Many business owners don’t hesitate to insure physical assets such as motor vehicles, plant and quipment. However, they often overlook the importance of insuring themselves (and other key people in the business) in the event of illness, injury, disability or death.
This can be a very risky oversight, as the long term absence or loss of a key person can have a dramatic impact on your business and each owners’ interest in the business. Insurance can help to minimise the financial impact of events beyond your control.
What are the risks?
Source: Munich Reinsurance Group in Australasia, 2009. (1) This is general population data based on those who are currently 30.
Who is a key person?
Most businesses have one or more key persons whose skill, knowledge, experience and leadership ensures the success of the business. A key person in any business may generally be defined as one whose death, disablement or early retirement may have an adverse economic effect on the business.
It is important to identify these key people and to quantify the adverse effect that is likely to be suffered by the business in the event of death, disablement or illness.
Protecting your business
Most businesses use debt to start up and grow their operations. Whilst few businesses could exist without entering into these types of arrangements, problems can arise if you, or another key person, are lost to the business, either temporarily or permanently.
Your business could therefore have difficulty meeting its loan commitments. If the lender has concerns regarding the business’ cashflow and credit position, they may require the outstanding loan to be repaid immediately. You may even be forced to sell personal or business assets used as
security so the debts can be cleared.
One way to reduce these risks is to insure yourself and other key people in the event of death, total and permanent disability and critical illness. If any of these events should occur, the lump sum insurance payment may be used to:
- reduce or pay off the debts
- release any loan guarantee or security provided
- protect your personal and business assets, and
- ensure the business can continue as a viable operation.
Business insurance as part of a business succession plan
Whether your business is structured through a partnership, company or trust, it is important to have effective mechanisms in place for the transfer of equity and/or control, if one of the owners is lost to the business due to death, disablement or a critical illness.
In many cases the loss of a business owner results in the demise of an otherwise healthy business simply because there was no succession plan and funding agreement in place.
A business succession plan incorporating insurance funding protects your investment and helps to ensure your
business survives the loss of a key person.
Alex and Bill each owned 50% of the shares in a successful engineering business when Bill died
suddenly. Bill’s shares were inherited by his wife Lynn via his Will. Because there was no Buy Sell agreement in place, Lynn is not obliged to sell the shares to Alex and Alex is not obliged to buy the shares from Lynn.
- there was no agreed price or timeframe for the transfer of Bill’s shares
- there was no insurance in place to enable Alex to buy the shares, and
- Alex doesn’t have enough funds to buy out Lynn and doesn’t have the capacity to borrow the Money
To further complicate matters, Lynn is entitled to the same management rights and share of profits as her deceased husband, while Alex is doing 100% of the work and only receiving 50% of the profits.
This outcome could have been avoided if Bill and Alex had sought financial and legal advice
and executed a Buy Sell agreement, funded by insurance. By using this strategy, Lynn would have
received the insurance proceeds in exchange for handing over her interest in the business to Alex.
As a result, Lynn would have been fully compensated, while Alex would have taken ownership of 100% of the business and received 100% of the profits.
Note: This case study highlights the importance of speaking to a financial adviser and solicitor about establishing a Buy Sell agreement funded by insurance. A financial adviser can also address a range of potential issues and identify other suitable protection strategies (see Tips and traps).
In this example, the insurance proceeds would be paid directly to Lynn. However, different payment arrangements may be preferable for businesses set up under certain ownership structures, or due to the preferred approach recommended by your solicitor and/or accountant.
Tips and traps
- Because a Buy Sell agreement affects your legal rights, it should always be prepared by a solicitor (preferably one that specialises in this area).
- There are a number of ways to structure the ownership of insurance policies used to fund a Buy Sell agreement. As each ownership method will have different legal, tax and stamp duty implications, the ownership should be reviewed by the advising solicitor and registered tax agent.
- It may be more cost-effective over the longer term if you pay level premiums, rather than stepped premiums that increase each year with age.
- You should consider using insurance to protect your assets and business revenue.
How do you best protect your business’ future?
A financial adviser, specialising in business insurance, can help you better protect your business by undertaking a business needs analysis and then delivering advice relevant to your business.
For more information To find out the types and amounts of cover you may need to protect your assets, you should speak to a financial adviser who specialises in business insurance. A financial adviser can also review your insurance needs over time to help you make sure you remain suitably protected.
Based on information from MLC, brought to you by InterPrac