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Risky Thinking
On Risk Management, Business Continuity, and Security
24 June, 2017
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Key People Never Die

When does key person insurance make sense? A look at some of the reasons why Key Person insurance is not always a good risk management strategy.

A risk for many smaller companies, and even some large ones, is the loss of a key person. Valuable knowledge and contacts vanish instantly. The company incurs costs as a replacement is recruited and trained. There is uncertainty as the position is filled. Creditors and customers become nervous because they thought of the person as the company.

Ask an insurance salesman, and the answer to dealing with this risk is key person insurance. The company takes out key person insurance — a life assurance and disability policy payable to the customer in the event that a specified key person dies or is disabled.

Does this approach effectively manage the risk?

There are a number of problems if this is our entire approach.

Firstly, ask yourself which is more likely: that the person dies next year or that the person leaves the company? A quick look at life expectancy tables can give us half the answer. For somebody under 65, the chances of dying in the next year are under 2% in the tables I'm looking at, significantly less if they are female. From personal observation, the chances of someone leaving a company through their own or their board of director's volition are an order of magnitude higher. Insurance does not help with this more likely eventuality.

The second problem is that key person insurance rarely actually covers critical people. The designer who is responsible for the success of a product range; the guy in technical support that holds the team together; the employee who knows everything there is to know about running the company on a day to day basis, but never made it to the senior management team. None of these are typically covered. Key person insurance is too often regarded as a badge of senior management. Senior management must be critical, otherwise we wouldn't pay them so much, would we? And if we let other staff know that they are critical, then we would have to pay them more too, wouldn't we?

In one place I worked, I watched the technical support department disintegrate after one key employee left. He wasn't the highest paid employee, nor was he particularly outstanding technically. He would never have been seen as a candidate for key person insurance. But what he provided to the department was the vital social glue that kept the department a fun place to be and work. After he left, the department lost its soul. The other members of the department started looking for new jobs and, within a year, they were all gone. Their knowledge went with them.

So how should we protect ourselves against the risk of loss of a key person?

There are two things we must do. First, we need to ensure that critical knowledge is shared and, where possible, documented. We need a system or systems in place that ensure that knowledge cannot disappear with the loss of a single person. This might involve pairing on jobs; the provision of executive assistants (real secretaries, not typists); the creation of procedures which advise people how to perform their jobs.

Second, we must ensure that critical staff are identified and paid and treated well. The grass should never look greener on the other side of the fence for the staff we particularly need to keep. When we evaluate staff, we should not look just at technical, sales, or managerial skills. We should also look at whether the person is critical to their group's happiness and well-being. Remember that providing people are reasonably paid, money is rarely the reason they decide to move jobs. Sometimes it's the nature of the work, or a lack of perceived personal growth. But more often it's lack of appreciation, or blind indifference.

Does this leave a place where Key Person Insurance makes sense as a risk reduction strategy? Yes, but it's a short-term strategy, not a long-term one.

If you have someone with major external visibility who is the focus of much of your marketing, such as the late Dave Thomas, CEO and pitchman of the Wendy's restaurant chain, then it makes sense to hedge against the risk of having to replace an entire marketing campaign. It's as if you were shooting a movie with your CEO as star, and you were worried about sickness or death forcing you to scrap the movie. Key Person insurance should be a strategy for the short term with limited objectives. It may help finance a replacement marketing campaign, but it certainly won't save the company.

Michael Z. Bell
March, 2005

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