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A brief explanation of each valuation method follows;
Replacement cost method:- The amount of insurance cover needed is based upon what it would cost to replace that key employee in the event of their death or incapacity which temporarily or permanently renders them unable to perform their key employment role in the business. The replacement cost of a key employee is determined by their salary and/or personal earnings from or for the business; depending on their employment structure.
Other and ongoing expenses also have to be factored in to the methodology such as for hiring, training a replacement and/or completely replacing the key employee altogether. The costs associated with decreased or lost revenue may also be factored in when determining a key employee’s replacement cost.
Contributions to earnings method:- The contributions to earnings method is usually calculated on the percentage contribution the key employee makes to the business’s bottom line profit. For example, a top salesperson in a small business may contribute 50% or more of the sales directly resulting in half of the business’s profits. In this case, the actual value of half of the business’s profits would be multiplied by the number of months/years needed to train-up an equivalent replacement.
Multiples of income method:- The multiple of income method is the simplest most common form of determining the value of a key employee. Most insurance companies accept a multiple of 5-7 times current salary including benefits as a general rule of thumb. Of course, depending on the specifics of the employee’s position, a higher or lower multiple may be justified.
An example of the multiples of income approach would allow $1,000,000 of key man insurance on an executive making $200,000 in earnings and benefits assuming a 5 times multiple.
Getting the Employee Valuation Right
The key employee valuation methods canvassed above are not an exhaustive explanation of how to value a key employee’s worth; however, each of the methods are capable of determining a reasonable value figure for the purposes of taking out Key Person insurance.
As part of RGIB’s ‘Key Person’ insurance services, we’ll help you determine a suitable employee value -/- insurance cover ratio, so you get the right level of cover without paying any unnecessary premium.
In some case depending on the scope and complexity of an employee’s key role activities; and the complexity of and/or uniqueness of the business itself, it may be necessary to seek an independent opinion from a human resource expert, experienced in calculating the monetary value of a particular employee to a business.
For further information about valuing a key employee you have a couple of choices…….
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