Business insurance can be used to repay debts and protect assets used as security if you or another key person in your business dies or a seriously injured.
It’s important as a business owner to protect your assets via business insurance, because the financial consequences of a potential mishap could easily wipe out the assets of a small business. In addition to protecting yourself, it’s also important to have business insurance so you can protect others. For example – If you own a restaurant and a customer becomes ill after eating one of your products or you own a delivery business and one of your vehicles hits a pedestrian, you need to be able to pay for the damage you’ve caused.
Protecting your assets
How does the strategy work?
Most businesses use debt to start up and grow their operations.
- Loans sourced from a lending institution (e.g., a bank) that are secured by personal assets (such as the family home) or business assets (such as business real property)
- Proprietor loan accounts (your personal funds into the business)
- Significant trade creditors
While few businesses could exist without entering these types of arrangements, problems can arise if you or another key person to the business are lost to the business temporarily or permanently. Your business could have difficulty meeting its loan commitments. The lender could also have concerns regarding the business’ cashflow and credit position and may require the outstanding loan to be repaid immediately. You may even have to sell the 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 (TPD) and critical illness.
If any of these events should occur, the lump sum insurance payment can 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
Other key considerations
- It’s important to update your insurance cover in line with the changing value of your debts, as failing to do this may lead to underinsurance.
- If you (or the entity through which your business is run) own an insurance policy taken out for the purpose of repaying a debt, the premiums paid by you (or the entity) may not be tax-deductible. You should get advice from a registered tax agent relevant to your circumstances.
Business Insurance Case study
Release from the personal guarantee is particularly important if either exits the business due to death or disability. They do not want their families to be exposed to the ongoing fortunes of a business they no longer participate in.
Protect your revenue
- Stabilise and protect the business
- Offset a reduction in revenue
Cover the costs associated with finding and training a suitable replacement
Alternatives to insurance
There are various alternatives that could be used if a person who is directly responsible for generating revenue is lost to the business. For instance, the business could absorb the reduction in revenue into the current year profits. Although, this would generally reduce the income the principals could receive and may result in the business running at a loss. Significant drops in revenue may also lead to a lending institution recalling credit it has extended to the business, in part or in full, as a deterioration of revenue may cause the business to breach a loan covenant.
Alternatively, the business could accumulate a reserve. However, it could take many years to build up enough funds and, because the money needs to be readily available, it would need to be invested conservatively in liquid assets that typically yield a lower return. Most businesses generally prefer to put capital to a more efficient use, earning higher returns and generating greater value for stakeholders.
Who can be insured? When using insurance for revenue protection purposes, the policy will usually be taken out on the life of the principals and any key employees of the business. Examples of key employees include a sales manager, supervisor or technical adviser who may make a significant contribution to the revenue or have decision making powers or a unique talent. As the premiums are generally tax deductible to the business, or less commonly, to sole traders, the ATO has provided guidance in IT 24341 on who can be insured for revenue protection purposes.
How to determine sum insured
The present value method and the multiples method are often used to calculate the sum insured for revenue protection purposes. With both these approaches, it’s important to take into account any underwriting rules that could limit the amount of insurance that can be taken out in certain circumstances and keep appropriate records. Also, the sum insured should be reviewed at least annually and adjusted accordingly.
Present value method
This method involves estimating the costs that would be incurred if a key person needed to be replaced. These would normally include recruitment, relocation, and training costs, as well as the salary that would need to be paid up to the point where the new person is of an economic value to the business equivalent to the departed key person.
This method uses a Key Person Factor (KPF), or multiple to assess the impact a key person has on the business’ revenue. For example, in a business with two key people and a small number of employees, each key person may be regarded as having a KPF of 50%, as they are responsible for 50% of the success of the business. If, on the other hand, there were a larger number of employees with specialist skills contributing towards the success of the company, the KPF may only be say 33% or 25%.
Exiting the business
There are a range of issues for business owners to consider preparing for planned and unplanned business exits.
Every business owner will one day exit their business. Sometimes it is due to an insurable event, such as death. However, there are a broad range of exit triggers that are not insurable. Some of which can be planned such as a trade sale or retirement and others that are not planned such as where there is a fall-out or dispute between owners.
Sometimes where two or three owners have been working productively together in a business for years, an Ownership Agreement may be unnecessary. A buy sell agreement is almost always necessary, as it facilitates a smooth and equitable transfer of business ownership when an owner departs the business due to death, total and permanent disability and (sometimes) trauma.