One of the greatest tests for a business is how it would cope if faced with the sudden absence of a key business leader. Whether it’s an owner, director, or CEO, the premature death or extended incapacity of a crucial employee due to illness or disability can severely disrupt operations and threaten the survival of the business.
Surprisingly, research indicates this is a common occurrence—on average, approximately 7 CEOs of publicly-listed companies pass on each year; of which 75% are sudden and unexpected. While cancer, heart attack, and stroke are the most frequent causes, automobile or airplane accidents and other incidents are also common1.
To plan for the unexpected, HR Directors have now placed contingency measures for the loss of key persons firmly on their agenda. This makes sense, given the impact to business results—for SMEs, sales on average drop 60% in the four years following the death of a CEO2. For listed companies, the loss of investor confidence could mean a share price plunge. One example of this was when the shares of computer chip-maker Micron Technologies fell 2.8% the day its CEO Steve Appleton died in 20123.
How can businesses mitigate this risk?
A Key Person Insurance policy protects the business in the event of loss of its most valuable assets—its crucial employees. The policy is taken out by the company, not the individual, and compensates the business for financial losses that would likely arise if something unexpected happens to its key person or persons.
Unlike other business insurance policies, key person insurance does not indemnify the actual losses incurred—which is a commonly held myth. Rather, it compensates the business with a fixed monetary sum as specified in the insurance policy.
The company would then use this fixed monetary sum to offset the likely costs. This could include items such as recruiting a worthy successor and managing public perception, as well as other losses such as individual expertise, risk of losing key contacts, and a decrease in productivity until successors are fully established.
Pitfalls to avoid
When calculating the insured amount, there are several approaches in determining the appropriate sum assured—it’s important to ensure that the payment limit is sufficient. Additionally, insurers will also apply a cap to the fixed monetary sum that depends on a key person’s age, lifestyle, health, and their contribution towards company revenue or profitability.
Here’s how it works:
Sum assured of a Key Person based on the ‘multiple of salary’ approach
The greater the contribution of the key person, the more severe the loss and higher the cost of replacing them. This approach takes into account the key person’s annual salary, including the value of any benefits, and applies a multiple to that annual amount. Insurance underwriters will typically look at a multiple of 5 to 8 times the annual compensation.
Mr Chan, Group Sales Director of a specialist semi-conductor business has an income of $200,000 per annum. The Board agrees that that, due to the revenue he brings in for the company per year and the valuable contacts he has in the industry, they will seek cover for a multiple of 8 times his annual salary—amounting to $1.6 million.
1 Between 1977-2000. Sudden deaths of CEO – Stanford Business School, 3 June 2012
2 Surviving after death of an owner – Forbes, 26 February 2013
3 http://www.usatoday.com/story/money/markets/2013/04/18/apple-crash-steve-jobs/2094379/ on 8 May 2014
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