For many business owners, securing life insurance on a key employee feels like a task completed. Once the policy is issued and the first premium is paid, the coverage is often treated as a permanent safeguard and rarely revisited.
But key person insurance is only as effective as the assumptions behind it. When coverage is based on rough estimates—or allowed to sit unchanged while a business grows—the policy can give leadership a false sense of security while the actual protection falls far short of what the company would truly need.
Conversations that uncover the company’s real risks and financial exposure can open the door to stronger protection for the business and a deeper relationship between the producer and the business owner.
The First Misstep: Undervaluing the Cost of Loss
Key employees are not limited to owners or executives. They encompass anyone whose sudden absence would immediately derail cash flow or operations—a VP of Sales who personally manages the company’s top accounts, the lead engineer who is the only employee fluent in the company’s proprietary code, or the Director of Operations whose decades-long vendor relationships keep supply chain margins intact.
When an owner takes out a key person policy on these individuals, the death benefit is usually calculated using a straightforward metric, such as five to ten times their current annual compensation. Small and medium-sized businesses (SMBs) are especially likely to rely on this simple salary-multiple estimation because they often lack the time or resources required to perform a rigorous, in-depth business valuation. However, while this method provides a baseline, it rarely captures the full financial impact of losing a top performer.
This gap between a simple estimate and the true economic impact of losing a key employee often becomes clear when producers walk business owners through the operational realities of that loss. According to HR and financial industry estimates, the hard cost of replacing a key executive—headhunting, hiring, and training—can reach up to 200% of their base salary. In addition, the business often must absorb compounding operational hits such as:
• Lost revenue—a dip in sales, production, or operational efficiency while the position remains vacant—especially likely after the loss of a founder or top salesperson, and potentially eclipsing initial hiring costs
• Client attrition—the loss of key client or vendor relationships that the key employee had built and nurtured
• Financial disruption—reassessment of credit and loan terms if lenders or investors viewed the key employee as critical to the company’s financial stability
Determining the right value for a key person insurance policy is extremely important but also difficult. It’s easy to see why the shortcut multiples-of-income method is so often used. For a more accurate picture, though, companies should consider industry best practices and apply one of the following methods:
• The “cost to replace experience” method. Start with the key employee’s salary, subtract the salary that would need to be paid to a replacement to perform the same duties, and multiply this by the number of years it will take to recruit a replacement and bring that person up to the key employee’s current level of experience.
• The “contribution to earnings” method. Estimate the loss of annual earnings the employee’s death would likely create, multiply that by the key employee’s estimated remaining working years (a number that may be limited by underwriting guidelines), then multiply that by the present value factor for $1 per year (using a reasonable rate of interest to discount future earnings).
The Second Misstep: Failing to Regularly Review Coverage
Even a policy that was well-valued at inception can quickly become inadequate. A policy purchased five years ago for a rising star in a growing company isn’t likely to reflect their value today as a more seasoned executive in a larger, more successful company. As the business expands, the financial gap between that initial death benefit and the employee’s economic footprint may widen dramatically.
For example, suppose that five years ago, an SMB purchased a $500,000 policy on its primary salesperson—a value thoughtfully determined and sufficient to cover the costs of recruiting an experienced salesperson and making up for lost revenue. Since that time, the company has doubled its sales and now relies heavily on the covered employee to sustain the new operational volume. If the key salesperson dies, the company will discover that the policy value that worked when the company was grossing $2 million annually is outdated now that the company is generating $5 million a year.
Ultimately, an underfunded policy may fail to provide the liquidity bridge a business needs when tragedy strikes, possibly forcing the owners to dip into critical cash reserves, halt expansion plans, or take on unfavorable debt just to keep the doors open.
Guiding the Conversation
The most productive conversations with business owners begin with operational realities. During a standard annual review, producers can use open-ended discovery questions to help the owner realistically assess their risk and clearly see any current coverage gaps. Ask directly how much the company would need to absorb the financial shock of a key employee’s loss—or how much the company would need today compared to when an existing policy was purchased.
This is a conversation focused on protecting the company’s current revenue streams. Insurance can provide that protection if it is properly valued and adjusted over time. The goal is for the company’s safety net to grow right alongside its success.
