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Business Insurance – The application of life insurance solutions for business needs

Extract: “Challenges of life insurance marketing – business applications” by Rizwan Ahmed Farid, 2012. This July we feature an exciting series of extracts from the upcoming practitioner guide on Challenges of Life Insurance market by Rizwan Ahmed Farid, the CEO of Dawood Family Takaful.

An Introduction[1]

The term “Business Insurance” covers not only insurance to fund the purchase of a business interest on the death of an owner or partner, but could also encompass life, health and accident policies on lives of key persons. These policies are owned by and payable to a business. Examples of Business Insurance include insurance creatively used to fund a buy-sell agreement on death or retirement, a disability income plan, a nonqualified deferred compensation plan, and insurance to indemnify a business or business owner for an economic loss that would be suffered in the event of death or permanent disability of the key personnel (the life insured). For life insurance marketing personnel therefore, the transition from the sale of personal insurance to Business Insurance is largely a shift in [customer] focus; the buyers’ motives, the procedure and the prospects remain the same.

 

Scope for Business Insurance

Small and Medium Enterprises (SMEs) are the backbone of any country’s economy. In USA for example there were over six million small businesses having 100 or fewer employees in 1999. 86.7% of these establishments had less than 20 employees whereas 11% had hired between 20-99 persons. They were paid payroll totalling US$ 1,394 billion which accounted for nearly half of the total payroll disbursed during that year.  No doubt small business is big business when it comes to employment opportunities.

In industrialized countries, Small and Medium Enterprises (SMEs) are major contributors to private sector employment. Empirical studies have shown that SMEs contribute to over 55% of GDP and over 65% of total employment in high income countries. SMEs and informal enterprises, account for over 60% of GDP and over 70% of total employment in low income countries, while they contribute about 70% of GDP and 95% of total employment in middle income countries.[2]

The real opportunity for marketing Business Insurance, therefore, lies in Small & Medium Enterprises – entities owned and managed by a limited number of individuals. Besides building professional prestige, Business Insurance offers tremendous opportunity for an insurance agent: large sales, increased premium, a high level of persistency and income. In U.S.A and Canada the need for Business Insurance is fully recognized for sustainability of business enterprises. But in South Asia, South East Asia, the Middle East, the Far East, and even in Europe the market for Business Insurance is almost virgin.

Small and Medium Enterprises are generally more vulnerable to the problems that Business Insurance specifically addresses and helps solve. On the other hand, large organizations can borrow money on their own names because of stable and sound cash flow & liquidity ratios (either actual or by employing financial wizards); they can spread management responsibilities among a number of individuals; and run a well organized human capital development programme. Hence a major portion of the Business Insurance market consists of a large number of small and medium enterprises rather than big organizations. The latter in turn are ideally suited for qualified employee benefit schemes, such as group life, health and pension insurance; provident fund and gratuity schemes, etc.

 

Motive for Business Insurance

Besides fires, accidents, and thefts; tsunamis, earthquakes, windstorms, floods, water damage; terrorism and riots; forgeries, personal, professional or product liabilities, etc., businesses are constantly exposed to the perils of human capital – premature death, disability, illness, resignations, insolvency and retirement of key persons. These human hazards bring about major changes in continuity, solvency, ownership, control and earnings of any business.

The coverage of human hazards in small business, partnerships or professional organizations is an important and creative use of life insurance. The fortunes of a family and business are complimentary. The motive for buying Business Insurance is the same as that of personal insurance, i.e. PROTECTION. When people buy personal insurance they are concerned about the security of their families; when businesses buy Business Insurance they are concerned about the security of owners, associates, employees, customers and creditors. Indirectly they are also concerned about the security of their families as the fate and welfare of the family and small business are often interlinked. The continued financial well-being of a family depends not only upon the continuing flow of income from the breadwinner but also upon the continued good health of the business in which the breadwinner is engaged.

Forms of Private Business Organizations

To envisage the problems of ownership and control of a business it is necessary to become thoroughly familiar with the three basic forms of business organizations, viz. sole proprietorships, partnerships and private limited companies. In particular, we want answers to the following questions which respect to each form:

  • What are the relative rights and liabilities of a business enterprise?
  • What happens when a business owner dies?

The following chart provides a comparison between the three types of business organizations:

LEGAL CONSTITUTION OF PROPRIETORSHIP, PARTNERSHIP & PRIVATE LTD. COMPANIES

 

LAW POINTS

PROPRIETORSHIP

PARTNERSHIP

PRIVATE LTD. COMPANY

1No. of MembersConsists of one person who is the sole owner of the business.May consist of two or more members.A private limited company may consist of two members but not more than fifty.Under the Single Member Companies Rules 2003, a person may form a single member company (SMC).
2Creation and OrganizationBy voluntary action of the individual. Ordinarily no formalities.By voluntary agreement of the parties. Ordinarily no formalities.By consent and authorization of law, after compliance with the statutory formalities.
3Relationship of Owners to BusinessThe business and its owner are not separate entities. The sole proprietor and the business are the same. Personal and business assets are merged.Association of owners, managed by general partners, business conducted in the firm’s name. Partner acts as principal for self and general agent for associates. Assets may be in the firm’s name but partners are co-owners as tenants in the partnership.The company and its shareholders are separate entities. The company is a legal entity unto itself; capable of owning on its own name and own rights. Managed by directors and officers.
4Liability of Owners for DebtsThe sole proprietor is personally liable for all the debts of the business.The partners are liable for the full amount of the debts of the partnership but with the right to have the firm’s assets first applied to its debts, and with rights of contribution between partners.Each member’s liability is limited to the nominal amount of capital subscribed, unless a shareholder personally guarantees the company’s debt.
5Capital FacilitiesNo legal limitations on the amount of capital practically, however, capital is limited to the resources of the individual owner.No legal limitations on the amount of capital, but as a practical matter, capital is limited to the individual resources of the partners and what they are willing to contribute. The actual amount of capital in the business can be altered at will.Legally limited to the capital authorized in the memorandum of association. This can be increased or diminished only by proper amendment of the articles as permitted by law; practically, capital is limited to amount the shareholders are willing to invest.
6Balance SheetAn annual balance sheet is not compulsory.An annual balance sheet is not compulsory.An annual balance sheet and profit and loss account are compulsory which must be audited and authenticated.
7Sharing of ProfitsAll profits belong to the individual ownerShared equally, in the absence of special agreement. Direct division of profits among members.Shared indirectly through dividends declared by directors out of profits. Apportioned among the outstanding shares of stock.
8TaxationTaxed as individuals under the head “income from business.”The firm is taxed on the firm’s income. The partners are also taxed as individuals for their share of profits.Taxed as a separate unit. Dividends are also taxed in the hands of the recipients.
9Sale of Ownership & interestThe proprietor may dispose of his business at any time.Shares are not transferable.In private limited companies transfer of shares may be restricted.
10Period of Legal LifeLimited to life of individual owner.Ends with winding up of affairs following dissolution on death, withdrawal or insolvency of a member unless there exists a prior contrary agreement.Perpetual, unless limited by terms of charter, law or statute.
11Effect of Owner’s DeathBusiness passes into the owner’s estate with other personal assets.Business is automatically dissolved and must be liquidated or reorganised, unless there exists a prior contrary agreement. Deceased partner’s interest passes to his or her estate.Business continues its independent legal existence with the deceased shareholder’s shares passing to his or her estate and through it to his or her heirs.
12ReferencePartnership Act 1932Companies Ordinance 1984. (Companies Act 1913. Repealed.)

 

The problem that death creates in a proprietorship or partnership is apparent from the above. On death there is dissolution of the partnership or business arrangement and parties are faced with the liquidation imposed by law unless some alternative solution can be worked out (a buy-sell agreement, for example, is one logical solution in the case of a partnership). On the other hand a private limited company does not “die” with the death of a shareholder. However the death of a majority shareholder could lead to changes in control which could impact the future of the business.

Human Capital in Business

The most vital asset of any business or professional organization is the human mind, in particular the technical or managerial skill acquired and experience gained. Business profits are the product of human activity, ability and skill. In professional firms (e.g. accountants, lawyers, risk consultants, etc), a partner’s professional ability to handle a client’s needs leads to profits. In other cases, the combination of knowhow, mental ability, technical and manual skills, combined with raw materials, machinery and technology result in profits. Remove the material assets of a business and it will come to a standstill; wipe off the human assets – especially its key executives – and the business dies.

Thus, the two elements in profit making and enhancement of a business’s worth are human ability and material assets. Impair or destroy either of these elements and the business suffers. A business that insures its buildings, machinery, automobiles and stocks from every possible hazard can hardly be expected to be careless in protecting itself against the interruption of its profit making process due to impairment or loss of human ability.

 

Business Applications of Life Insurance:

Business Insurance has many dimensions, which can be grouped as follows:

  1. Business Continuation Plans
  2. Key-executive Coverage
  3. Credit enhancement and collaterals
  4. Employee Benefits Plans

Life Insurance in a business setting can cover these four major areas as follows:

  1. It can be used as a funding medium, whereby life insurance is employed to fund a buy-sell agreement to transfer ownership between partners or shareholders or to fund a deferred compensation plan.
  2.  It can mitigate losses by covering the value of human life in business rather than property values. It cannot prevent the interruption of business activity caused by death, disability or retirement of its key stakeholders. However it can indemnify the business for the losses that are created by these interruptions.
  3.  It can be used as a shield to retain the good credit standings of a business. It may also protect the creditor. For example, a bank (the creditor) has confidence in the business but feels that the only obstacle to issuing additional credit is the fear of not being repaid if the business owner or CEO or other key executive dies. However, it may safely extend additional credit to the business if an insurance policy for an appropriate amount on the life of the key person(s) is assigned to the bank for the tenor of the loan.
  4. It can be used to protect employees and their families from the problems of death, disability and retirement. It can be used to provide for three basic types of benefits: death and disability benefits; medical, surgical or hospitalization cost; and old age benefits.

 


[1] The original version of this is article was first published in the “Insurance Journal: Jan-Mar 86 Issue.”

[2] “The Importance of Small and Medium Enterprises (SMEs) in Economic Development.” – The Free Library (by Farlex). Visited on February 11, 2010

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