| Life Insurance Funding Formulas |
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| There are a number of techniques to determine how much key person insurance is needed. A business owner may use one or a combination of these methods. However, only the business owner can truly evaluate the potential loss and the effects of a key employee's death. |
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The following formulas are discussed:
Multiples of Salary
Replacement Cost
Contribution to Profits/Earnings |
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*Death benefits and cash value increases may be subject to the alternative minimum tax which may cause taxes and penalties.
**Policy loans and withdrawals will reduce cash value and death benefit. Policy loans are subject to interest charges. If your policy is a modified endowment contract, loans and withdrawals may be subject to taxes and penalties. |
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| Multiples of Salary |
This method may be the simplest. The key person's value is estimated based on a multiple of his/her compensation.
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•Determine the base compensation for the key person.
•Add the dollar value of significant benefits, such as medical, life and retirement plans.
•Use a multiple of years based on how may years may pass before a new employee will perform as well as the key employee, i.e., replacement time. |
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( $75,000 |
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$15,000) |
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5 years |
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$450,000 |
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Base Comp |
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Benefits |
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Replacement Time |
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Life Insurance Amount |
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| Replacement Cost |
| The replacement cost of an employee is more that just expenses incurred. Those expense do not consider lost revenues, lost customers and other intangibles. Expenses incurred may include advertising costs, executive search firm fees, travel expenses for candidates, temporary housing, etc. The formula below estimates the total replacement cost based on how much money the company would have to earn to pay the expenses incurred. The number is larger that the expenses because it considers the cost of doing business, and thereby may approximate the intangible costs of replacing an employee. |
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| Contribution of Profits |
| This method evaluates the key person's contribution to the company's profits. Then, using a method similar to valuing a business, the "contribution to profits" is capitalized, or converted to a single value. Consider this example: |
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Assumptions:
•Average profits are $100,000
•Book value of business is $400,000
•Rate of return for book value is 6%
•Key person contributes 50% of excess earnings
•Capitalization rate for business is 8% = Capitalization factor of 12.5 (100 / 8)
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| Average Profits |
$100,000 |
| Book Value at 6% |
$24,000 |
| Excess Earnings |
$76,000 |
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| Percent of Contribution |
.50 |
| Key Person's Contribution |
$38,000 |
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| Capitalization Factor |
12.5 |
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| Key Person Value |
$475,000 |
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| Important points to Consider |
| The company is the owner and beneficiary of the policy. The premiums are non-deductible business expenses. If the business is a "C" corporation, the death proceeds and cash value increases may be subject to the alternative minimum tax (AMT), which may cause taxes and penalties. |
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