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How much key person insurance do I need?

Different businesses have different needs, so there’s no such thing as a one-size-fits-all policy when it comes to key person insurance. Each company should carefully assess the potential consequences if a key individual were to become absent due to death or serious illness.

The loss of a key person can disrupt operations, lead to financial losses and jeopardise the future of the business. Therefore, understanding the specific needs of your business and the potential costs associated with such a loss is crucial. To find out about keyperson insurance, read our ‘What is key person Insurance‘ blog.

Cost of Recruitment and Training.

Replacing a key person often involves significant expenses in recruitment and training. Finding the right candidate to fill a pivotal role can be a lengthy and costly process. Businesses should factor in the costs of:

  1. Job advertisements.
  2. Recruitment agency fees.
  3. Potential higher salary is needed to attract top talent.

Additionally, once a replacement is found, there will be training costs and a period of adjustment during which the new hire becomes fully productive. In some cases, it may be that more than one new recruit is needed to cover the duties, responsibilities and knowledge of the key person.

Cost of Lost Productivity.

The absence of a key person can lead to a direct loss of productivity.

  1. With fewer people on the team, overall capacity is reduced, which can slow down projects and impact revenue.
  2. The remaining team members might face increased pressure, leading to burnout and further productivity losses.
  3. Lost knowledge and/or experience could result in work taking longer than usual – for example, if time is needed to catch up on what stage a project is at and learn all the intricacies of that particular job.

Ensuring that your business can maintain operations without a critical team member is essential, and key person insurance can provide the necessary financial support during this transition period.

Cost of Lost Relationships.

Key people often have strong relationships with clients and business contacts.

  1. The loss of a key person can result in the loss of these valuable relationships, potentially leading to a decline in sales and difficulty in securing new business.
  2. if a key person had a close working relationship with other employees, such as a mentee, the departure might prompt additional resignations, further intensifying the impact on the business.

Impact on a Business.

In a recent survey, businesses were asked about their biggest perceived risks:

  1. 15% thought that the premises being damaged by fire or flood was their biggest risk.
  2. 3% thought that being broken into would cause an impact. It’s likely that this figure is so low because most businesses already have insurance in place to cover such an eventuality.

However, over a quarter (28%) of businesses reported having experienced the death or critical illness of an owner or a key employee. This situation impacted the business in various ways, including:

  • Loss of profits: 30%
  • Loss of confidence from customers: 19%
  • Need to recruit replacement staff: 20%
  • Repayment of a loan: 10%

How to calculate key person insurance needs.

Once you have identified your key people, you need to work out a reasonable amount of cover per person. There are several options to consider:

Multiple of Profits.

This method protects business profit. You need to decide whether to base this on gross profit or net profit:

Gross profit:

Consider 2 times the gross profit for key people who directly influence revenue, such as sales staff. Example: if the salary was £60,000 – we would recommend you obtain £120,000 in cover.

Net profit:

Use 5 times the net profit for key people responsible for managing cash flow, such as a Managing Director. Example: if the salary was £80,000 – we would recommend you obtain £400,000 in cover.

If there’s more than one key person, split the cover according to each person’s contribution.

Multiple of Salary.

To cover replacement and recruitment costs:

We suggest 7 to 10 times the gross salary for any key person who doesn’t own the business, this includes employment benefits like car allowances.

Example: if the salary was £50,000 – we would recommend you obtain £350,000 – £500,000 in cover.

Proportion of Salary Roll.

This approach calculates the key person’s contribution to company turnover using the following formula:

Salary x turnover x years to recruit and train a replacement.

Example: £80,000 salary x 2.5 million turnover x 2 years = £400,000 cover required.

Consider costs such as:

  1. Loan Security – Base the cover on any loans, business overdrafts, and other relevant lending to ensure debts can be repaid if a key person is lost.
  2. Recruitment Costs – Consider the cost of recruiting and training a replacement, as well as the time required for the new hire to become fully productive. There will inevitably be a delay between the replacement’s arrival and making a meaningful contribution to profits.
  3. Business Start-Up – For new businesses, determining the amount of cover can be more challenging. One approach is to assess the working capital at risk compared to the key person’s proportion of this.

Case Study: Key Person Loss.

A marketing agency of around 25 people relied heavily on its Creative Director, who had been with the company for over a decade. The director’s sudden illness and inability to work not only halted ongoing projects but also led to the loss of several key clients who had a personal rapport with the director.

The company faced an immediate need to recruit a replacement, incurring substantial recruitment and training costs. Additionally, the team’s morale was affected.

Fortunately, the company had, which provided the necessary financial support to manage these expenses and stabilise the business.

  • Medical conditions: Type 1 Diabetes
  • Term: 5-year term
  • Cover amount: £400,000
  • Monthly premium: £49.15 (tax-deductible)

Protecting your business from the unexpected loss of a crucial team member ensures that you can navigate such challenges without jeopardising your operations or financial health. For more information and to explore your key person insurance options, visit The Insurance Surgery.

 

 

References:

LV, client video guide to key person cover

Legal and General, Business protection, state of the nation SME’s report