Corporate Risk

KEY PERSON INSURANCE

Definition

This type of insurance is designed to protect a business in the event of the loss of a person who makes a significant contribution towards the profitability of the business.

How to determine the need

There are many ways to determine the need and quantify this in dollar and cents terms. The method used will be determined by what makes the person important to the business.

If, for instance, the person has given a personal guarantee for a business loan or has given a director's loan to the business, then the need is simply the amount outstanding under the loan.

In other cases, when determining the need, it may be necessary to take into account:

• the length of time it would take for the business to achieve the status quo prior to the key person's death or disability; and/or
• the additional salary needed to be paid to the replacement; and/or
• anticipated profit reduction

Basically, the factors which must be considered when determining the need are:

• Possible loss of customers
• Lead time for replacement to be effective
• Possible loss of production whilst training a new employee
• Additional cost of hiring a new employee
• Loss of credit rating
• Loss of credibility if current orders cannot be met
• Current loans may be called up
• Loss of goodwill

In actual practice, the value is often decided in an arbitrary fashion and is to a large degree dependent upon the willingness of the business to recognise the need for protection and to pay the premium required to cover that need. Accountant's play an important role in providing a framework for company's to determine the correct value.