A small business can plan for the retirement of someone who makes a substantial contribution to its success. But the death of a key person can spell real trouble, especially if this person also happens to be one of the principals.

A ready solution to this problem may be found in key person insurance. Under this plan, which is available to unincorporated businesses as well as corporations, the company owns, pays for, and is beneficiary of insurance on the life of a key employee. The insured employee may also be an owner or major shareholder. The insured has no ownership rights under the policy. Depending on age and health, the insurance is usually purchased with cost-effective dollars.

A business has an insurable interest in the life of a key employee, but it is not an unlimited interest. Although a number of key person valuation methods are available, the following guidelines can be used in estimating the amount of insurance needed:

• How much would it cost to recruit, hire and train a suitable replacement?
• How much would it cost to replace revenue lost if the employee died today?
• How much would it cost to replace the employee's contribution to net profits?
• How much of these costs is the business willing to cover?

Many companies simply arrive at an indemnification figure by multiplying the key employee's annual salary by five.

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