Protection matters

Despite the reluctance of some companies to cover their key staff, business protection cover is a good potential source of business, says Alex Adcock

The economic downturn may have made the case for business protection insurance stronger than it has been for some time but many companies remain reluctant to cover themselves, whether they feel vulnerable or not.

But the current financial uncertainty means business protection now has even more potential for advisers, particularly so when compared with other markets.

Most businesses have not quantified or planned for the impact of losing the key people who run and own them. Research from Legal & General has found that 78 per cent of small to medium-sized businesses admit they are unaware of the true impact that death or critical illness could have on profits, and that more than 70 per cent of these businesses did not have any cover against the loss of future profit.

There were 4.7m business enterprises at the start of 2007, according to figures from the Department for Business, Enterprise and Regulatory Reform, representing a protection market that Swiss Re estimates as approaching £500 billion. Of these businesses over 99 per cent have fewer than 50 employees. These small businesses are exactly the sorts of operations that are less likely to be able to deal with the loss of their key personnel.

Business protection insurance covers a business against losing a high earner, partner, shareholder or the guarantor of a loan, through death or critical illness. It comprises key person cover, shareholder or partnership protection, and business loan protection. For some businesses one person may fulfil all these roles making cover even more critical.

As Stephen Crosbie, proposition development manager at Aegon Scottish Equitable observes: “Businesses may know the insurance value of their buildings but have no idea how much their key people are worth.”

Business protection comes in many shapes and sizes, and matching the right solution to a company’s circumstances is crucial.

Key person cover insures a business against the loss of income, the cost of finding a replacement or the inability to raise capital which results from the loss of an individual. The business takes out cover on the key person to provide it with an adequate lump sum. The value of the individual and the sum assured can be calculated in different ways according to the business and the key personnel involved. It may be a multiple of profits or it can be a multiple of the key person’s salary if it reflects their true worth to the business.

Business loan protection provides a lump sum for the business to repay a loan if an owner or one of the directors becomes ill or dies.

Shareholder or partnership protection safeguards the ownership and control of the business by ensuring that the remaining shareholders or partners can buy the deceased’s shares and compensate the estate. Each partner sets up an ‘own life’ plan equivalent to their share of the business under a business trust for the benefit of the remaining partners. There are different ways to set this up according to individual circumstances.

Using a ‘buy and sell’ agreement partners can agree that they will buy the deceased’s share and that their share will be sold to the remaining partners. This is a straightforward arrangement with an assured outcome but it may not be efficient with regard to Inheritance Tax.

A more flexible and commonly used method is a double (or cross) option agreement. Here the partners have an option to buy the deceased’s share of the business within a specified period during which the estate has a duty not to sell the share to any other party. In addition, they have an option to insist on purchase by the remaining partners. If one party exercises their option, the other party must comply. Only if neither party chooses to exercise their options will the share of the business remain with the estate. They can accommodate new partners and are tax efficient.

Business protection can provide an alternative business stream for advisers, particularly for employer clients who are in a battening down the hatches state of mind. Jonathan Reynolds, director of financial services at Tenon Group says: “For small business owner clients business protection is a good avenue as it tends to be high value and can pay well.”

But do businesses recognise its value even in a downturn? There are three main obstacles to the take up of protection. Some businesses consider it unnecessary, too complicated to spend time on, or too expensive.

Reynolds, the subject of key person cover himself, is philosophical on the point. He says: “People perceive the need for it or they don’t. When you talk to some people and mention insurance they turn off.”

Taking out cover also requires commitment, although providers will take some of the leg-work out of the process. “It can be a laborious process with the medical and financial underwriting,” says Reynolds. “Critical illness and share protection are emotive issues. What are the shares worth? How much will it cost to buy them? Reciprocal arrangements are needed and people can’t break ranks. I don’t think there is a hard sell in business protection.”

Furthermore, the relative expense of cover increases when finances are tight. Reynolds says: “Most people could do with the full suite of protection but in a business downturn my view is that most businesses look to control costs rather than go for more protection.”

Jerry Bayman, national partnership manager for corporate protection at Bright Grey says: “It’s not the first time I’ve seen economic uncertainty, and it is not surprising that businesses might want to cut unnecessary expenditure as liquidity levels and working capital become strained.”

But the harsh environment can be a selling point. Despite the Government’s stated conditions on the bail-out of banks regarding lending to small businesses, these organisations are unlikely to enjoy easy credit in the near future.

Bayman says: “Saving on business protection could be a false economy. I would argue that a business with tight liquidity is the ideal client for this type of cover. If they lose a key person they have no cash reserve to deal with that contingency. In boom times banks might be more prepared to be positive and help a business through this loss. In the current climate however, losing the key person could be the factor which sends the bank running for the cover of it’s security and calling in the administrators.”

And of course it is not only banks which finance businesses. “Companies can become indebted to their own directors as they either lend their own cash to the business or leave bonus and dividends in. The problem on losing one of these individuals is that the loan becomes immediately repayable to the estate thus putting additional cash strain on the business.”

There are also secondary effects of the downturn which make protection worth considering for businesses.

Wojciech Dochan, head of commercial marketing at Unum says: “The landscape of UK corporate is changing, with more small firms with limited cash flow. The economic downturn means employees being laid off and this puts more pressure on key people, with implications for stress and mental health.”

There is scope for refining and combining products. Protection insurance can be tailored to the needs of businesses. As Dochan says: “Shorter duration cover, more affordable cover, and provision of welfare and legal advice to HR departments are examples of how to cater for smaller businesses.”

But despite businesses’ reluctance to spend on cover when they are stretched, the case for protection remains. In Crosbie’s words: “It’s a massive opportunity to get involved with.”

Why demand for business protection should rise

In times of economic uncertainty, people generally look at how they can protect the assets that they hold. This is particularly important for those who own their own business and they will want to seek out protection in an effort to protect their assets against any future loss.

“Advisers will play a key role in driving the amount of business protection that is sold over the coming months and while some cases will come about at the request of the client, a large portion of business will be sold by advisers proactively looking for new business streams.

“With financial markets currently in a downturn, credit lines have become harder to find, creating an opportunity for the insurance industry. With the amount of credit on offer drying up, businesses need to consider protecting the credit they do have by taking life cover and/or critical illness cover on key personnel for existing business loans.

“It is possible that over the coming months, both banks and lenders will become more aggressive towards collecting debts and as a result it is possible that sound businesses that experience the loss of a key person could collapse through the unnecessary loss of a loan or credit line.

“With economic conditions devaluing even strong businesses, more company directors may consider ensuring their families gain the full value of a company shareholding should the worst happen. This can be achieved by using life/critical illness cover to ensure the family benefits by the value of a shareholding and the business can continue by distributing the shares amongst the remaining shareholders.

“While we are yet to see any surge in the protection market due to the current downturn, the credit crisis may well tip the balance and get people thinking about how to ensure their business continues to flourish in a time of financial hardship in the event of their death.”