Valuing the Key Person
Valuing an individual with respect to profitability is a subjective exercise to a certain extent. The amount of cover chosen will normally be based on the following information:
- Past profits and projections for the future
- The effect that the loss of the individual would have on future profitability
- The anticipated cost of recruiting and/or training a replacement
- The expected recovery period, i.e., the length of time before a replacement is effective
- The amount of any loan(s) that would be called in on the death of the key person
Whilst it may not be possible to calculate precisely the level of cover required there are accepted methods of approximating the sum insured for Keyman Protection.
The following methods should be used where appropriate:
Multiple of Remuneration
A multiple of the keyperson's total remuneration, including any fluctuating emoluments and fringe benefits, may be used to calculate the sum insured. The exact multiple chosen will depend on the potential loss, but 5 to 10 times remuneration may be considered reasonable.
This method is particularly appropriate where the objective is to headhunt a replacement. It is less usetul when attempting to ensure against loss of profit and may show up some anomalies e.g. an individual who is running a developing business may be accepting a modest income, which does not reflect their true worth to the business.
Multiple of Profits
In this instance a multiple is used which should not normally exceed 5 times the net profit or twice the gross profit averaged over the last 3 years. Adjustments may need to be made for a rapidly expanding business. Where there is more than one keyperson involved the result must be appropriately adjusted.
Whilst this method ensures that the sum insured is related to the loss of profits that may be caused by the loss of the keyperson, care must be taken in using a net profit figure, since some businesses aim to produce a low net profit figure for tax purposes. Also using a net profit figure will not make any allowance for the fixed costs of the business, which still have to be met.
Obviously where the cover is being sought for more than one keyperson it will be necessary to establish the contribution to profitability made by each individual and to do so the following formula may be used:
(Average Net Profit for last 3 years) x 5 divided by the number of Keypersons
Directors Loan Accounts
Loans made by directors or other keypersons create known liabilities. The sum insured and the term should mirror as closely as possible the amount of loan(s) outstanding.
Effects on Taxation
Where the policy proceeds are taxable (see Revenue Guidelines) a higher sum insured will of course be required.
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