There are many different ways to protect your business from the unexpected – Howard Coleman examines the ‘what if’ questions all business owners need to consider.
Insurance is part of the risk management strategy of any business. In this article we will look at how life insurances may be considered as part of the risk management strategy of small to medium enterprises (SMEs).
As part of the risk management process we usually ask a series of ‘what if’ questions. For SMEs, these may include:
- • Who will own the business if…
- • Who will run the business if…
- • How will the loans be repaid if…
- • Who will pay the bills if…
For small and medium-sized businesses, these questions are vital, as the success of the business often depends on the energy, drive, and knowledge of a few people, usually the owners of the business. And it is these owners and their families who are most likely to experience the negative financial impact if one of the proprietors were to suffer an ‘if…’
The ‘if’ in these situations is an event on which an insurance policy will pay the sum insured if the person dies, if the person is totally and permanently incapacitated, if the person suffers a trauma (or dreaded disease), or if the person is incapacitated for some period of time.
The role of insurance is to put a predetermined amount of money on the table in case of one of these events. While insurance is unique in its ability to produce a lump of money if something happens, there has to be a need for the insurance cover, or there is no point in having the insurance. In this article we will look at the various business insurance needs and some of the issues owners should consider.
Planning For The Future
This is the ‘Who will own the business if…’ Many people have plans for their business and plans for their retirement. But this issue addresses the question of who will own your share in the business if something were to happen to you.
If the proprietor were to die their shares would form part of their estate and are dealt with in accordance with their will. That will typically mean that either the spouse and/or children will inherit an interest in the business. If this is what the surviving business party and the beneficiaries of the deceased party want, then it’s not an issue. But if the surviving party doesn’t want to be in business with the spouse or children, or if the proprietor wants cash for the business to go to the estate, then we need to do something to make this happen.
The thing we need to do is have a succession planning agreement (often called buy/sell agreements) and a method of funding the sale of the shares in the company to the survivor. Then, we need to have a funding vehicle. There are potentially several funding options, one of which is insurance.
The same issues need to be considered in the event that a proprietor were to become totally and permanently disabled, except that the sale would be from the then disabled partner or shareholder rather than from the estate.
The final issue to consider is that of funding the succession plan. While insurance is generally regarded as the most efficient method, there are other options. These include: using one’s own money, borrowing, paying for an interest by instalment, selling a business interest to a third party as well as insuring. Each of these methods has plus and minus features. A financial planner can help you decide which is most appropriate.
Protecting Key People
This is the ‘Who will run the business if…’ Many smaller businesses are critically dependent on the skill and drive of one or two people to make the business happen and to keep it profitable. This issue addresses the question of how will the books be balanced if something were to happen them.
While insurance can’t put the disabled or deceased key person back into the business it can arrange for a lump of money to be paid to the business to:
• offset the lost revenue that the key person was generating,
• pay for the increased running costs,
• pay market rate salaries for a replacement, or
• have enough money in the bank so that the business may be sold or wound up in an orderly manner.
Getting the sum insured right and properly documenting the purpose of any insurance is critical to having the sum insured paid to the business while avoiding any unnecessary tax on the possible proceeds. Your accountant and financial planner can help you sort out these details.
It can be said that key person protection puts money into the business so that you or your estate has options, rather than simply walking away from the business if something happens.
Loan Debt Protection
This is the ‘How will the loans be repaid if…’ Very few, if any, businesses are debt free, and many small business owners have also given personal guarantees to the lending institution (such as a bank) to secure this loan.
The issues to consider here are:
• how would the business repay the bank loan?
• how would my estate be exposed if the bank were to exercise the personal guarantee?
In some cases the answer may be that there is no potential problem, in other cases the business and/or the estate may be in deep trouble. The purpose of insurance in this environment is to have money paid to either the business or the estate so that it may meet any liability.
Here we need to consider how much the cover should be for. Where the loan debt is a modest amount then insuring for the full amount may be the most appropriate option. However, there are situations where part coverage of the loan debt may be sufficient.
Also, consider who should be the policy owner. Some options are: the business proprietor, the business itself, the lending institution, or the spouse of the proprietor.
Each case is different and your financial planner or accountant can help you determine the most appropriate ownership option for your situation.
Business Expenses Protection
This is the ‘Who will pay the bills if…’ Many people in business understand the importance of income protection insurance that brings home the pay packet if they are disabled for a period.
However, there is a business expenses policy that provides a benefit amount for the business to pay many of their fixed overheads (such as rent and wages) if the principal or anyone the business is critically dependent on for its revenue is disabled. Generally these policies are for a fairly short benefit period of, say, one year, and cover a focused range of expenses.
This type of cover can be useful in providing funds to keep the doors open, so the proprietor still has a business to come back to after having been disabled for a period of time.
Who Can Help
In putting together a succession plan there are usually three professional involved—accountant, solicitor, and financial planner.
The accountant is usually involved in identifying what type of business structure is involved, such as a company, trust or partnership. The accountant usually values the business so that any plan can be appropriately funded, and accounts for the premiums paid.
The solicitor drafts the agreement. It is important that this is done by a professional who understands the issues involved, so any potential for capital gains tax is minimised.
The financial planner looks to put in place the appropriate funding mechanism. This will often involve some form of insurance that is owned in a way that effectively funds the arrangement.
There are many myths and misconceptions about Key Person insurance. For example:
Myth: The sum insured is not necessarily
Fact: Each business is different and the effect of a ‘What if…’ on each business will be different. While in some cases a large sum insured may be needed, in others it may only need to be enough to pay the staff their entitlements, a couple of months’ rent and to clear out the office.
There are as many different sums insured as there are businesses. Your financial planner and accountant will help determine an appropriate sum and what types of cover may be needed for your situation.
Myth: The premium is not necessarily tax deductible.
Fact: In deciding whether or not a premium is a deductible expense for the business we need to determine the purpose of the cover. In simple terms if the cover is for revenue purposes then the premium is deductible, but the proceeds in the event of a claim would then be assessable. If the cover is for a capital purpose then there would not be any deduction for the premiums, but in the event of a claim there would be no tax on the policy proceeds.
Every situation is different. Your accountant can help your financial planner properly structure a policy that meets your needs and strikes an optimal tax position.
Are You Fully Covered?
Where a loan is backing a business or gearing into an asset it is useful to consider what the person would want to happen to the business if something were to happen.
If the person is trying to build an asset, then having insurance to repay any loan debt will leave the business unencumbered for the benefit of the then disabled proprietor or their beneficiaries.
However, they may want the estate to sell the business quickly, in this case insurance may be used to cover any ‘fire sale’ loss.
Or they may simply want to cover several months of interest bills, in order to give the executor time to sell the business in an orderly manner, so that the estate can receive full value for the business.
* Howard Coleman is a life insurance subject matter expert with some 40 years’ experience. He is a fellow with the Australian and New Zealand Institute of Insurance and Finance (www.theinstitute.com.au).
The area of business protection is potentially complex and each situation is different. In this article we have only addressed the types of cover in a general or overview approach. People in business should not take this article as advice and should consult with their own professional advisers on matters raised should they be considering insurance protection for their own business situation. The relevant product disclosure statement should be received and understood before implementing any insurance policy.