formulas either use an earnings or profits approach, or at the other end of the spectrum they may just use a “laundry list” approach, which adds up the total costs and expenses associated with finding and training a replacement.
A couple of the common approaches to valuing a key employee include:
Contributions to EarningsValue is calculated based on comparing actual average earnings to expected returns per year for a set number of years.
Replacement ApproachValue is calculated based on the salary required to replace the key executive for the number of years it would take to fully train the replacement.
Technical ApproachValue is calculated by subtracting the difference between what the key employee contributes to the business (less his/her compensation) and the replacement employees contribution (less compensation and less training costs). That difference is calculated over the number of years it takes to fully train the replacement and then discounted back to a present value.
