How Does Debt Reduction Cover Affect the Amount of Your Buy/Sell Cover?

Normally, the amount of a Proprietor's Buy/Sell Cover reflects their share of the Net Asset Value of the Business (i.e., Gross Assets less Liabilities).

This is relatively straightforward if the only Need is Buy/Sell Cover.

However, what if the Business has Debt Reduction Cover that will reduce the Liabilities upon the occurrence of an Insured Event?

Does the Sale Price and Buy/Sell Cover need to reflect the reduction in Liabilities and the increase in Net Asset Value that occurs after the Insured Event and the payment of the Claim?

Example

A Business is owned by two Proprietors equally.

The Gross Assets of the Business are $2M, while the Liabilities are $1M.

The Net Asset Value of the Business is $1M. A 50% share is therefore worth $500K.

If only Buy/Sell Cover was obtained, the Sum Insured would be $500K per Life Insured.

So far, so good.

However, the situation might be different, if the Business takes out Debt Reduction Cover for half of the Liabilities.

The Debt Reduction Cover would be $500K per Life Insured.

If a Life Insured died, the Liabilities would decrease by $500K and the Net Asset Value of the Business would increase by $500K.

As a result, it is arguable that the Sale Price and therefore the amount of the Buy/Sell Cover should be increased from $500K to $750K for each Life Insured.

The more Debt Reduction Cover you have, the more Buy/Sell Cover you need.

For every $2 of Debt Reduction Cover you have, a two Proprietor Business needs an extra $1 of Buy/Sell Cover.

Clover Law calls this "insuring insurance".

Effective Date of Valuation

Clover Law does not normally adopt this approach.

One concern is whether an Underwriter would accept a valuation on this basis.

However, another issue is the effective date of the valuation.

Clover Law recommends that the effective date of the valuation should be the day before the occurrence of the Insured Event and the payment of the Claim.

This means that the value of the Debt Reduction Cover is assessed at Nil.

Clover Law adopts the same date of valuation for the purposes of considering the impact of the Insured Event on the Goodwill of the Business.

If the Business was valued the day after the payment of the Claim, it would be necessary to consider the impact of the loss of the Life Insured as a Key Person.

Any drop in the Goodwill would reduce the Net Asset Value of the Business and the amount of the Sale Price.

Thus, if the damage to the Goodwill was taken into account, the Insured Event would reduce the Sale Price and therefore the amount of the Buy/Sell Cover that was needed.

In other words, the Life Insured's Equity might be worth less, precisely because they had died.

This is not normally acceptable to Business Proprietors.

Therefore, Clover Law recommends that the effective date of the valuation should be the day before the occurrence of the Insured Event and the payment of the Claim.

In the case of Debt Reduction Cover, the reduction of Liabilities would not be taken into account in determining the Sale Price and the Buy/Sell Cover.

Debt Reduction Cover as an Asset of the Business

Another way to look at the issue is to see the Debt Reduction Cover as an Asset of the Business.

If a Proprietor pays an appropriate Price for the Equity in the Business, then it is entitled to an indirect share of all of its Assets.

The Policy is one of these Assets.

If the Insurance Proceeds are paid after the transfer of Equity in the Business to the Purchasers, then the Insurance Proceeds should indirectly belong to the Purchasers.

In reality, this argument adds nothing to the Effective Date of Valuation argument.

Substitute Loan Accounts

A more compelling argument follows from how the Clover Law Business Insurance Trust Agreement structures the Debt Reduction Cover.

The Agreement effectively gives the commercial benefit of the Debt Reduction Cover to the Continuing Proprietors.

It then requires them to lend the Insurance Proceeds to the Business (by way of Substitute Loan Accounts), so that it can repay the External Creditor.

This Strategy effectively replaces the External Liabilities with identical Loan Accounts.

Thus, it has a neutral impact on:

the Liabilities of the Business;
the Net Asset Value of the Business; and
the Sale Price of the Life Insured's Equity.

Fairness

This approach effectively enriches the Continuing Proprietors.

Some Clients consider that there is an element of unfairness or windfall in this Strategy.

If they want to balance the benefits more equitably, the question is how to do so.

Increase the Sale Price

The intuitive response is to increase the Sale Price and therefore the Buy/Sell Cover.

However, this would also increase any CGT Liability with respect to the Sale Price .

Increase the Personal Cover

For Clients who wish to balance the beenfits, Clover Law normally recommends that the additional Cover be allocated to Personal Cover.

This avoids CGT on the Sale Price and ensures that the Insurance Proceeds are not assessable.

How Much Compensation is Required?

If the whole of the benefit of the Debt Reduction Cover is given to the Continuing Proprietor, then they would receive a benefit of $500K in the above example.

This suggests that the matching benefit needs to be $500K.

On the other hand, if the benefit had been shared, then the Life Insured would have received a half-share or $250K.

This suggests that the matching benefit need only be $250K.

This approach doesn't treat the two Lives Insured equally.

Instead, it puts the Outgoing Proprietor in the same position they would have been in, if the benefit had been shared.

It also has the advantage of being a cheaper Strategy.

Ultimately, the choice of Strategy depends on the commercial views of the Business.

Adviser Tip

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