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Lifeline for the unexpected
Recent NZBusiness snap poll targeted at business owners asking if they currently have income protection or key person insurance drew one very interesting response in particular that I believe captures the importance of having such policies in place. It was from a small business owner who was prompted to take out policies only after a key staff member was diagnosed with cancer and had to take time off work. This respondent naturally wished to cover the wages of both the staff member off work and the temporary replacement, which she admits, cost the business a lot of extra money. Key person insurance cover would have saved her the added expense.
At a rate of $78 per month, another business owner respondent described his insurance policy as “an easy investment to choose”.
So why do many business owners still hold off taking out such insurance? Is it that they don’t fully appreciate the risk to their business of losing their own personal input, or those of their staff? Perhaps it’s the old ‘head in the sand’ attitude that ‘it won’t happen to me’?
The death or disability of a key person or shareholder in the business can indeed be catastrophic. It could result in personal guarantees being called up by security holders, says Dean Young, director of Brave Day, a provider of insurance management for professionals. “Debt servicing could become difficult with potential restrictions imposed on credit terms and weakened cashflow. There’s also the risk of the loss of relationships and goodwill and a perception of instability amongst creditors.”
If all this loss was to occur, access to a cash resource could be the lifeline your business needs, he says.
David McIntosh, an associate director at Marsh Ltd, believes that many business owners just don’t think through the consequences of losing a key person such as themselves. “It’s not just the financial loss and the loss of expertise. What about the loss of all that knowhow and training resource, the unfinished business, loss of credit approval, loss of confidence in your business, and so on?”
Of course there are some sobering statistics available in this market if you still need convincing. “If you take a group of say three partners in a business, and looked at the probability of premature death by age 65, if their average age is 55, there’s a 38 percent chance. That figure rises to 48 percent if their average age is 45, and 51 percent when the age averages 35,” says McIntosh. “And everyone tends to focus on death statistics, but what about the figures on permanent disablement?” he asks.
Before we go too much further, let’s make the distinction between income protection and key person (‘keyman’) insurance policies – which should be looked at separately.
Milton Jennings, CEO of Fidelity Life, explains that key person policies are designed to inject cash into the company – either to then be paid to an individual/s or kept in the business to help it survive over the period of uncertainty. The money can be used for such purposes as covering debt, recruiting or penalties on contracts say.
“Income protection, on the other hand, provides monthly cashflow to cover the loss of income from personal exertion, and it’s critical for business owners.” You need to think beyond your own income production too, he says. Think what happens to the income producers below you in the business who are directly impacted by not having you, the owner, around driving things.
Dean Young puts it succinctly: “Income protection protects an individual’s biggest asset – his or her earning potential. It offers certainty and protection of cashflow.”
Recent developments
This sector of the business insurance market has seen the development of more specific and tailored products, providing more flexibility and certainty at claim time. Businesses and individuals can be covered for society’s most common problems, he says, such as cancer, heart attack, stress and stroke. “Thus ensuring their business can survive and families can be together at life’s most important times.”
Milton Jennings says Fidelity Life has seen a shift from key person cover to personal protection policies, and he puts this down to continued product development that originated around five years ago and largely out of Australia.
The shift has also been encouraged by the recent economic climate – but he’s quick to remind people that such policies should not be regarded as redundancy benefits, or as cash to make up for poor trading policies. “It’s purely for sickness and accident.”
Jennings also points out that mental illness is covered by these policies, but depression, for example, must be clinically proven. Not surprisingly, depression and ‘bad backs’ are the two main areas of claims abuse, he says.
Types of policies
The two major types of policies in the income protection market are Agreed Value and Indemnity. Both provide monthly cashflow on a personal basis, the difference being that Agreed Value policies have the medical and financial underwriting completed before the policy is issued; indemnity policies have only the medical underwriting done, with the financial underwriting performed at claim time. In other words, says Jennings, with one you must prove your income at the time of proposal (Agreed Value); with the other you prove your income at claim time.
In determining the definition of earnings, examples include ‘the best 12 months earnings over the last three years’ or an actual salary at time of claim. Insurers will seek proof of disablement and earnings loss at time of claim.
There are differences from a tax perspective too, according to Marsh Ltd. Under Agreed Value the IRD allows benefit payments to be tax free, proving that benefits are derived during a period of incapacity for work and benefits are not calculated according to loss of earnings or profits – and premiums are not deductible. Under Indemnity insurance, benefits are usually subject to income tax and premiums are deductible.
Understandably, if you still have income coming in at claim time, this would have to be declared and offset from the agreed benefit paid out. Most standard policies provide benefits up to a maximum of two years or age 65.
Business overhead or continuation policies that insure a key person in the business and where the policy is owned by and paid to the business can be either indemnity or agreed value, says Dean Young. He recommends Agreed Value where possible as it provides more certainty at claim time.
Other policies worth considering include Business Expenses cover. Ideal for small businesses with less than five staff or partnerships, this allows you to claim the costs associated with the running of your business if you are unable to work due to illness or injury.

Jennings says cover can be up to two years and the monthly benefits can be used to cover things like rent, salaries and utilities. “In the case of a doctor’s surgery, for example, you could use the Business Expenses cover to pay for a locum to come in and keep the business going.”
Seek advice
It’s recommended that you seek advice from a specialist who understands business insurance, and who has received and managed claims for their clients and can ensure that you are neither under-insured nor over-insured. Agreed Value income protection is generally recommended as it provides more certainty at claim time.
Young also advises full disclosure. “If in doubt put it down and disclose it to the insurer. The major reason that policies don’t pay out is non-disclosure.”
Review your policies at least once a year, he adds, “and make sure you have a basic understanding of what you are covered for.”
Don’t always base your decision on price either, he says. “This should be a factor when making a decision, but not necessarily the driving factor. Cheap might seem good, but it’s not helpful at all if claims aren’t paid. No one moans about premiums at claim time”.
Milton Jennings says one of the biggest mistakes people make is insuring all their personal income. “It’s not there to cover non-business related income, such as rentals or investments.
It’s not about putting you in a better financial position either – these policies are generally designed to cover you with up to 75 percent of your previous income.”
That said, Jennings says income protection insurance is vital. “You’d insure a $5000 Japanese import – why wouldn’t you cover one of life’s big risks?” He says research shows that there’s a one in three chance of being off work for a ‘longish’ period through illness or injury.
Protecting core shareholders
Under the total risk management umbrella for business owners is the need to protect the interests of core shareholders – and this is where buy/sell agreements come into play. Essentially, in a two-man partnership, for example, each partner insures the other. If one dies or can no longer continue working in the business through disability, then the majority of the pay-out goes to his/her family, and the remaining partner ends up with all the shares – it means minimal lawyer involvement and total business continuity. (For more on buy/sell agreements, see the separate sidebox.)
Jennings says it has even been known for businesses to insure their competitors – so if one owner dies, the business can be sold on certain terms to the competing company.
Advisors are faced with a number of scenarios, he adds, especially involving family members in the business, and this is often where a strong succession plan must dovetail with your insurance policies.
Industry trends
There will be some further development of income protection and key person insurance products in the foreseeable future. According to the experts we spoke to this will mean products that structure benefits to match what plays out in reality regarding an illness, as well as products that are easier to put in place and provide greater certainty for business owners.
It’s also agreed that premiums will trend upwards. Jennings is predicting a rise of around five percent per year, due to the escalation in claims. He also points out that some policies restrict ‘bad back’ and depression related pay-outs to two years, in order to keep premiums down.
Despite rising premiums, the popularity of income protection insurance across the board is expected to continue to grow. Figures from the insurance industry body, Investment Savings and Insurance (ISI) show the actual volume of income protection policies in force in New Zealand and compares 2009 with 2005. The percentage increase across the whole industry was 40 percent.
If you’re a business owner without any income protection or key person cover in place, perhaps this article is a timely reminder to give it some serious consideration. Your business’s very survival may depend on it.
Glenn Baker is editor of NZBusiness.

 

 

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