At a recent meeting with the founding attorney of a successful law firm, the lawyer lamented, “The trouble with my business is that my key assets all go home at night!”
His point underscores the challenge facing service firms.
Traditionally, we think of the key assets of a business as the capital assets (such as the factory and equipment), or the operational assets (such as the inventory). But if you’re a law firm, a web design company, a literary agent, or … shall I go on? … any kind of firm where human capital is the key driver, the term “key asset” has a different meaning. For so many of these firms, their key assets breathe oxygen, drive their own cars and break down from non-mechanical reasons.
So how do you protect your business when your key assets go home at night? How does Berkshire Hathaway protect itself from the loss of Warren Buffett, and how does the local Smith and Jones law firm deal with a possible loss of its top rainmaker?
First, you have to quantify the risk. Losing a $1 million factory calls for a $1 million indemnity policy. Losing a key salesperson calls for some kind of indemnity plan as well, but for how much? And when does it apply? With the growth of the service sector, we’ve seen a growth in key person life and disability insurance policies — coverages that pay a death benefit if the key person dies or a disability benefit if the key person is no longer able to perform his or her services because of an accident or illness. Insurers have been more willing to issue these death and disability policies, and employers have become more comfortable with adding them to their risk management plan. But again, how to quantify?
In the business environment, we need to remove the emotion involved in assessing the human life value. The fact is that the risk of losing a key employee can be quantified, and insurance can be purchased to protect the company. Let’s take the example of a firm with three key employees: Jane, a 53-year-old smoker; Sam, a 50-year-old nonsmoker; and Chris, a 49-year-old nonsmoker.
Using an actuarial table that assesses mortality risk, the chances that Jane, Sam and Chris all live to their respective ages of retirement (let’s assume that is age 65) is over 75%. But let’s look at this glass from the half-empty perspective: the chances that at least one of these key assets will not survive to retirement is more than 24%.
Putting emotion aside, there’s a 1 in 4 chance that a death will occur before corporately desired. If you are the risk manager for your firm, these are fairly high odds that you may lose one of your key assets before "planned obsolescence." In other words, they die before retirement.
Now that the risk has been quantified, there needs to be a risk control indemnity plan. Just as a company would do for its non-air breathing assets, it’s time to make an assessment and devise a risk management plan. Some basic elements to get started with developing a plan:
- Determine the risk. Insurance companies can help with mortality modeling.
- Determine the potential loss. Assess what it will cost the firm if the employee is lost:
- Lost sales and/or profits?
- Cost of replacing the key person?
- Loans that may be called?
- Determine ways to protect the firm from the loss.
- Create a management succession plan.
- Document and protect what the employee contributes and knows.
- Determine ways to indemnify the firm.
- Purchase “key person” life insurance on the employee’s life.
- If the employee is uninsurable or near retirement, set up a sinking fund to level out the effects of cash flow.
It may sound brutally cold to put numbers to a sentient being, but the simple fact is a business can suffer more financially from losing a key employee than from the loss of virtually anything else in its arsenal of assets. If you care about your business and the people who own, work for, and invest in the business, maybe you should protect the firm from the financial loss of those assets who can drive themselves home at night.
For more on key employee insurance, see: