How do I calculate the level of key person cover needed?

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There are usually three ways of arriving at a suitable level of key person cover.

Salary-based approach

Method Formula Life/Critical illness Income protection
Salary-based approach Salary x multiple (the multiple is dependent on the benefits chosen) Yes Yes

Notes

This method is based on the assumption that a salary reflects an employee’s contribution to the company. The cover is estimated by multiplying the key person’s total salary, including any benefits. The multiples are different depending on the benefit. For example, life protection is 10x, critical illness and total permanent disability is 5x and income protection is 2.5x.

This method may not be suitable if a key person’s salary doesn’t reflect their contribution to the company’s profits. If they aren’t being paid their ‘true worth’, the estimate of the cover required may be too low. Equally, the cover may be too high if they’re close to retirement. A shareholding employee’s salary might not be linked to their contribution to the business, as they may take a lower salary and dividends. As the cover is to replace loss of profits, it may be more appropriate to link the cover level to the company profits.

Payroll-based approach

Method Formula Life/Critical illness Income protection
Payroll-based approach (Key person salary/total salaries) x sales turnover x expected years to recover Yes No

Notes

This method estimates the key person’s contribution to the company’s profits by dividing their salary by the company’s total wage bill, multiplying that by the company’s sales turnover and then multiplying by the number of years it would take the company to recover. This method may not be suitable for a new or unprofitable company, or if the shareholder is taking a low salary, perhaps because they’re receiving dividend payments instead.

Profits-based approach

Method Formula Life/Critical illness Income protection
Profits-based approach Gross profits x multiple (for example 2) Yes Yes
  Net profit x multiple (for example 5) Yes No

Notes

The cover is estimated by multiplying either the gross profit or the net profit. The typical multiples are two times gross profit or five times net profit. Gross profit is shown in the accounts as total sales less cost of sales or direct costs. Net profit should be taken before tax. Care should be taken with net profits, as some companies will keep these artificially low. This method may not be suitable where several key people are covered, as it may be difficult to determine the contribution each individual makes to profits, although a higher multiple may be justified for a rapidly expanding business.