Protecting business debts – and the assets used to secure business debts
At some point, most businesses will borrow money from a financial institution or a company director, or both. This might be to provide the business with a capital injection for a major purchase or expansion or simply a source of working capital. These loans are usually secured by a first or second mortgage over the personal assets of the Director and their family, such as the family home and/or business assets.
Whether that security asset is the family home, the actual business premises itself, machinery, or other large plant equipment, there are clear issues to consider by using insurance to clear these loans, in the event of an unexpected death, disability, or serious accident or illness.
What Business Debt insurance does
A Business Debt Protection strategy is designed to help remove (or substantially pay down) business loans in the event a business owner passes away or suffers a serious disability. It's a risk that every business regardless of size, must protect against.
- Insuring your debts is a lot like insuring your working assets – in accountants' speak – business debts are considered assets – you need to protect the assets that drive the profit and revenue.
When taking out business loans and credit facilities, businesses need to consider what would happen if a business principal (ie: the Director) were to unexpectedly suffer from one of the statistical realities of Life and Business, and suffer an insurable event such a serious illness or accident, become disabled and unable to work or even unexpectedly die?
Protect the Business Debt Guarantor
Insurance can be used to protect the assets better used to guarantee the business debts, in case the principal becomes totally and Permanently disabled, suffers a critical illness, becomes terminally ill, or even passes away.
- Secured Loans, from a lending institution are usually secured by personal assets owned by the business Principal. If the owner of that security departs the business their ongoing guarantee of the business debt will end and the debt can be called up for immediate repayment.
- Unsecured Loans, are usually provided personally by a business owner or partner (and usually recorded in a directors loan account entry by the bookkeeper) while unsecured still have to be paid out if that business owner or partner departs the business.
Business Debt Insurance protects the guarantor/owner of the debts in the event of an insurable event.
A cost effective solution to a significant problem
A cost-effective way to provide an injection of cash to address these risks is for the principals to take out sufficient Life insurance, Total & Permanent Disability (TPD), and Critical Illness\Trauma insurance.
Without a business debt insurance strategy in place, if any of these events occurred, the business could have difficulty meeting its loan commitments.
- Usually, the death or disability of a Director is considered a contractual trigger event for an automatic call-up of any outstanding loans for repayment immediately
- The lending institution could have concerns about the business's cash flow and credit position and may require the outstanding loan to be repaired immediately.
- The lenders may then move to first seize the assets used as security for the debt, and then move to seek a mortgagee in possession order and fire sale assets so the debts can be cleared.
Important to Understand The death, disability or serious illness of a Director (who acts as a guarantor to the loan) may automatically trigger a contractual loan 'call-up' with the debts having to be paid upon demand and cripple the cash flow of an unprepared business.
How does this help you?
The funder will always deal with a business in a commercial manner.
- This means you can expect them to consider you have your own business debt insurance policies in place.
- Your family would probably expect you would have a backup plan in place too.
- Your accountant or business advisor would expect you have a Loan to Business Agreement in place as well to put it beyond doubt, that any loans to the company were in fact at call loans, and not to be considered an equity injection by the owner.
If your business has business debts secured by personal or business assets, you need to get business debt insurance in place.
Three types of business debt insurance
Business owners can protect themselves from insurable events occurring.
- Life Insurance can play an important role in clearing business debts in the event of the principal's death or terminal illness.
- Total & Permanent Disability (TPD) insurance pays out upon a long-term disability and usually has a 6-month waiting period.
- Crisis\Trauma (CI) Insurances pay out immediately in the event of a specified serious illness occurring.
Insight: A common misconception is that Crisis\Trauma (CI) Insurance and Total & Permanent Disability (TPD) Insurance are interchangeable and payout on identical conditions. This is not the case for all clients and won't apply in all situations.
For example; a principal may suffer a heart attack and return to work several months later. In this case, a CI not a TPD claim may be paid. Conversely, if a principal suffered a nervous breakdown, they might not be covered for this under a CI-specific list of health conditions but may be able to claim under TPD as a general 'inability to continue to work' due to that condition.
Depending on a client's individual circumstances, taking out insurance to cover all three insurable trigger events (death & terminal illness, TPD and CI) may be appropriate.
Case study
Business Debt Insurance | Raj's Story
Most businesses owe their Directors money.
This was the case for Raj who started his family-run wholesale food distribution business 6 years ago from his home garage. Rather than take a full wage, he decided to leave most of the profits in the company as 'Owners Funds' (money lent to the company by the director to help grow the business and lower the costs of running a bank overdraft account).
- Over the years Raj's accountant calculated the company debt to the company Director was $500,000.
One day Raj wants to take those funds out of the business but until then, to protect himself and his family, Raj’s company took out two types of life insurance policies naming Raj as its beneficiary, each for $500,000 to cover the outstanding balance owing to Raj and his family.
- Life insurance & linked Permanent Disability Insurance $500,000 - paying out if Raj were to pass away unexpectedly or suffer a terminal illness.
- Medical Crisis insurance for $500,000 - paying out if Raj were to suffer a listed medical crisis event and be unable to continue to work.
Having Business Debt insurance in place has brought certainty to him and his family that the business he worked so hard to establish will be able to meet its business debt responsibilities to its Director and his family, just in case life and business do not continue as planned.
How is the level of Business Debt insurance calculated?
Two approaches are used to calculate the sums insured required; debt cancelation and proportionality.
1. Debt Cancellation Method
The Debt Cancellation method involves calculating the cost of canceling the entire debt so that all guarantees or assets used as debt security can be released.
The basis for this method is the business principles are each jointly liable for the entire business debt and it may be appropriate where there are only a small number of principals (eg; two or three) and each of them plays a crucial and distinct key person role in the business.
In this scenario, the death, disability or serious illness of one of these principals is likely to have a significant impact on the business's ability to meet its loan commitments. Therefore, there is a high risk that the remaining principals could lose (or be forced to sell) any personal or business Assets used as loan security
Pro Tip: The debt cancellation method may not be suitable for businesses where there are several principals as the underwriting rules may determine the key person effect is not equally born between a large number of principals.
2. Proportionate method
The Proportion Method calculates the percentage (or degree) each business principal has in a particular debt, and then insures each principal for that specific amount. The basis for this method is that business principals are joint and severally liable for the business debt.
Having the right debt insurance in place means that you’ll have the funds to reduce or repay any business debt (and importantly safeguard any funds the business owns you as a director or shareholder) and protect your personal assets from being seized to pay business debts, should one of the insurance events take place.
Pro Tip: You should be aware the proportionality of debt obligation is not automatically always aligned with their equality share in the business or interest in the debt. For example; the principal who has provided the highest amount of security assets securing the debt might have the highest proportion of insurance taken out on their life.
Special Note: Milestone Fixed Term Life policies for Business Owners & Special Use
Need protection for a set period of time only or want to lock in premiums for 5, 10 or 15 years
Sometimes people need a life insurance or disability policy for a fixed period of time; whether that's to protect a fixed-term debt, safeguard the run-up to a business sale, or even a retirement, a Milestone Strategy can be useful. Often referred to as 'Term Level Policies', these strategies have Business and Personal applications that can help you better match the right premium pattern to your needs.
Business Short-Term Needs
Business succession - for pre-retiree.
Business loan on equipment.
Key Person with short term need.
Business Medium-Term Needs
Business succession - partner to retire in 10 years.
Business protecting debts secured by family home.
Key Person with needs of up to 10 years.
Business Long-Term Needs
Business succession - a younger business owner.
Key Person with long term need.
Buy & Sell strategy with stabilised premiums.
What happens at the end of the fixed term?
You can continue with the cover after the initial term expires on variable premiums with no additional underwriting required.
How we can help
Business Debt Protection insurance strategies are an important part of protecting your business and your family, from the business.
Contact us for a confidential chat about your needs.
Related: Types of Business Insurance products we work with
There are lots of different types of risk protection insurance that can help in different situations.
- Protecting Fixed Business Expenses - those recurring cost-to-stay-open-for-business expenses
- Protecting Business Key Revenue Makers - those Key People in the business
- Protecting Business Debts - the ability to continue to pay debt during recovery from a serious illness or injury
- Protecting Business Ownership - the ability to pay debt determines who ultimately owns the business
- Shareholder and Capital Protection - protecting all Investors in the business, great and small
