How Much Key Person Life Insurance Do You Need?

When we figure out how much life insurance coverage a key person needs, we're estimating a bunch of variables, so the final answer has a bit of volatility. We're going to look at two ways to reduce the volatility in our estimate. First, we are going to look at ranges in our calculations. Secondly, we are going to vary the mechanism of our estimates (basically, we're going to use a couple of different calculators and compare the answers).

Method 1: Multiple of Income

The first and common way of estimating the amount of coverage on a key person is a simple multiple of income. We start with 5–10X.

The most common assumption, and readily accepted by underwriters is just 5X the key person's income.

If you assume that there are non-standard factors (like loans) that would require an increase from the commonly accepted multiple, you can use that factor instead.

If you start approaching 10X multiples we will need to justify this in more detail – a rough estimate will no longer suffice. In that case we can start with the 10X multiple but will need to back it up with the second method – the underwriters will want to see some specific justification as to why we've deviated from common practice.

In summary, estimates of 5 to 10 times income is a good starting point for our estimates.

Method 2: Business Impact

This method is more exact than the multiple of income, or at least it takes into account specific losses and additional costs.

In this method we look at the following factors:

• Replacement cost (recruiter fees, increased salary of new key person × some years)
• Sales impact – lost salesperson
• Loans and line of credit tied to the key person
• Estimates of any other indirect costs

You can also jump to our online calculator for “how much key person insurance do I need?”

Method 3: Loan Coverage

Not really a direct comparison against the first two methods, this is often a requirement for business loans. Your corporation takes out a loan, the lenders require that the key person get life insurance.

Of course that's an easy calculation, it's just the amount of the loan.

In this case there are some additional considerations we will cover later; specifically tax treatment of key person life insurance (in some cases, the premiums may be tax deductible) and collateral life insurance for loans (we only want to pay off the remaining balance of the loan, any remaining life insurance proceeds should go to the corporation).