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Calculating key employee cover

Working out the sum assured needed for each key employee is not an exact science. This article outlines the key considerations.

When determining how much cover is needed the areas to consider are:

  • the potential loss of profits
  • the potential loss of business contacts and goodwill
  • a reduction in turnover
  • the possible loss of confidence in the business by its bank or other investors, who could then withdraw their financial support or recall loans
  • a possible problem with the business’s suppliers, who might withdraw credit or tighten their terms of trading
  • the knowledge and expertise which will no longer be available to the business, even for the time while the key employee is ill
  • the effect on potential investment, such as a management buy-out, expansion plans and industrial relations
  • the cost of recruiting and training a replacement, and the time it may take to do this
  • different levels of life cover and critical illness cover. The event of death or critical illness could affect the business in different ways, so different levels of cover may be required.

Other considerations include how long it would take the business to recover, and the costs that the business would have to bear during such a recovery.

Which method should you use?

There are several different methods to use when calculating cover, however, where the cover is taken out to cover a loan, the cover for each person is usually equal to the amount borrowed.

Apportionment method

This uses an average of the last three years’ pre-tax profits, less any exceptional or extraordinary items. Normally, someone inside the company will be able to allocate the profits between the key personnel, based on their individual contribution to the business.

The advantage of this method is that it can be simple, and related to the company’s profits. However, the disadvantage is that it uses a subjective assessment of the key employee’s contribution to the company’s profits.

Salary method

This method uses a straight multiple of the key person’s full salary package, including their pension, company car and any other benefits in kind. This method can be simple to work out and understand but does not take loss of profits into account.

Example:

  Total salary package

  £50,000 a year

  Chosen multiple 

  the normal multiples are:
  up to 10 for life cover
  up to 5 for critical illness cover

  So the cover needed is

  £50,000 x 10 = £500,000 (or (£50,000 x 5 = £250,000)


Loss of profits method

This method uses a straight multiple of the business’s profits. This can be based on either the net or gross profits. It is simple, but does not take fixed costs into account.

Payroll method

The total salary package is divided by the business’s total payroll, multiplied by the yearly gross profit and the number of years the business believes it will take to recover from the loss of the key employee.

It can reflect the true situation more accurately, but the key employee’s total salary package must be shown to be reasonable within the marketplace.

Example:

  Total salary package

  £50,000 a year

  Total payroll

  £2 million a year

  Gross profit

  £10 million a year

  Number of years to replace
  key employee

  3 years

  So the cover needed is

  £50,000/£2,000,000 x 3 x £10,000,000 = £750,000


Financial underwriting

In most circumstances there will not be a need for any further financial information than that on the application form. However, for sums assured above a certain amount, say £600,000, you may need to provide more information before a case can be underwritten.

In certain cases, for high sums assured, additional medical evidence may be required

The information provided in this article is not intended to offer advice.

It is based on Old Mutual Wealth's interpretation of the relevant law and is correct at the date shown at the top of this article. While we believe this interpretation to be correct, we cannot guarantee it. Old Mutual Wealth cannot accept any responsibility for any action taken or refrained from being taken as a result of the information contained in this article.

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