In times of economic uncertainty, there are financial protection products which could be vital in helping businesses to recover quickly and minimise the impact should the worst happen. Businesses know that they should protect premises, stock and equipment, but many firms are less prepared for a major change caused by the sickness, incapacity or death of owners or key employees. A business with suitable cover in place is supported financially in the event of hard times, when illness, incapacity or death affect its profitability, debt and knowledge base. Do you have insurance policies in place to protect your business? In this article I shall focus on the financial products designed to protect businesses and how these could be used to make sure your business is adequately protected.
Business Loan Protection
Business loan protection is taken out to enable the business to repay a loan or debt after the death or critical illness of a person responsible for that loan or debt. Often business loan protection is in the form of a term assurance or critical illness cover. Business loans tend to be fixed term and based on the sum repayment of capital and interest. Depending on the circumstances, a lender may require a fixed or floating charge over assets to secure the loan. A fixed charge applies to specific business assets – the borrower cannot dispose of these assets while they are subject to a fixed charge, which usually remains in place until the loan is repaid in full. A floating charge applies to a class of assets, such as inventory or trade receivables, that are continually changing in the borrower’s business. In the event of nonpayment, a floating charge crystalises and fixes on the applicable assets that exist at the time. The business owner generally also provides a personal guarantee, which is a legal agreement to pay the debts of a third party, such as those of a company, in the event that the third party cannot pay.
If a business owner falls ill, suffers an accident or dies, the lender may assume the business is at risk. They may then demand immediate reduction or full repayment of the business loan. This can have a knock on effect on other creditor’s perceptions of the business. Where the business fails as a result of such a financial shock, if there are not assets available to cover the debt the lender may seek repayment from the guarantor or their estate.
The amount of cover required is calculated as the amount outstanding on the loan, or such a proportion as is appropriate for each key person/owner. If the business already has cover in place for other purposes, the business should assess the current coverage to ensure owners do not become over insured.
Tax position – Business loan protection premiums are not tax deductible, but in the event of a payout, the funds will not be subject to tax.
Key Person Insurance
The prolonged illness of a key or important employee can have a devastating effect on a company’s profits, possibly even greater than the effect of their death. The financial consequences stem not just from the loss of the person’s contribution to the business, but also from the costs associated with sourcing and training a replacement.
In the event of a key employee’s illness, the income normally paid to them may not be available to pay their replacement because the employer is likely to continue paying the key person, at least for a while during sickness.
Protection against the adverse financial consequences of losing such a key employee should be a vital part of a company’s planning. Do you have a managing director with a charismatic personality? Or a researcher with a specialised knowledge that is essential to the company? A skilled technician who has a detailed knowledge of the company’s machinery? Or a salesperson with a wide range of personal contacts? All of these are examples of key persons within a company. Key person Insurance can be considered for directors, employees and contractors or anybody whose absence would have a direct or indirect impact on the finances of a business.
The amount of cover required is calculated by multiplying the key person’s salary by a factor of five or ten – if the key person does not directly contribute to a defined percentage of the profits, providers typically suggest up to five times salary for critical illness cover, and up to ten times for life cover.
However, if the amount of cover is aimed to replace business profits that might be lost if a key employee dies or is otherwise unable to work, the following formula should be used to calculate the cover required:
Current gross annual profit x key person’s remuneration x estimated number of years for the company to recover
Total annual wage bill
The type of policy chosen depends on the business’s circumstances, but a typical choice is a term assurance policy during which employee is a key person. This might be until retirement, end of contract, or end of particular project. A whole of life policy may be considered for a founding director who does not plan to retire. To protect the business in the event of illness or accident, critical illness cover may be arranged.
Tax position – a key person policy is usually an allowable business expense that can be offset against the businesses tax bill. However, if the premiums are offset in this way, any payout will be subject to corporation tax, unless they qualify for all four of the Anderson principles. A financial adviser will be able to advise on your company’s position.
Share and partnership protection
Share protection is for limited companies: life assurance taken out on the life of the company’s shareholders. Partnership protection is for partnerships and limited liability partnerships: life assurance policies taken out on the lives of the business partners.
On the death of the owner, their stake in the business tends to pass to their family, who may gain an amount of control over the business or wish to withdraw their share. If instead, an owner suffers a serious illness, they may wish to sell their business assets and withdraw from the business. Both of these cases can cause a serious problem for the remaining owners who will likely want to continue the business and therefore buy back the shares. They may have to sell assets to raise the required funds. If – as with solicitors and accountants – goodwill forms a large part of the business’s commercial value, the value may not be able to be realised except by selling the whole business. The question is whether the remaining owners would be able to buy back shares without the help of share or partnership protection insurance.
Things that should be taken into consideration if a business owner or partner dies:
Share or partnership protection offers business continuity without the need to consider raising a lump sum from the business or it’s owners.
To protect against the event of illness or accident a critical illness policy or income protection may be arranged.
Tax position – each owner undertake to pay premiums on their own life. The premiums may not necessarily be the same because of different ages and amounts of cover. If a company pays the premium on behalf of a shareholding director, this will be classed as remuneration and the shareholding director will become liable for income tax and NI contributions (if applicable) on it.
Share protection on Death
There are three main types of scheme through which businesses can take over or buy another owner’s share of the business on death, each supported by life assurances policies. These methods are too complex to summarise in this article, but in essence:
Each owner takes out life assurance policy equal to the value of their business shares
The policies are written in trust for the other owners benefit
Each owner pays their own premiums, which may vary based on their health, age, and the size of their stake in the business
The owners sign a share purchase agreement specifying what happens in the event of an owners death.
A share protection scheme provides the required funds to buy back the shares and ensures that the deceased’s family gets a fair price.
Sole versus group employee protection
As well as protecting the business from overwhelming financial effects, employers can protect their employees in the event of their death or critical illness:
These schemes benefit the families of the deceased whether employees or directors, and large employers often use group schemes to cover all their staff. However, a group death-in-service benefit tends to be part of the workplace pension scheme and may not be cost-effective for smaller businesses. A relevant life policy is appropriate as an alternative to a group scheme. It can cover anyone who takes a PAYE salary from the business.
Protection for the self-employed
Business partners fall into the general category of the self-employed. Most self-employed people have a hand-on role and so are a key person in their own business. Anyone who is self-employed may suffer immediate adverse financial consequences if they are unable to work owing to illness.
Points to consider for self-employed:
Adequate financial protection is vital for self-employed via person income protection policies, critical illness policies, life insurance, private medical insurance, or a combination, as appropriate.
As we have discovered, Businesses have a range of protection needs. Due to the complex nature of some businesses, structures and circumstances, an adviser would need to be aware of your businesses set up in order to be able to recommend suitable products. If you feel your business is underinsured, book an appointment with Stephanie Johnstone now to discuss this further.