Valuation Methods — Income Multiplier, Replacement Cost, Contribution to Profits
Three commonly described ways of estimating how much keyman cover a business's loss would justify: a multiple of compensation, replacement cost and contribution to profits. All are underwriting conventions, not rules, and every figure here is an assumption.
What is being measured
Sizing keyman cover means estimating the financial loss the business would suffer if the key person died. No legal or IRDAI formula or multiple of salary for this has been identified, and insurers apply their own financial underwriting. Three approaches are commonly described, and each looks at the loss from a different side.
They are underwriting conventions that vary by insurer. No multiple or formula is a rule, and each insurer assesses the proposed sum assured through its own financial underwriting.
The three approaches
Multiple of compensation. The person's annual pay is multiplied by a chosen number. It is quick, but it starts from pay. Where a founder draws a modest salary and yet accounts for a large share of profit, it can understate the loss.
Replacement cost. This adds up the cost of finding a successor, the cost of training that person, and the business lost in the meantime.
Contribution to profits. This works from what the person adds to earnings, not from pay. The profit the person is expected to add over a chosen period is discounted to a present value, using discounted cash flow (DCF) analysis.
Why discounting is used
A rupee received five years from now is worth less than a rupee received today, because today's rupee could be put to use in the meantime. Discounting converts each future amount into its value today. That is why the present value of a stream of future profits is less than their simple total.
The projection period and the discount rate are assumptions chosen by whoever prepares the estimate. Neither is prescribed, and a different rate or period gives a different answer.
Illustration: the same person under two simpler approaches (all figures assumed)
Suppose a key person is paid ₹40 lakh a year. If the estimate uses a multiple of 5, chosen only for this illustration, the figure is 5 × ₹40 lakh = ₹2 crore.
Now take replacement cost, with assumed figures of ₹15 lakh to recruit a successor, ₹10 lakh to train that person and ₹75 lakh of business lost in the meantime: ₹15 lakh + ₹10 lakh + ₹75 lakh = ₹1 crore.
The two approaches give different answers for the same person. Neither is the correct one; they are different views of the loss, and the insurer's financial underwriting decides what sum assured it will accept.
Contribution to profits by discounted cash flow (assumed figures)
- Assume the key person adds ₹3 crore a year to profit for 5 years, received at each year-end, and use an assumed discount rate of 10% a year.
- Year 1: ₹3 crore ÷ 1.10 = ₹2.7273 crore. Year 2: ₹3 crore ÷ 1.21 = ₹2.4793 crore. Year 3: ₹3 crore ÷ 1.331 = ₹2.2539 crore.
- Year 4: ₹3 crore ÷ 1.4641 = ₹2.0490 crore. Year 5: ₹3 crore ÷ 1.61051 = ₹1.8628 crore.
- Sum: 2.7273 + 2.4793 + 2.2539 + 2.0490 + 1.8628 = ₹11.3723 crore.
- Check with the annuity factor: (1 − 1.10^-5) ÷ 0.10 = (1 − 0.62092) ÷ 0.10 = 3.7908, and ₹3 crore × 3.7908 = ₹11.3724 crore.
Result. The present value is about ₹11.37 crore, less than the simple total of 5 × ₹3 crore = ₹15 crore because later amounts are discounted.
Key points
- Sizing keyman cover means estimating the business's financial loss on the key person's death.
- Multiple of compensation starts from the person's pay and can understate the loss where pay is low relative to contribution.
- Replacement cost adds the cost of finding and training a successor and the business lost meanwhile.
- Contribution to profits discounts the profit the person is expected to add to a present value, by discounted cash flow analysis.
- The discount rate and projection period are assumptions, not prescribed figures.
- All three are underwriting conventions that vary by insurer; none is a rule.
Common misunderstandings
- A multiple of salary is not to be read as a regulatory figure: no regulatory multiple has been identified, any multiple is an insurer convention, and insurers differ.
- The contribution to profits figure is not the simple sum of future profits: each year's amount is discounted to present value.
- A 10% rate or a 5-year period is not a standard: both are assumptions and change the result.
- An estimate prepared by the business is not the sum assured: the insurer's own financial underwriting decides what it accepts.
Questions people ask
Which approach suits a founder with a small salary and a large share of profit?
The contribution to profits approach works from what the person adds to earnings, so it does not depend on pay; a multiple of compensation could understate the loss in such a case.
What does DCF stand for?
Discounted cash flow: future amounts are converted into present value using a discount rate.
Does IRDAI prescribe any of these methods?
None has been identified: no IRDAI formula or multiple of salary has been found. The methods are underwriting conventions that vary by insurer, and each insurer applies its own financial underwriting.
What this lesson relies on
- Insurers' financial underwriting practice for keyman proposals (conventions that vary by insurer; no regulatory formula identified)
This lesson was reviewed independently against these sources on 8 October 2026. Rules change: check the current regulation, scheme document or policy wording before relying on any figure. This is education, not advice.