Dealing with loss
1 Mar 10
What happens to a small business when a co-owner or a key director dies or falls seriously ill? As Ian Harper explains, there is an insurance solution, but many firms are still unprotected
by Ian Harper
Research carried out last year by the insurer Legal & General among 1,000 members of the British Chamber of Commerce, claims to have uncovered a “business protection gap” of £1.1 trillion.
This comprises a “shareholder protection gap” of more than £400bn and a “key person protection gap” above £400bn. Another gap – the “corporate debt gap” – accounts for the balance.
Astonishingly, 45 per cent of the 1,000 British Chamber of Commerce members said their business would fold within 12 months of the death or critical illness of a key person.
Only four per cent said they had shareholder protection in place, while nearly half had no formal agreement on what would happen should a business owner die.
The existence of key person or shareholder protection insurance could spell the difference between the life or death of a company. In addition, says Mike Reid, corporate development manager at Kudos Financial Services, legislation could make directors personally liable if a company fails.
A “key person” is someone whose death or disability would seriously impact a business’s future profits, and insurance can cover their death, critical illness, or both. While life insurance pays out a lump sum on death of the insured, critical illness pays out on diagnosis of a pre-agreed serious illness. As such, key person cover provides the financial means to allow an individual to be replaced, to recover or leave without imposing a major financial strain on the company. Key person insurance can also be used for loan protection and may be a pre-condition for a bank loan.
Bruce Saunderson, a senior manager at Grant Thornton Scotland, says: “I have been aware of a number of occasions whereby companies have been strongly advised to take out key man insurance by the bank on request of a loan.”
Shareholder protection insurance pays out on the death of a shareholder and enables the other shareholders to buy the deceased’s shares.
Peter Haveron, financial services manager at French Duncan Financial Services, paints this picture: “If two partners or directors have an equal share of a business and one dies, the family of the deceased will be looking to receive its share of the business. If the business cannot pay it, the surviving owner is stuck with a partner and the deceased’s family gets nothing in compensation. The ongoing relationship and the future for the business is likely to be difficult.”
Such insurance is usually used in conjunction with a cross-option agreement – where the payout must be used to buy the deceased’s shares from their family, who in turn are required to sell their shares to the other shareholders.
For small and medium businesses, a lack of suitable cover can cripple their finances. Keith Minnis, a financial planning specialist with Coutts, says: “There are several well-documented instances of businesses either failing or seeing their value plummet, when an unexpected death or serious illness occurs within the ranks of either business owners or key employees.”
The key is to identify the need for cover at the outset. Eddie McAvinchey, senior solicitor at McGrigors, says: “We recently advised an Alternative Investment Market (AIM)-nominated adviser on a proposed admission to AIM, and one of our recommendations after the legal due diligence had been completed was that key man insurance, directors’ and officers’ insurance and business continuity insurance be put in place, as none of these had previously been taken out by the board.
“It was particularly an issue as one individual on the board was identified as being the main driver behind the future growth and technical know-how of the company.”
On shareholder protection, Saunderson says: “I am aware of a case involving two brothers who were in business together. When one died, the survivor was forced to sell personal assets and raise funds in order to purchase the shares in the business which had been left to the widow. The circumstances were quite acrimonious.”
Jayne Deeble, a consultant at Aon Consulting, says the tax treatment of key person and shareholder protection is complex and usually depends on who the policy owner is and, therefore, who would receive the benefit in the event of a claim. She says: “For example, if the business is the policy owner and also pays the premiums for the cover, the cost of premiums are usually treated as an allowable expense and the proceeds of a claim are treated as a trading receipt for the company.
“However, there are lots of exceptions to this rule.
For example, cover to protect the repayment of a loan is not usually classed as an allowable business expense.
“The take home message for businesses is to seek appropriate advice when arranging such cover.”
Fiona Middlemiss, a tax specialist at Alan Steel Asset Management, says: “There is a belief that if you do not claim tax relief then the proceeds of the policy will be tax free. This is not so. What matters for tax purposes is: does the policy qualify to be deductible, that is, meet the conditions for relief, and is the policy to replace profits? If a policy is tax deductible and is to replace profits, then it is likely that the proceeds will be taxable on the company in the same way that profits would have been.”
So what does it cost? Middlemiss says that one client, a Scottish business valued at £1.5m, has three shareholder directors, all non-smokers and in good health. Each has £500,000 of cover with the two male directors, aged 40 and 45, paying £43 and £57 per month respectively, and the third, a woman aged 40, paying £34 a month. So, the average cost per director is less than £540 a year, (or one per cent of the total cover per person).
In the absence of such an insurance policy the probable alternative might be a temporary bank loan. However, such finance is unlikely to come cheap – if at all in the current climate – to a business that has just lost a key person. Even then, the cost of the loan is likely to be well in excess of one per cent of the amount.
So why do so many businesses seemingly lack cover? The only answer can be ignorance and lack of advice – from the professional advisers, the trade bodies and relevant government departments. However, there is a growing awareness of the importance of putting adequate protection in place.
IAN HARPER is a freelance business journalist.