Business risk insurance - the key to an effective risk strategy

Business risk insurance should be a key component of every risk strategy, but only a fraction of companies are properly insured, writes Jason Bamford.

For self-employed clients or those in a small partnership, income protection insurance only provides half the necessary protection in the event of illness or injury.

That is why business expense insurance – in addition to income protection – is fundamental to ensuring the continuity of your client’s business.

Business expense insurance should be a key component of every business risk strategy – regardless of whether the client is a tradesperson with an apprentice, a dentist running their own practice, or a new growing business that is still reliant on your client generating the income.

However, while there are 1.9 million Australians who own and operate one or more businesses, only 18,300 are covered by business expense insurance.

This suggests many are either uninsured or relying on other insurance in place.

The concept of business expense insurance is relatively straightforward, as most business owners have taken on some debt and signed a lease.

However, sole-traders who are setting up their businesses often fail to include this cover in their business plan, as minimising the burden on cashflow is seen to be more important.

People in this position are often particularly exposed, as their sole source of income is reliant upon their ability to operate their business. In the majority of cases, they simply don’t have the reserves to draw upon if they can’t work.

When the risk becomes reality

Over 60 per cent of Australians will be disabled for more than one month during their working life. Further, over 25 per cent of Australians will be disabled for more than three months. 

In the event the client is unable to work, income protection replaces up to 75 per cent of pre-disability income. This money can help cover everyday costs and household bills, but how will business expenses like rent, salaries and overheads be paid? 

While revenue has been reduced through the client’s inability to work, the fixed business expenses have not. Effectively, this may result in one of two scenarios:

1. The client will be forced to cover their business expenses using financial resources not intended for this purpose (eg, income protection benefits, mortgage – or second mortgage – on the home).
2. Debts will simply rise and the business will be at risk. 

Business expense insurance, therefore, helps businesses survive by covering the business costs while clients are unable to work due to illness or injury.

No other insurance cover – be it life, total and permanent disability, critical illness or business interruption cover – is an effective replacement for this.

Case study 1: sole-trader

Amir, a glazier and keen sportsman, has recently set up his own business as a sole-trader. He earns a net income of $10,000 per month and insures himself for $7,500 under income protection (ie, 75 per cent of his income).

He does not have business expense insurance.

Amir dislocates his knee while participating in a social football game and the doctor is adamant he must remain off his knee for up to six months.

Although Amir has stopped earning an income, the following monthly expenses continue to accrue:

• Rent of building: $1200
• Electricity: $200
• Water: $100
• Lease of work car: $400
• Advertising (contracted): $500

Amir’s income has dropped from $10,000 per month (pre-disability income) to $7,500 (income protection benefit payment) – and he must continue paying his business expenses.

Once these costs are subtracted, he is left with just $5,100. 

This leaves Amir with 51 per cent of his pre-disability income to cover his personal expenses including the mortgage, children’s school fees and general day-to-day costs.

Case study 2: joint partnership

Dina and Brett run a successful business. They each generate an income of $22,000 per month and are jointly responsible for meeting the total average business expenses of $20,000. This leaves them $12,000 each to draw as net income every month.

Brett has taken out income protection and business expense insurance, but Dina has only covered herself via income protection.

The tables show what could happen if either Dina or Brett became disabled.

Dina’s income protection cover would provide a monthly benefit of $9,000. This represents 75 per cent of her income (net of expenses) before tax.

However, because she doesn’t have business expense insurance, she will either have to rely on Brett to cover her share of the expenses (reducing Brett’s income) or fund the business expenses out of her own pocket (most probably from her income protection benefit).

As a result, she is only left with $1,000 per month to meet her personal expenses.

Effectively, Dina’s income protection policy is not replacing 75 per cent of her income. It is now being used primarily to cover the business expenses to keep the business going while she is disabled.

In fact, she now has less than 10 per cent of pre-disability income to live off while disabled.

On the other hand, Brett is insured for 100 per cent of his share of fixed business expenses. He can use his income protection benefits for what they are intended for – to meet living expenses while unable to work.

Avoid a nasty tax surprise 

From a taxation perspective, income protection claim proceeds constitute assessable income and are assessed at the client’s marginal tax rate.

However, the Income Tax Assessment Act 1997 contains provisions prohibiting the offset of business losses against other categories of assessable income.

In accordance with this legislation, the Full Federal Court in Watson v Deputy Commissioner of Taxation 2010ATC20 has ruled against an income protection claimant offsetting his business expenses against the claim proceeds from his income protection policy for tax purposes.

Therefore, the failure to supplement the income protection cover with business expense cover can lead to the client having a tax liability in spite of being in a loss position economically.

In the context of Case Study 2, Dina has assessable income of $9,000.

She cannot deduct her business expenses of $8,000 to reduce her taxable income to $1,000.

She is required to carry forward her $8,000 business loss and may only utilise this deduction if she derives sufficient business income in future years.

This is contrasted with the position of Brett. He receives $8,000 from his business expense policy. This is assessable business income and he has business deductions of a corresponding amount.

The $9,000 income protection claim proceeds are also assessable but his taxable income matches the cash amount received by him.

Take the opportunity to upsell

Income protection is designed to cover up to 75 per cent of taxable income so that your clients can maintain their lifestyle if they are disabled and unable to work. It is not designed to cover the fixed business expenses.

Using income protection benefits for this purpose can effectively halve the protection that is needed.

Additionally, your clients could be up for an unplanned tax surprise.

Business expense insurance is required to cover salaries, rent, equipment expenses, business insurances, interest on loans and everyday business overheads such as electricity and cleaning – so your client’s business can survive.

With the large number of small businesses out there and the under-penetration of business expense insurance, take the opportunity to upsell this much-needed cover to your existing client base.

Jason Bamford is the national technical services manager at TAL Australia.