‘Too expensive’, ‘too unlikely’, too many ‘what-ifs’ and ‘how will it work?’ are just some reasons SME owners avoid trauma insurance. But think about this: for 4 male partners, aged 35, 45, 50 and 55, there’s only a 52.4% chance that all will remain healthy in the next 10 years. What impact will that have on their business? It’s time to rethink the need for trauma insurance.

That figure of 52.4% may seem high, so it may surprise you to know that statistically, a trauma claim is more likely across most business owners’ age groups than a death claim.

Trauma benefits can play a significant role in business-risk management outcomes, but it can also seem easy to ignore because the trauma “what-ifs” aren’t clear-cut black and white.

By comparison, it’s easy to quantify a specific result for a business if an owner dies or is disabled — because they will no longer be physically present in the business. An owner’s potential to have a presence in the business, even after a trauma, is a challenge when planning. But plan you must.

Why consider trauma insurance?

Well, firstly, come claim time, where other products may not pay due to their structure and breadth of benefits, trauma well may be the only product that can pay and therefore fill a gap.

There are 3 main types of “living” insurance product:

• total and permanent disablement (TPD)
• trauma
• income protection

If one of those can’t do the job (either fully or partially) of securing the desired level of financial security, then ideally another will fill the gap (as much as is possible).

Secondly, as mentioned in the beginning, the statistical risk is just too high to ignore.

Both these reasons mean that, as a business owner, you should have trauma insurance.

In business succession planning, if you choose to leave out trauma insurance, and review your needs later, that’s your choice. But do so understanding what it is that trauma insurance offers you and where it fits in business succession planning.

So where does it sit with other business insurances?

Trauma benefits can:

• repay debt (inside or external to the business)
• pay to replace a key person
• reimburse the balance sheet for loss of goodwill
• fund the transfer of shares back to the remaining owners

If none of these financial needs arise after the illness or injury of an owner and/or key person, then a decision needs to be made regarding those claim benefits. That’s usually pre-determined within the underpinning legal agreements. We’ll look at this briefly later.

Trauma insurance should be part of an overall protection portfolio. It pays a benefit when:

• there has not been a death, so the term life cannot be claimed
• the illness or injury will not lead to a total and permanent disablement, so TPD cover won’t pay
• the illness or injury may lead to a TPD, but the long-term prognosis is not known so the 6-month wait must be borne before the TPD claim will be assessed

The problem here — particularly the latter point —  is that business needs may arise immediately and funds need to be available.

But there can be limitations on trauma sums insured.

What can typically be funded by a trauma payout?

The various needs emerging from business succession planning — buy/sell funding, debt protection, key-person revenue and possibly key-person capital — all need to be catered for in the event of a serious illness or injury and not just death.

Most crucial to consider will be the debt protection, where a third party can affect the business’s future overnight.

In the buy/sell situation at least, all parties can agree how to manage what is needed.

With a business loan with personal guarantees, it only takes the bank to call in the whole loan and the business is affected by an event that may not even result in share transfer in the end. (Anecdotally, banks calling in the whole loan is a common strategy of theirs.)

What’s the likelihood of trauma?

1. The more, the less merry 

Quite simply, the more partners in a business, the greater the risk — as evinced by the 52% figure at the start.

It’s probably easy to accept that for anyone (of either gender) between ages 35-55, the risk of suffering a serious event and dying is far lower than the risk of suffering a serious event and surviving — even recovering.

Taking the effect of compounding into account, mathematically, across 4 business partners say, the chances of a trauma with survival increases exponentially.

That means any business with more than a sole proprietor has to address these risks — or be negligent of its owners’ collective needs.

Taking our 4 male partners from the opening example, who are aged 35, 45, 50 and 55, according to actuarial research commissioned by Aviva Australia:

• the likelihood of reaching age 64 unscathed by trauma events (including death), is only 23%
• the group’s risks of cancer, or a heart attack alone, are 12% and 13.2% respectively

Given that the effects of just the “big 4” trauma events — cancer, heart attack, stroke and coronary bypass — let alone all the others, are so variable, the level to which the sufferer subsequently can or cannot work is what presents everyone (including lawyers) with a challenge.

It needs careful consideration.

If what ensues is a serious and ongoing illness, then an exit from the business is likely and the outcomes are as straightforward as for death and TPD — with the additional safeguard built in that the owners have given themselves a window within which to make that decision.

But what if there could be a return to work? What if the sufferer’s goal is to return to work, but the other owners believe he/she isn’t well enough to maintain the same contribution level to the business? What if the sufferer is well enough to work but chooses to opt out, having received a severe “health warning”?

2. Everyone should consider all scenarios

Depending on who is deemed the most likely owner to suffer the fictional trauma, the others’ view on where the policy benefits should land will always cause dissention and, at worst, conflict.

It is likely in the early discussions that the younger owner(s) will automatically assume that the older owner(s) is/are the candidates to trigger a trauma claim.

While understandable, it’s not necessarily true.

Voluntary versus involuntary business changes

Businesses can suffer from various types of interruptions and changes to ownership and/or normal flow of day-to-day operating.

Most of these fall under “voluntary” — say retirement, sale, resignation, bankruptcy or divorce.

“Involuntary” interruptions to business viability include:

• death
• serious illness
• serious injury

…where the latter 2 may or may not see the sufferer out of the business. And it’s this uncertainty for which you need to plan. Ideally now.

Case study:

Jack and Bill own a business and, with good advice, agree to set up a portfolio of term life, TPD and trauma.

Scenario 1, “the ideal world”: Having assessed the business structure and liabilities, Jack and Bill determined that when one died or became totally and permanently disabled, the other would need/want to:

• ensure that the remaining owner had the funds to pay the sufferer’s estate fair and agreed value for their share of the business. The remaining owner would then retain total control remove the business loan over which both owners have given personal guarantees. The estate/sufferer would then be released from that guarantee and the balance sheet would be adjusted accordingly.
• pay to find and secure a replacement for the sufferer’s contribution to the running of the business
• secure a lump sum that would help plug the revenue gap the business would endure after the loss of the sufferer, and before the replacement person could be effective.

The non-variable in the above example was the sufferer’s departure from the scene.

Scenario 2: “alive and able to claim trauma”: Take the same needs as above, but in the case where Jack has suffered — and survived — a heart attack.

Jack qualifies for a claim, and lump sum benefits are paid out. The funds are designed to fulfil the same aims as above.

But while it’s not yet known whether Jack is coming back to work, what happens to those funds? Here are some likely scenarios:

• The estate accepting the funds, in return for the equity transfer, is delayed until a reasonable time has passed so everyone can work out if Jack will return to work or not. The mechanism that allows and dictates this is called a “sunset clause” and will have been incorporated in the buy/sell agreement. Commonly, it’s 6 months, but the owners can dictate this at the outset.
• The loan is paid out regardless, as this transaction can be discrete and independent of any other business transactions arising. The business has then benefited from this event by being relieved of debt repayment from cash flow. The owners have been advantaged also, having a business with reduced or no debt. This means the business is worth more and personal guarantees have been released.
• Any decision to replace Jack is similarly postponed, unless the key-person revenue funds are used for temporary replacement, which, in some cases, may be practical and possible, and in other cases not.
• Cash flow can be shored up if required from the funds set down from the key-person revenue cover.

In the above example the owners will be looked to for decisions about what happens to the funds after payment and before being used — if their use is postponed.

Also, the trauma fund distribution may not be used if Jack decides, in agreement with Bill, that he will stay in the business.

There are a few feasible options here that your financial adviser may instruct your lawyers to build into the agreements (after you’ve discussed them and agreed to them). The most common are:

• unused funds are kept by the recipient in lieu of or part-payment towards a subsequent exit from the business
• unused funds are split equally between the owners and regarded as a windfall
• unused funds are spilt equally between the owners and lent into the business to provide working capital (this creates directors’ loan liabilities, which all parties must agree is acceptable)

Naturally, each has tax implications.

Scenario 3: “alive and unable to claim trauma”: Assume, however, that only death and TPD have been bought and these are designed to fund all the same needs as listed above.

(Bear in mind that the TPD will have a waiting period of 3 or 6 months before assessment can be made and a claim admitted, if eligible. Also, TPD can take a very long time to be assessed due to the level of disability needed to be proved.)

Jack has suffered and survived a heart attack. His prognosis is unknown, because it is too early in his recovery.

The following is likely:

• no lump sum benefits are payable from any source yet
• it is reasonable that the estate will wait until Jack’s future in the business is determined — unless he decides he has had a scare and it is time to exit — if he does, no funds are available to pay him out yet
• the lender is nervous and will probably call in the loan, for the full amount, but no funds are yet available for this and negotiations are attempted with the lender
• the pressure is on to support cash flow as the loan is still being repaid, costs continue in the business, but revenue is suffering
• this doesn’t leave sufficient buffer to recruit a replacement and no additional funds are forthcoming from the insurance policies

The above could easily be the foreseeable scenario if the business has no trauma insurance.

The secret to succession planning sums insured

If, as a business owner, you accept the concepts of trauma insurance, then you should be able to work out relevant sums to insure for your business’s circumstances.

Thankfully, the methodology for this in the business scenario is rather more straightforward than personally.

Discuss with your adviser your liabilities and equity share, identify key people and decide what it would cost to lose/replace them. That will populate your business-needs analysis.

Ideally, the sums insured will be the same across term life, TPD and trauma.

But in the real world, the limits the market imposes on trauma sums insured (particularly taking into account the personal cover the owner might also need on his or her life) may have an impact.

However, as discussed, statistically, a trauma claim is more likely across most business owners’ age groups, than a death claim. So approach trauma insurance with an open mind — it might just plug the gap to keep your business in business.

Source: “Trauma – a business insurance necessity” by Kaplan Education Pty Limited, December 2009; Actuarial research commissioned by Aviva Australia.

Tags: Insurance, trauma