Most businesses in the UK today make sure they are covered against the effects of fire or theft – but many do not consider the financial value of their people. This is where business insurance comes in.
Financial protection is a crucial part of the financial planning process for your business. Unfortunately, it is one area that is often overlooked.
Think about it. What would happen to your business if a partner or member became critically ill or even worse, died? This could have the potential to cause significant financial problems for your business.
Types of business insurance
Key person’s protection insurance
Businesses that rely heavily on the contribution of one or more key employees are financially at risk if those people were to pass away or can no longer work if they have being diagnosed with a critical illness.
Key person protection is a policy written on the life of an employee who makes a considerable contribution to the profits and sales of the business. If such an employee dies or is diagnosed with a serious illness, their absence would obviously severely affect the finances and turnover of the business.
Key person protection either pays out a benefit equivalent to the profit the key person would have generated or would cover the finances of employing a substitute to replace the member of staff.
Calculating key person cover
It is essential to attach a financial value to the contribution to the business of the person concerned, in order to protect your client’s business against the loss of a key employee. Most of the methods for doing this are approximations of the key person’s financial contribution to the business based on known financial indicators, which are acceptable to the insurer for financial underwriting purposes. It is accepted that it is not completely straight forward to put a monetary value on the contribution made by a key person. This is one of the reasons why companies do not put in place this important aspect of the risk management of their business.
Possibly the most accurate, the actual impact method requires a detailed analysis of the key person’s value based on their contribution to revenue. This is given by;
Loss of revenue
Loss of Revenue is the element of turnover attributable to the key individual.
Savings include the key person’s salary, bonuses and share of profit.
Payments include money that the business receives as a result of the loss or absence of the key employee.
One-off Costs can be for example, recruitment fees.
In the case of a critical illness claim, these may include benefits from a key person income protection plan, for example. Many providers have a calculator to help advisers assess the key person cover required using this method.
Loss of Profit
Key person cover can be calculated as a multiple of the loss of profit due to key person’s absence
The following amounts are generally acceptable to providers.
Life cover: 5x net profit or 2x gross profit
Critical illness: 3x net profit
A common technique to use for employees is the multiple of salary method. The sum assured is given as a multiple of the key person’s total remuneration package.
Typically a multiple of 5 is used, but sometimes it can be as high as 10. It is widely acknowledged that a salary does not necessarily show a person’s correct value to a business, plus it will often be necessary to allow for dividend payments and other forms of payment in the overall calculation.
For protecting against the loss of profits this method is arguably less appropriate, as the multiple is only loosely related to the key employee’s contribution to the profit of the business.
Proportion to payroll
In proportion to payroll, the contribution to turnover from the key employee is ascertained by reference to their remuneration as a percentage of the total payroll and multiplied by the number of years required to recover from their loss.
Key person’s salary
÷ Total payroll
x Years to recovery
= Proportion of payroll
The accuracy of methods that rely on the salary of the employee is dependent on their remuneration being a true reflection of their worth. Employees that are overpaid compared to others within the business could be overvalued; shareholders who may take a reasonably low salary could be undervalued.
Providers specialising in business protection will be able to assist advisers with assessing the value of the individuals both from the perspective of their own financial underwriting limits and in the most appropriate way for the business to be concerned.
Structuring the Plan – business insurance
In the case of business that have their own legal identity, for example, limited companies and limited liability partnerships, key person’s cover is set up and owned by the firm on a ‘life of another’ basis.
For key persons who are directors of limited companies, an alternative method is for the key person to create a policy on their own life, but held in trust for other directors. In the event of a claim the directors can use proceeds to compensate the business for the loss of the key person. Typically for tax-efficient reasons, they would loan the proceeds to the business in the form of directors’ loans.
In the case of a partnership that does not have its own legal identity key person cover can be arranged in one of two ways. For a partner of the business, an own life policy held in trust for the other partners is an effective way of compensating the business. For employees of partnerships, one or more of the partners would have to take out a policy on the individual on a ‘life of another’ basis. In a business where there are a small number of partners, they can each effect ‘life of another’ policy in an amount in proportion to their loss if the key person were to have left.
Corporate Loan Cover
Business loan protection safeguards business against the premature death of a person who has guaranteed a business loan. Also, banks sometimes make business loans on the basis of the involvement in the business of certain key employees. If such a key employee is no longer part of the business, the bank may want the load to be repaid early. Additionally, it is common for directors to make loans to their companies. Corporate loan cover is comparable to key person protection; the life cover is set up in amount of the outstanding debt instead of having to determine the value and worth of employee to the business. The policy will be set up differently depending on whether the business is a limited company or a partnership. In the event of the life assured death, the benefit is used to repay the business loans concerned.
Taxation and Business Protection
While beyond the scope of this guide, the selection of product type will impact upon the conditions to be met for corporation tax relief on the premiums. The taxation implications for the company will depend upon the solution, the type of plan chosen, the reason for the cover and the relationship between any key person and the employer.
When a shareholder or partner in a business passes, their share of the business, for example, company shares or their interests in the value of a partnership, normally forms part of their estate and passes to their beneficiaries. In the case of a controlling partner or shareholder, this could mean the direction and running of the business is then dictated by the people not hitherto associated with it. They may not have the requisite skills or there may be a variance to the remaining shareholders/partners. To avoid this happening, a legal agreement is put in place giving the remaining partners or shareholders the right to purchase the shares. Shareholder/Partnership protection provides the funds to implement the agreement.
There are a number of common solutions.
Own Life in Trust
Each shareholder or partner takes out a life policy on their own life for the value of their share of the business, but held in a business trust for the other shareholders or partners. If one of them dies (or diagnosed with critical illness), the other remaining shareholders and partners receive the benefit through the trust and enabling them to purchase the deceased’s shares.
Life of Another
In cases where there are just two or three shareholders or partners, each takes out a series of policies on each of the other’s lives for the value of their shares of the business. If one of them dies (or diagnosed with critical illness), the pay-out is used to purchase the deceased’s share. A business’s trust is not required, but this method is not suitable for businesses with more than a few shareholders or partners because the number of individual policies required could make for too much complexity.
Joint Life First Event Policies
A less common approach is to use joint life first event policies. For example, for three shareholders or partners, each takes out a joint life policy on the lives of the other two. This may be more cost-effective as fewer policies are required overall.
Cross Option Agreements
This is a legal document which should be drawn up to facilitate the purchase of the share in the business of the deceased employee.
A double option agreement is required for death benefits. It obligates the deceased shareholders beneficiaries to sell their shares if the other shareholder wants to buy them, and it obliges the other shareholders to buy the shares if the beneficiaries want to sell them. For any critical illness benefits a single option agreement is put into place. A critically ill shareholder may not want to abandon their shareholding, the agreement allows them to sell the shares however doesn’t give the other shareholders the right to buy.
Business protection providers have draft documents to establish cross option agreements. Advisers should involve their clients’ lawyers in setting up these arrangements.
If equal shares are held by a number of partners, one might expect them to share the total premium cost equally too. But this presupposes that they are of a similar age and state of health. Premium equalisation is required by HRMC to ensure that each individual is contributing in proportion to the potential benefit they will receive. Many providers operating in the business protection space host a premium equalisation calculator to help advisers ascertain the fairest way of dividing the expense.
Company Share Purchase
For business types constituting a legal entity. On the death or critical illness of a shareholder, the company itself purchases the shares. The shares are then cancelled leading to an increase of value of the remaining shares of the business. In such cases, the company should insure the individual shareholders for the value of their shares in order to finance the purchase.
For partnerships that do not have their own legal identity, share buy-back is undoubtedly not an option; however, automatic accrual arrangements are sometimes used. On death, these arrangements help the transfer of the deceased partner’s interest in the business to the other partners. In conjunction with this, each partner takes out a policy on their own life. On death, the beneficiaries receive the proceeds of the life policy instead of the deceased’s share of the business. These arrangements are common in professional practices where goodwill forms a major party of the value of the firm.
The Articles of Association and the Memorandum of Association govern the setup of limited company businesses. All arrangements which are put in place for share protection must be permitted by the requirements of these two documents.
Valuing business for shareholder/partnership protection
The valuation of businesses is a skilled task and it is appropriate for advisers to work with their clients’ accountants or solicitors to agree a suitable value for business purposes. An adviser’s chosen business protection provider will be able to give some broad guidance.
Price earnings ratio (PER)
The net profit of the company is multiplied by the PER to establish the value of the company.
÷ Earnings per share
x (Profits – Corporation tax)
= Price earnings ratio
The share price that investors would we willing to pay can be ascertained by reference to the required yield compared to actual dividend.
Net Asset Value (NAV)
In the professional valuation of the business the NAV may feature to get a better view of the finances of the business, however, the NAV may not always be helpful on its own. A company that has been in existence for a long time may have a NAV significantly lower than its market value because the assets have been subject to depreciation.
In the case of partnership, as estimation of goodwill value agreed among the partners is one method of valuation. However, a frequently used method is to average net profits. A given number of years is specified and the average value of profits over that period calculated and dividend among the partners in proportion to their share of the business.
Key person income protection insurance
Key person income protection insurance is an insurance policy written on the life of the key employee, but owned by the business. If they are unable to work due to an accident or sickness, the monthly benefit can be used to employ a locum or replace the profits that the employee would have generated.
Executive income protection insurance
This is used to pay the salary and related expenses of a senior member of staff in the event of them being unable to work. Such policy does not replace the loss to the business that their absence may incur, however it is a staff benefit and it could be argues that it relieves the business of the burden of continuing to fund an individual’s salary.
Relevant life plans
This is a tax-efficient way to provide a single employee with death-in-service benefits. In essence, relevant life plans are set up under group scheme rules, but, unlike most large employer-sponsored schemes, they are ‘non-registered’ and therefore the benefits do not form part of an employee’s lifetime pension allowance.
Relevant life plans can be established for employees or directors to benefit their dependents via a discretionary trust. There are several types of clients that would benefit from a relevant life plan.
Highly paid employees who have accrued a large pension fund can be provided with death-in-service benefits that don’t contribute to their lifetime allowance.
Small businesses may have insufficient employees to warrant a group death-in-service scheme as most schemes require at least five employees. Relevant life plans can be set up for each of the employees in the small firm.
Some employees may need more life assurance than that offered by the min death-in-service scheme. A relevant life plan can be set up alongside the aim scheme to achieve this objective.
Premiums are paid by the business and are an allowable deduction against corporation tax. There is no liability for employer or employee National Insurance on the premiums. The premiums are not considered to be a benefit in kind so the employee is not liable for income tax on them. Life benefits can be paid tax free to the employee’s beneficiaries through the discretionary trust.
INFORMATION REGARDS TAXATION LEVELS AND BASIS OF RELIEFS ARE DEPENDANT ON CURRENT LEGISLATION, INDIVIDUAL CIRCUMSTANCES ARE NOT GUARANTEED AND MAY BE SUBJECT TO CHANGE.
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