A worksheet for sizing key person coverage at a small firm

The right amount of key person coverage is the sum of what the company would plausibly lose, spend and owe in the months after the person dies, not a multiple of their salary. You get there by estimating five pieces separately (lost profit, recruiting, the productivity gap, debt tied to the person, and the recovery period that multiplies them), adding them up under a low, a base and a high case, and then choosing a policy length that matches how long the exposure lasts. This worksheet walks through each step with a hypothetical firm and leaves blanks for yours.

Before you start: what you are measuring

key person insurance pays the company, not a family. That changes the question. A family asks how much income must be replaced. A company asks: if this one person were gone tomorrow, how much cash would it take to keep the doors open, find and train a successor, keep lenders calm and ride out the dip in revenue?

Two cautions before the arithmetic.

First, the number is an estimate of a loss that has not happened, so it should be written down with its assumptions. An insurer's underwriter may ask how you arrived at the amount, because the company must have a genuine financial stake in the person's life (the insurable interest: who can buy life insurance on whom rule). A coverage amount supported by a worksheet is easy to defend. One pulled from the air is not.

Second, this is a sizing exercise, not a pricing one. Premiums depend on the person's age, health and the term, and you will get them from quotes. The worksheet tells you what to ask quotes for.

Gather these before starting: the last two years of profit and loss statements, a list of the person's customer relationships or technical duties, current loan and lease balances, any personal guarantees the person has signed, and the compensation of the person and of a likely replacement.

The hypothetical firm used throughout

Say a 14-person commercial HVAC contractor has one senior estimator, Priya, age 51. She prices and wins most of the firm's larger bids and holds the relationships with three general contractors who send repeat work. The owners estimate that her bids account for about 60 percent of revenue. The figures below are invented to show the method. They are not benchmarks for any trade, and they are not a recommendation about how much any firm should carry.

Step 1: Describe exactly what the person does that others cannot

Before any number, write three or four sentences answering: what would stop happening, and how fast?

For Priya the list is: (1) large bids stop being priced, so the backlog starts to thin within a couple of quarters; (2) three general contractors lose their point of contact; (3) a lender who knows her name sees a guarantee with no guarantor behind it; (4) two junior estimators lose their mentor.

This description does two jobs. It tells you which of the later steps even apply (a founder who guarantees no debt can skip step 5), and it becomes the explanation you give an underwriter or a lender if they ask why the coverage amount is reasonable.

Step 2: Estimate lost profit

Lost profit is usually the largest piece, and it is the one most often guessed at. Break it into a percentage drop and a duration.

1. Start with a normal year's profit after paying everyone at market rates. Use a figure that already includes a market-rate salary for the owners, so you do not double count the person's pay as both a saving and a loss.
2. Estimate the percentage by which profit would fall in year one, year two and year three, if at all.
3. Multiply each percentage by annual profit and add the years.

For the HVAC firm, the base case is a 50 percent drop in year one and 25 percent in year two:

• Year one: 50% of $360,000 = $180,000
• Year two: 25% of $360,000 = $90,000
• Lost profit, base case: $180,000 + $90,000 = $270,000

Run the same arithmetic for a low case and a high case, because the honest answer is a range:

Your blanks: annual profit $______; year one drop ___% = $______; year two drop ___% = $______; year three drop ___% = $______; total lost profit $______.

A check on honesty: if you assume the drop starts at the very moment of death, you are assuming no one else can step in. If you assume the drop is tiny, ask why the company is considering the insurance at all. The three cases together give a reasonable bracket.

Step 3: Add the cost of finding a replacement

A replacement for a person with unusual skills rarely appears on its own. Cost items typically include a recruiter or advertising, interview time, relocation help for someone from another city, a signing bonus if the market demands one, and the cost of covering the work with contractors until the hire starts.

For the example, the owners choose figures they could document with quotes from a recruiter and a relocation provider:

• Low: $20,000 (hire from the local market)
• Base: $30,000 (recruiter fee plus modest relocation)
• High: $45,000 (a longer search and a signing bonus)

Do not include the replacement's ongoing salary here. A replacement is paid out of the profit that remains, and the profit figure in step 2 already assumes full staffing at market pay.

Your blanks: search and advertising $______; relocation or signing bonus $______; interim contract help $______; total $______.

Step 4: Add the productivity gap

A new hire does not equal the person they replace on day one. For some months you pay a full salary for partial output. The cost is the unproductive share of the replacement's pay.

The example uses a $110,000 replacement salary:

• Low case: three months at 50 percent productivity. Pay for three months is $110,000 × 3/12 = $27,500, and half of that, $13,750, is unproductive. The owners round to $15,000.
• Base case: six months at 50 percent. Pay for six months is $55,000, and half, $27,500, is the gap.
• High case: twelve months at 50 percent. Pay is $110,000, and half, $55,000, is the gap.

Be wary of double counting with step 2. If your lost-profit percentages already assume a slow ramp-up, do not charge the same slow ramp-up again here. A simple rule: step 2 captures revenue the firm never wins, and step 4 captures wages paid for work that is not yet being done.

Your blanks: replacement pay $______; months to full productivity ___; average productivity during ramp-up ___%; gap = pay × months/12 × (1 minus productivity) = $______.

Step 5: Add debt that depends on the person

Debt is the piece with the sharpest edges, because lenders can react quickly. Look for three kinds:

• Personal guarantees. If the person signed a guarantee, the lender may look to their estate and to the company when they die.
• Key person covenants. Some loan agreements name individuals whose continued involvement is a condition of the loan. A death may be a default event. Read the covenant language, or ask your lender or attorney to.
• Loans that are repaid from the person's work. A construction line of credit that is paid down from jobs only that person wins is effectively tied to them.

Some lenders ask for a pledge of the policy itself, a collateral assignment of life insurance; the Life insurance for an SBA loan guide covers the version found in small business loans.

In the example, the balance on the guaranteed line and equipment loan is $180,000. The owners count all of it in the base and high cases. In the low case they assume the lender would keep the loan performing because the company is profitable and the covenant does not require repayment, so the debt line is $0. That is an assumption to confirm with the lender, not a safe default.

Your blanks: guaranteed debt $______; debt with a key person covenant $______; debt the company could not repay without the person's work $______; amount to include $______.

Step 6: Choose the recovery period honestly

The recovery period is the thread that connects steps 2 to 4. It is the time between the loss and the point where the firm is again earning roughly what it did before, even if with different people.

Ask three practical questions:

1. How long does it take to hire someone qualified in this field? Three months? Nine?
2. How long does it take for that person to be trusted by your best customers or by regulators and licensing bodies?
3. Is there a deputy who could cover part of the role immediately, or is the knowledge in one head?

If the answers are "six months, another year, and no deputy," a three-year high-case window is realistic. If the person has a capable second-in-command who already runs half of the relationships, the low case may be fair. Whatever you pick, put it in writing with the date and your reasons. Those notes become the file you keep with the policy.

Step 7: Add it up and choose a range

Now combine the pieces for each case.

Check the arithmetic: low is $180,000 + $20,000 + $15,000 + $0 = $215,000. Base is $270,000 + $30,000 + $27,500 + $180,000 = $507,500. High is $432,000 + $45,000 + $55,000 + $180,000 = $712,000.

The range is wide, as it should be. The owners can now have a sensible conversation: coverage of $500,000 roughly matches the base case. Coverage of $250,000 would leave the firm exposed if the loan is called. Coverage of $700,000 would cover nearly everything but costs more in premium.

A few ways owners narrow the range:

• Insure the base case and plan for the rest. Keep $500,000 of coverage and a credit line that does not depend on Priya's guarantee.
• Stack coverage. Buy two policies with different lengths so the amount steps down as debt shrinks. That is the idea behind a term ladder; see how long a term should you buy: 10, 20 or 30 years.
• Look at the person's value, not just the loss. The human life value calculator frames a person's economic contribution over their working life. It is a personal tool, not a company one, but the thinking is similar: what flows from this person's work.

Your blanks: low $______; base $______; high $______; amount to apply for $______.

Step 8: Match the policy length to the exposure

Coverage amount answers "how much." Length answers "for how long."

Make a simple timeline of when each exposure fades:

• The loan balance falls each year as it is repaid. If it is paid off in seven years, the debt piece disappears then.
• The relationship risk fades once a successor owns the key accounts. If Priya is training a junior estimator who could take over in eight to ten years, that is when the profit piece fades.
• The person's own retirement date caps everything. Exposure rarely continues past it.

For the HVAC firm, the owners see a 10-year horizon: seven years for the debt, a few more to build a successor. A 10-year level term insurance policy would match that. Because the cost of term life insurance is lowest for the shortest term that covers the need, the owners should compare 10-year and 15-year quotes and ask whether the policy has a conversion privilege in case the need extends. They should not buy a 30-year term just because it is available.

Some firms use permanent coverage because the person will always be central, or because the cash value serves other goals. The trade-offs are covered in key person life insurance. The point for this worksheet is to choose deliberately rather than by default.

Step 9: Document, then check the legal steps

Once the number is chosen, the paperwork matters more than the arithmetic.

• Written notice and consent first. Because the company is the owner and beneficiary of a policy on an employee, the tax-free treatment of the death benefit depends on notice and consent before the policy is issued. See section 101(j) notice and consent and the companion checklist, the notice and consent checklist for employer-owned life insurance.
• File the worksheet. Keep the assumptions, the three cases and the date with the policy file.
• Revisit it. If the debt is paid down, the person retires, or the business doubles in size, the worksheet needs rerunning. The same discipline appears in what to check and when in a buy-sell agreement's yearly review for ownership agreements.
• Ask a professional. A CPA can confirm how premiums and proceeds are treated for your entity type, and an attorney can review any loan covenants and the consent forms.

Common ways the worksheet goes wrong

• Insuring salary instead of loss. A person paid $120,000 may be worth far more than that to the firm, or far less. The loss, not the paycheck, drives the number.
• Counting the same dollar twice. Lost revenue, lost profit, and slow ramp-up overlap. Pick one measure per step.
• Forgetting that death proceeds are not the only help. A line of credit, an owner's willingness to defer pay, or customers who stay loyal all reduce the true gap. Count what you can verify.
• Ignoring disability. Key person policies pay on death. A person who is disabled but alive creates a similar loss without a death benefit. A separate disability arrangement may be worth discussing with a professional.
• Setting and forgetting. The right amount in year one is rarely the right amount in year seven.

Key takeaways

• Size key person coverage from the company's likely loss: lost profit, recruiting, productivity gap and debt, each estimated on its own and added up.
• Run a low, base and high case rather than a single figure, and write down the assumptions, since an underwriter or lender may ask for them.
• In the example, the cases total $215,000, $507,500 and $712,000, which shows how much the answer moves with the recovery period.
• Choose a policy length that matches when the debt and relationship risk fade, and ask about conversion rights if the need could last longer.
• Get written notice and consent before the policy is issued, keep the worksheet with the policy, and rerun it when the business changes.