Business insurance how much cover is needed? Fact Sheet - October 2014

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1 Business insurance how much cover is needed? Fact Sheet - October 2014 This fact sheet examines various methods of estimating the level of business insurance. The calculation methods do not take account of any tax that may apply to the receipt of insurance proceeds, earnings or income. Business insurance The adviser is usually required to assist the business or business owner/s to establish both the type and amount of insurance cover required. A business owner or employee may need to be insured for: death critical illness (trauma) permanent incapacity (total and permanent disability). The needs of business may include: key person insurance (revenue purpose) required through absence of a key person/s who generates revenue for the business loan protection (guarantor cover - capital purpose) required for funding loan payment buy/sell insurance for funding the departure of a business owner. A business may require insurance cover for one or all of these events or purposes. Scenario Ernie and Bert are co-owners of a toy business. They are paid $100,000 each by their jointly owned company, Ernie as marketing manager and Bert as product manager. Their contribution is critical to business success and each brings in revenue of $500,000 per annum. The business has been expanding and taken on $1,000,000 in debt for the purchase of a warehouse. Ernie and Bert are guarantors for $500,000 of the debt each. Their accountant calculates the gross value of the business to be worth $4,000,000. Each co-owner estimates that if the other left the business, revenue would be affected for 2 years. The costs of replacing either is a one-off cost of $50,000 and the business expense, including salary for each of them is $150,000 per annum. Asteron Life 1

2 Key person insurance (revenue purpose) The absence of Ernie or Bert would significantly affect the revenue of the business. For complete coverage, each key person needs to be insured by the business according to their contribution to the business. The following factors must be determined before making the calculation: the gross annual salary package of the key person the gross annual revenue attributable to the key person the business expenses attributable to the key person (this will be the salary package and on-costs, such as workers compensation insurance and payroll tax). These factors could be supplied by the business owners and/or their accountant. The estimate is calculated as follows: Term life insurance Example Label Gross annual salary package of life insured $100,000 A Gross annual business revenue attributable to life insured $500,000 B Less: business expense attributable to life insured ($150,000) C Net business revenue attributable to life insured $350,000 B - C = D Maximum loss of revenue over 2 years $700,000 2 x D = E Add: cost of replacement and recruitment of key staff $50,000 A x 50% = F Suggested term life insurance $750,000 E + F = G Less: existing term life insurance for purpose of key person insurance Nil H Term insurance shortfall $750,000 G - H Suggested trauma insurance $750,000 G Less: existing trauma insurance for purpose of key person insurance Nil J shortfall $750,000 G - J Suggested TPD insurance $750,000 G Less: existing TPD insurance for purpose of key person insurance Nil L TPD insurance shortfall $750,000 G - L Limitations This example assumes that loss of revenue is limited to 2 years and that replacement costs are 50% of the key person s salary package. A different period and percentage may be appropriate. It is often difficult to quantify the loss a business would suffer from the incapacity of a key employee. In the case of a small company the loss of a key employee is often critical to a business s continuance, not just its net profit. As the purpose of key person is to insure the business for loss of the individual s contribution, which would happen on any one event being death, disablement or trauma, standalone benefits are not usually required. Therefore life insurance linked with trauma and TPD insurance is usually sufficient. Loan protection (guarantor cover - capital purpose) This method calculates the cover required to extinguish either Ernie or Bert s share of business debt should they depart the business. For complete coverage each owner needs to be insured for their share of the business. The following factors must be determined before making the calculation: The total debt of the business The life insured s percentage of business ownership. The estimate is calculated as follows: Asteron Life 2

3 Term life insurance Example Label Total business debt $1,000,000 A % life insured is responsible (% of business ownership) 50% B Suggested term life insurance $500,000 A x B = C Less: existing term life insurance for purpose of debt insurance Nil D Term life insurance shortfall $500,000 C - D Suggested trauma insurance $500,000 C Less: existing trauma insurance for purpose of debt insurance Nil F shortfall $500,000 C - F Suggested TPD insurance $500,000 C Less: existing TPD insurance for purpose of debt insurance Nil G TPD insurance shortfall $500,000 C - G Limitations Usually only the total debt of an entity can be insured with apportionment to each owner based on their business share. This is assumed in our example. Owners may be able to insure for the full amount of the business debt each, if they have joint and severable liability for the debt. This is not assumed in our example. Buy/sell insurance This method calculates the cover required to fund a buy-out of a departing owner. For complete coverage each owner needs to be insured for their share of the business. Two factors must be determined before making the calculation: The value of the business The life insured s percentage of business ownership. The estimate is calculated as follows: Term life insurance Example Label Gross business value $4,000,000 A Less : business debt ($1,000,000) B Net business value $3,000,000 A - B = C % of business ownership of life insured 50% D Suggested term life insurance $1,500,000 C x D = E Less: existing term life insurance for purpose of buy/sell insurance Nil F Term life insurance shortfall $1,500,000 E - F Suggested trauma insurance * $750,000* E Less: existing trauma insurance for purpose of buy/sell insurance Nil G shortfall $750,000 E - G Suggested TPD insurance $1,500,000 E Less: existing TPD insurance for purpose of buy/sell insurance Nil H TPD insurance shortfall $1,500,000 E - H *If a business owner is expected to return to work after a trauma event and the business may increase in value during their absence it may be advisable to have standalone trauma cover of a lesser value to life cover. In this case the Suggested Trauma Insurance figure should use the key person guideline. This compensates the active owners for the increase in the value of the business during the inactive owner s absence. TPD can be linked to life cover as either event would lead to permanent departure from the business. Asteron Life 3

4 Limitations A proper and current valuation of the business is critical. As the purpose of buy/sell insurance is to ensure remaining owners can buy out the departing owner s share, standalone benefits are not usually required. Therefore life insurance linked with trauma and TPD insurance is usually sufficient. Contact Details Technical Services Suncorp Portfolio Services Limited ABN AFS Licence No For more information on Asteron product solutions, please contact the Sales Manager in your State. NSW/ACT Level Kent Street Sydney NSW 2000 T NSW callers outside Sydney: VIC/TAS Level Collins Street Melbourne VIC 3000 T VIC callers outside Melbourne: QLD Level Wickham Terrace Brisbane QLD 4000 T QLD callers outside Brisbane: SA/NT Level Grenfell Street Adelaide SA 5000 T SA callers outside Adelaide: WA Level William Street Perth WA 6000 T WA callers outside Perth: Important note The information contained in this publication is of a general nature only and is intended for use by financial advisers or other licensed professionals only. it must not be handed to clients for their keeping nor can any copies of sections of this publication be given to clients. The information has been compiled based on regulatory policy at the time of writing. We recommend that your client refer to their professional tax or legal adviser prior to implementing any recommendations you may make based on the information contained in the publication. 10/2014

5 Templates Key person insurance (revenue purpose) Term life insurance Client data Label Gross annual salary package of life insured $ A Gross annual business revenue attributable to life insured $ B Less: business expense attributable to life insured $ C Net business revenue attributable to life insured $ B - C = D Maximum loss of revenue over 2 years $ 2* x D = E Add: cost of replacement and recruitment of key staff $ A x 50%* = F Suggested term life insurance $ E + F = G Less: existing term life insurance for purpose of key person insurance $ H Term life insurance shortfall $ G - H Suggested trauma insurance $ G Less: existing trauma insurance for purpose of key person insurance $ J shortfall $ G - J Suggested TPD insurance $ G Less: existing TPD insurance for purpose of key person insurance $ L TPD insurance shortfall $ G - L * A different period and percentage may be appropriate. Asteron Life 5

6 Key person insurance (guarantor cover - capital purpose) Term life insurance Client data Label Client data Label Total business debt $ A % life insured is responsible (% of business ownership) % B Suggested term life insurance $ A x B = C Less: existing term life insurance for purpose of debt insurance $ D Term life insurance shortfall $ C - D Suggested trauma insurance $ C Less: existing trauma insurance for purpose of debt insurance $ F shortfall $ C - F Suggested TPD insurance $ C Less: existing TPD insurance for purpose of debt insurance $ G TPD insurance shortfall $ C - G Asteron Life 6

7 Buy/sell insurance Term life insurance Client data Label Gross business value $ A Less : business debt $ B Net business value $ A - B = C % of business ownership of life insured % D Suggested term life insurance $ C x D = E Less: existing term life insurance for purpose of buy/sell insurance $ F Term life insurance shortfall $ E - F Suggested trauma insurance * $ E Less: existing trauma insurance for purpose of buy/sell insurance $ G shortfall $ E - G Suggested TPD insurance $ E Less: existing TPD insurance for purpose of buy/sell insurance $ H TPD insurance shortfall $ E - H * If a business owner is expected to return to work after a trauma event and the business may increase in value during their absence it may be advisable to have standalone trauma cover of a lesser value to life cover. In this case the Suggested Trauma Insurance figure should use the key person guideline. Asteron Life 7