Policies can be used to replace income or to fund shareholders’ agreements, depending on the business
By Gavin Adamson
Published on Nov 2008
Small-business owners are often too busy running their businesses to think about insuring them. But advisors who work with entrepreneurs say insurance is as important to small businesses as wills are to individuals.
There are a number of insurance products you can offer business-owner clients to ensure their risk needs are met, should they die or become unable to operate their businesses because of illness or disability.
For example, long-term disability and critical illness insurance products provide income replacement in the event of some health risks. Term and, occasionally, per-manent insurance fit the bill for capital risk and to fund shareholder agreements, should an owner/partner die and leave business partners in the lurch.
But a business person’s insurance needs depend on a number of factors, including income level and the structure of the business, says Jason Abbott, a certified financial planner who sells insurance through Desjardins Financial Security in Mississauga, Ont. Here are the types of insurance that make sense for small-business owners:
Disability Insurance. Abbott’s typical client is a small-business owner making $80,000 to $100,000. He or she needs disability insurance.
“For a start-up or smaller company, you want the owners to be able to make sure the lights stay on and that they don’t go into debt,” Abbott says, should they fall ill or become disabled. “It’s an affordable place to start to cover fixed expenses such as rent, utilities and employee salaries.”
Most workplace benefits plans offer some form of disability insurance, but it also is available to self-employed business owners. Disability insurance pays policyholders 70%-80% of income if they can’t perform the main duties of their jobs because of illness or injury.
Advisors note that most disability insurance policies pay benefits for a maximum of two years. Certain manufacturers offer riders that “top up” the disability insurance for more coverage. For example, a dentist could buy a policy that will pay out forever at his or her original salary base, whether or not he or she can work in any other occupation.
Businesses with several employees can also set up a higher-grade policy for owners/shareholders than the clerical and service staff receive.
Critical Illness Insurance. Business owners are also good candidates for CI policies. The policies pay a substantial figure if the policy owner is struck with any one of several specified life-threatening diseases within a certain time frame.
Although CI insurance can be costly, some companies offer “return of premium” policies, which pay back premiums if the insurance is unused over the period.
Life Insurance. A business owner over the age of 40 should have life insurance, too, notes Abbott. But, he adds, such a client would have a greater chance of becoming disabled than dying.
“It comes down to premium constraint,” Abbott says. “Our job as advisors is to educate clients about the risks, and try to cover off as much risk as possible. You can’t cover all risk — it’s impossible.”
Capital Risk. An important category of insurance for business owners is capital risk. As Abbott’s clients’ businesses mature, his clients and their accountants often call him about the possibility of funding shareholders’ agreements with life insurance — and, in some cases, with lump-sum disability and CI insurance.
Shareholders’ agreements are typically structured into businesses that make $1 million-$5 million in income a year and that have multiple owners or shareholders
“The purpose of the agreement is to provide direction and certainty in the event that one of the shareholders dies, becomes disabled or retires,” Abbott says. “It provides a plan for the transfer of the business interests.”
If one of the partners dies, the life insurance policy pays the surviving business partners. They can then use that money to buy the company shares held by the deceased partner’s estate, family members or other beneficiaries.
This way, the business partners can be assured that an unqualified beneficiary won’t end up holding a controlling interest in the company.
Entrepreneurs who spend years building a business, Abbott says, want to make sure they don’t end up working with someone who doesn’t understand the business and could run it into the ground.
On the positive side, the strategy can work very well because it not only covers the risk to the integrity of the business but also the loss of income to the business owner’s family. “What happens to the family?” says Bruce Cumming, owner of Cumming & Cumming Wealth Management Inc. in Oakville, Ont. “The funding fulfils a dual requirement”: it ensures the continuation of the business and provides a benefit for the family of the deceased partner.
The legal structure of the shareholders’ agreement is of paramount importance, says Cumming. Accountants, lawyers and often consultants from the manufacturer of the policy confer to make sure it works well for all shareholders.
“Getting the insurance companies and tax and estate-planning crews involved is a huge issue,” Cumming says. “They can provide great value and make the advisor look very good.”
The policies can be owned personally by the shareholders. Or they can be held within the corporation or by a holding company.
The simplest way to implement the strategy is for each shareholder to be named as the beneficiary on a life insurance policy on the other shareholders’ lives. That’s known as the “criss-cross” method.
Corporate ownership is usually used in more mature businesses. “Corporate ownership has tax advantages because you can use pretax dollars to pay for the term insurance,” Cumming says.
Funding a shareholders’ agreement with insurance will require a lot of preparatory work on the part of the client, including getting his or her lawyer involved and having the business evaluated. Both Cumming and Abbott agree that it’s best to get the underwriting process and purchase of the policies underway long before the agreement is final.
The question of the value of the policy is important, but try not to let a drawn-out evaluation decision delay the process, Abbott advises: “I tell my clients: ‘Even if you don’t get the funding amount right, it’s better than nothing at all’.”
He suggests asking: “If you were to sell your business today, how big a cheque would you need?”
There is always opportunity to change the dollar amount on the policy later, Cumming adds.
Manulife Financial Corp., for example, is among several manufactures that make business-protection riders available on term life insurance policies that allow the owner of the policy to increase the benefit without further evidence of medical insurability.