Injecting new life into small business

Small and mid-size businesses may be the growth engine of the Australian economy, but, alarmingly, only a small proportion appear to have adequate insurance in place should the unexpected occur.

Most business owners recognise the need to insure their buildings, plant or stock, but neglect to take similar precautions when it comes to another major asset — themselves and their key people.

A lack of awareness among small business operators about how business protection works and what it can offer, coupled with the reticence of some advisers to get involved in an area they perceive as complicated, are often cited as two key reasons why many small businesses are underinsured in this area.

But if advisers can explain the need for, and the mechanics of, all forms of personal and business cover, they can ensure small business clients are suitably protected should misfortune strike.

This requires a solid technical understanding and a handle on how to identify and measure both personal and business risks, which ultimately will bring clarity for clients.

After all, clients who understand the risks will understand the impact it could have on their families and their business and are more likely to keep paying the premiums, and that means more business for advisers.

There’s a perception that many forms of business protection are too time consuming for small business owners and too complex for advisers to even consider offering to clients.

The reality is that the financial underwriting of business insurance is relatively straightforward and offers tremendous growth opportunities for advisers, particularly in areas such as buy-sell, key person, loan, income protection and business expense cover.

The whole aim of business financial planning is to protect the intentions of a business owner. If tragedy strikes, financial planning can stop banks from foreclosing, prevent the business being sold, avoid sale at an unfair price or profits being lost.

It is therefore crucial that, for the insured to enjoy full protection and for the underwriter to make sensible underwriting decisions, the risk is properly and expertly evaluated at the outset by the insured and its advisers.

From an underwriting perspective, insurance applications for business owners are generally straightforward to assess, as long as the sums insured are linked to real risks and supported by evidence.

Insurance is, after all, a tool designed to replace loss incurred, and the underlying principle is that the beneficiary should not be better off financially after the unexpected event. So advisers and their clients need to make sure they provide the underwriters with as much relevant information as possible when they submit an application.

These principles apply to life insurance in the same way as general insurance. Have you ever tried to insure your home under buildings insurance for an additional amount so that in the event of loss you can build the two-storey home you have always wanted? Can you envisage the loss adjustor signing the cheque for the full amount?

Part of my job involves helping underwriters review and interpret the financial statements used to support insurance applications, and I often see advice opportunities for advisers. Ranging from ways to speed up assessment to maximising client protection, they include:

> focusing on the client’s earning capacity, not their taxable income;

> utilising a three-part formula when valuing a key person;

> considering the need for loan protection; and

> articulating how individual risks are assessed in the application form.

Earning capacity

For self-employed clients to receive the maximum personal insurance coverage it’s imperative that advisers fully understand how their earning capacity is measured. It is not the taxable income, dividends or any amounts drawn from their business.

The earning capacity of a self-employed person is measured by reference to their share of the net profit generated by their business before tax. By calculating the net profit, advisers don’t need to worry about adding back profits that are reinvested into the business or profits that have been distributed elsewhere as a result of tax structuring.

However, advisers should ensure they exclude passive investment income and add back all discretionary payments, and private expenditure of the insured, to their business partners and family. Advisers can do this using the insurer’s add-back form.

By using this methodology advisers can put larger levels of cover in place. Other methods for calculating earnings (salary, dividends and drawings) will usually deliver a much lower amount.

Often in a small business the owner splits their income with a spouse so they are taxed at a much lower rate. The underwriter won’t have a problem with this, but they will want to know that there is such an arrangement so they can insure the business owner’s total income, even though it has been split between the spouse and the owner.

If the spouse is genuinely participating in the business the level of add-back is assessed by reference to his or her estimated worth (determined by their hours and duties) and what they are actually earning.

In almost all cases, underwriters will put the cover in place: they simply need to know that it is justified.

Key person cover

For key person insurance, the sum insured should be enough to enable a business to survive the temporary (through illness or injury) or permanent (through irrecoverable disability or death) loss of a vital employee who is difficult to replace.

To determine the value of a key person, advisers can use the following three-step formula.

Step 1: Calculate the cost of a replacement. Consider one to two times the gross annual package cost;

Step 2: Add an amount to cover the total value of lost profits. Advisers should be realistic and estimate the impact based on sales or gross profit; and

Step 3: Gross up the sum insured to offset the impact of income tax on benefits.

Loan protection

Loan protection insurance is another necessity for small business owners, and despite the fact it is easy to obtain it’s often overlooked.

This form of insurance can help cover bank loans, overdrafts, hire purchase commitments and guarantees if one of the business partners was to pass away or become incapacitated.

All that an insurer will require is a copy of the loan agreement and a recent bank statement showing the current loan exposure.

Speed up the underwriting process

Advisers who support their business insurance application with evidence will ultimately speed up the underwriting process. This includes providing:

> an outline of the purpose for each type of cover;

> detailed calculations of the insurable amounts applied for;

> a structure diagram from the client’s accountant if the business interests are complicated;

> details on the nature and extent of a spouse’s involvement in the business if the spouse is receiving income; and

> a copy of the Statement of Advice, which will help underwriters understand the client’s protection gap, levels of cover and the reason for cover.

Advisers have so much to offer self-employed and small business clients. By identifying all of the risks and understanding what underwriters are looking for, advisers can implement a watertight risk management plan that will not only protect their client but go some way to eliminating underinsurance in the small business sector.

Ted Voges is manager of forensic accounting at ING Life Risk .