A key executive might be one who has relationships with key customers, bankers, suppliers, and/or industry contacts. This is the reason many realize Loss = Cost = Reason to Insure. After all, it’s the reason businesses carry fire, as well as other types of insurance: Protection against loss.
The loss of a key executive can impact a business’ bottom line in many ways:
- Cost to locate, recruit and train a replacement – all three are separate with their own time lines.
- Loss of the executive’s contribution to earnings – Which means the costs in #1 are being absorbed with reduced cash flow.
- Present value of lost business earnings until #1 and #2 have been completed and replaced.
Locating and hiring: Executives and high-performers – those that can impact the business growth trajectory – are hard, and expensive, to locate and hire. Executive search firms’ costs vary considerably; it would not be unusual for the fee to equal 50% of the executive’s first-year compensation.
Training: Getting a new executive ‘up to speed’ includes not only training costs, but costs to compensate for the mistakes the replacement might make before being able to function at the same level as the former executive.
How to Value a Key Executive
Revenue has two sources: Money working and people working. The necessity for putting a value on an executive’s ability has given rise to different methods of valuation:
- Contribution to Earnings
Typically, the 5-year average return on assets at book value is subtracted from the business’ 5-year average pretax earnings. The result provides the level of earnings based on management skill, which in turn are assigned to each member of the management team and multiplied by the time required to get up t speed.
- Key Executive Salary:
Under this method, the executive’s duties are grouped into two categories: (1) routine, and (2) duties that require special talent or expertise. The steps are as follows:
- Begin with the key executive’s salary
- Identify routine tasks performed by the key executive
- Determine the annual salary that would be to hire a replacement for performing only those routine tasks
- Key executive’s value would be determined by subtracting the results in Step 3 from Step 1.
- Present Value of Lost Business Earnings
This method is simply estimating the anticipated lost earnings resulting from the loss of the key executive. The present value of those lost earnings is then added to recruiting and training.
- One Year’s Business Earnings
This method has less credibility simply because it’s not based on any actual or perceived value the key executive might have to the business.
Remember to add executive search and training costs to any valuation method you use.
Funding Search, Replacement, and Training with Life Insurance
Typically, businesses don’t have a non-working capital set aside in a sinking fund in order to self-insure the loss of a key executive. This is why insurance is frequently the choice as a funding mechanism. It’s a ‘risk-transfer’ vehicle: Employers pay insurance companies to take the risk.
In typical arrangements, the employer is the:
- policy applicant, and owner
- premium payer
- beneficiary of the death benefit
The key executive is simply the insured and has no rights in the policy. The death benefit is tax-free to the employer provided notice and consent requirements have been met AND the key executive dies during the period of employment (or within 12 months of such employment), OR the key executive was a director or highly compensated employee when the policy was issued, even if no longer an employee at the time of death.
What Kind of Insurance
Where affordability is an issue: Term life, but with the understanding that a subsequent conversion to permanent life insurance will be done if possible. Reason: Term insurance has an expiration date, while the term of employment does not and the executive may no longer be insurable at that time. In addition, renewing the term insurance would result in higher rates.
Where seasonal or unexpected cash flow changes are an issue, whole life should be avoided in favor of universal life insurance, which allows for flexible premiums and can be designed with cost structures similar to term.
Where supplemental retirement benefits are desired, permanent insurance may be the best choice. Under this arrangement, key executive life insurance does ‘double-duty’ as a supplemental employee retirement plan (SERP) arrangement. You can learn more here.
While whole life insurance generally has the strongest guarantees, it’s also not as flexible and therefore less attractive to most business owners who tend to favor universal life insurance, which allows the employer to:
- increase or reduce premium payments – or pay none at all – depending on the business’ cash flow at the time the premium is due and its interest in increasing the policy’s cash value.
- Take cash withdrawals on a favorable FIFO tax basis under which all cost is withdrawn tax-free before any taxable gain is taken.
- Increase (with evidence of insurability) or decrease the policy’s death benefit to meet business needs.
Premium payments for life insurance are not tax deductible to the employer if the business is a beneficiary under the policy, either directly or indirectly.
Disability insurance premiums are not deductible either, but for a different reason: Since the benefits received under a key executive disability policy are not taxable, no deduction is allowed for premium payments.
Important: No level of premium payments to a universal life policy (unless there’s a secondary no-lapse guarantee) will ensure the policy will remain in force for the insured’s entire life. Insurers do have the legal ability to increase insurance rates and expense deductions, which could have an effect on policy cash values. If minimum premium payments are made for a short time and cash values are relied on to keep the insurance in force, insurance costs could use up the cash value over time.