Shareholder Protection Insurance Guide
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What is shareholder protection?
Shareholder Protection Insurance is a type of life insurance for small and medium-sized businesses. Policies pay a lump sum if one of the company shareholders dies or becomes terminally or critically ill. This lump sum is then used to purchase the shares from the affected shareholder or their estate.
Policies are set up with a separate, legally binding agreement called a cross option agreement. This obligates each party to buy or sell the shares and determines how the shares will be valued.
Ensuring funds are available to acquire the shares, ownership and control of the company stays with the existing shareholders. This mitigates many of the negative outcomes that can arise when shares are sold or bequeathed to a third party.
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What are the benefits of shareholder protection insurance?
If one of the shareholders dies or is diagnosed with a terminal illness the three main benefits are:
- Cost – The cost to buy the affected member’s shares of the company is covered by the policy. The remaining shareholders will not have to find the capital or raise personal finance.
- Control – Ensures that the control and direction of the business remain with the surviving shareholders. It prevents the company’s shares and / or voting rights from being acquired by a third party.
- Certainty – Creates financial and operational certainty for the business by greatly reducing the risk of business disruption and many undesirable scenarios. With the company’s valuation method agreed upon, it also creates certainty for shareholders and their families. In the event of their own passing, their shareholding will be purchased for a pre-agreed, definable sum.
These benefits assist with business continuity, risk management and succession planning.
What risks does shareholder protection insurance help mitigate?
Shareholder protection insurance helps to mitigate countless adverse scenarios and risk factors. Primarily, it eliminates the risk of company shares falling into the hands of a third party.
Shareholder agreements often have specific clauses that seek to prevent this too. However, they do not solve the issue of where the funds come from to acquire the shares. Without secured funds in place, the surviving shareholders could risk forfeiting any right to buy the shares.
Even a minority shareholding bequeathed to a third party can cause severe disruption in a small or medium-sized business. Ensuring the shares remain in the ownership of the existing shareholders helps to decrease or eliminate the risk of:
- Unwanted input from outsiders
- Change of business direction
- Misuse or incompetent use of voting rights attached to shares
- Unbalanced or unfair remuneration
- Delays caused by the probate process
- Potential threats of litigation
- Business distractions and legal costs caused by the above
Shareholder protection policies and tax
There are three main ways that a shareholder protection policy can be set up. Each has different characteristics and important tax implications. These should be discussed with the company’s accountant to ensure the most suitable policy is chosen.
IMPORTANT: The information provided on this page regarding shareholder protection policies and their tax implications is intended for general informational purposes only and should not be construed as tax advice. Tax regulations are complex and subject to change. The impact of tax laws and regulations can vary based on individual circumstances and may differ based on various factors.
Before making any decisions related to shareholder protection insurance or understanding the specific tax implications for your business, it is essential to consult with a qualified tax advisor or accountant. Black Lion Insurance does not provide tax, legal, or accounting advice. All content is provided without any warranty, express or implied, regarding its accuracy, completeness, or applicability to your specific situation.
Life of Another
This is the most straightforward type of shareholder protection. Life of Another is generally only considered for small businesses with just two or perhaps three shareholders. This is because the number of policies quickly becomes unmanageable with more than three shareholders.
- Each shareholder takes out a policy on the life of any other shareholder.
- Premiums are paid for personally by each shareholder.
- If a shareholder dies, the remaining shareholder(s) receive a personal tax-free lump sum.
- Remaining shareholder(s) purchase the affected shares.
Tax: Insurance premiums are paid for by the individual from post-tax earnings. Therefore there are no P11D or corporation tax considerations for the company.
Own Life
This type of policy is more complex in its structure, requiring the creation of a business trust. Favoured by companies with three or more shareholders or where shareholders may change more frequently. This is because adding or removing shareholders is relatively straightforward.
- Each shareholder takes out a policy on their own life.
- Premiums are paid for by the company.
- The benefit is written into trust with the company being the beneficiary.
- Should any of the shareholders die, the policy pays out to the business trust.
- Business trust is then used to acquire the affected shares.
Tax: Own Life policies are generally paid for by the company. This is normally seen as a benefit in kind, meaning shareholders are required to pay tax on the premiums. Premiums are unlikely to qualify for corporation tax relief. However, any lump sum payment would not be subject to tax.
Company
Simpler than an Own Life policy, a company policy does not require the creation of a business trust.
- Business that is the policyholder and takes policies on the lives of each shareholder.
- Premiums are paid for by the business.
- Should a shareholder die, the policy pays out the lump sum directly to the company.
- Company buys back affected shares which are then cancelled.
Tax: Premiums are unlikely to be eligible for corporation tax relief. The lump sum is not likely to be subject to corporation tax. HMRC generally does not look upon this as a benefit received by the shareholder.
However, there are some matters that require consideration before taking a company policy. These relate to the length of time the shares have been owned, capital gains tax, and any significant creditors the company may have.
Additional Contracts
Cross Option Agreement
When setting up shareholder protection, it is crucial that the policy does not conflict with any existing agreements. These can include the company’s articles of association and any existing shareholder agreement. Specifically, any pre-emption rights or clauses relating to share transfers need to be examined.
Once this has been established, if required, a ‘Cross Option Agreement’ can be put in place. Businesses should employ the services of a legal professional for this process.
Also referred to as “double option agreement”, this creates the following obligations regarding the shares:
- The surviving shareholders have the right to acquire the affected shares of the deceased / terminally or critically ill shareholder.
- The affected shareholder or their estate has the right to force the surviving shareholders or to buy their shares.
Premium equalisation
Age and health are two factors which play a large role in determining the cost of life insurance premiums. The same applies with shareholder protection.
This can lead to older shareholders paying far more towards the policy than younger shareholders.
Premium equalisation is a method used to address this. It divides the total cost of all the life policies among the shareholders. Each paying a percentage equal to that of their holding in the company.
Premium equalisation also raises some complex tax considerations. These are beyond the scope of this article and will require advice from an accountant.
How much does shareholder protection cost?
Annual premiums are determined by many factors which include but are not necessarily limited to:
- Company valuation – The overall amount of cover required directly correlates to the valuation of the company. The higher the value of the company, the higher the insurance premiums.
- Company industry – The market sector in which the company operates can influence the risk and, therefore, the premiums.
- Shareholders – As with a standard life insurance policy, various personal factors contribute to the cost of the premiums. These can include: Age, Occupation, Lifestyle, Smoking status, and Medical history.
- Critical Illness Cover – Policies that include critical illness cover are likely to be significantly more expensive. This is because it is far more likely that a shareholder protection policy will pay out during the term of the policy.
- Policy Type – If the policy is set up as Own Life, Life of Another, or as a Company Policy.
- Term of Policy – Whether the policy is set up for 5 or 10 years may also affect premiums.
Valuing the shares for the purpose of the policy
When setting up a shareholder protection policy, the method used to value the business must be chosen. The value of the business and the shares will determine how much cover is required which will affect the cost of the policy’s premiums.
Valuing a business can be an extremely complex task. Turnover, profit, assets, debt and future cash flows are just some of the contributing factors. Company accountants are likely best placed to advise on the most suitable valuation method for any business.
Different Methods are likely to be more appropriate based on industry or the age of the business. Price to Earnings Ratio, Cost of Entry and Discounted Cash Flow are just some methods.
Minority holdings are often considered to be less valuable per share than a majority stake since. This is because majority stakes may carry with much more control. If there are different classes of share each class may need a separate valuation.
For more information on valuing a small business, AXA have a great guide here.
Shareholder Protection Insurance Quotes
Obtaining a shareholder protection quote requires the insurance consultant handling the enquiry to have specific expertise and experience.
At Black Lion Insurance, clients will be assisted by a qualified, FCA registered consultant. Every consultant has the necessary knowledge and commercial acumen needed to help businesses make informed decisions.
Contact Black Lion Insurance today for expert advice on protecting your business.
Case Study
What Can Go Wrong When A Shareholder Dies?
This hypothetical case study examines what can go wrong when a shareholder dies. The scenario takes a successful small business with two 2 equal shareholders. They each play an important role in the success of the business. But, there is no shareholder protection insurance in place.
Frequently asked questions on Shareholder Protection Insurance.
What should small businesses consider when looking at shareholder protection versus key person insurance?
The two policies do very different jobs. Determining whether shareholder protection or key person insurance is the preferred option for any business depends on various factors. It can be a difficult decision to make and, in many cases, businesses may decide they need both. This provides a high level of business continuity and risk management but may be cost-prohibitive.
Here are some key points to consider:
- Value of the Business: What is the value of the business? Could the company or the surviving shareholders afford to buy any deceased shareholder’s equity? Could this be done without protection in place or would it require securing loans?
- Role of Shareholders: In many small businesses, shareholders are also key people. Assess the specific roles and contributions of each person. Consider how the business would cope without each individual shareholder. Perhaps some shareholders would be far harder to replace than others.
- Key Employees: Does the business have any key employees other than the shareholders? What percentage of the company’s profits are those people responsible for? How difficult would it be to recruit a replacement member of the team?
- Business Continuity: How critical is each key person? Would their passing cause concern for clients or other stakeholders in the business? Would it have a dramatic effect on the company’s valuation?
- Succession Planning: Without protection in place what would happen to the shares upon the death of each shareholder? How are voting rights affected? Is there a majority shareholder or controlling interest?
- Single Shareholder Director: For limited companies with one shareholder-director, key person insurance may be preferable. If the director handles day-to-day operations, business continuity is likely to be a greater concern. A key person policy will provide funds to keep the business running in their absence.
When does a shareholder protection insurance policy pay out?
Most policies also include the option to increase the cover by adding critical illness to the policy. A claim could then be made if one of the protected shareholders is diagnosed with or suffers from a serious health issue. The list of conditions covered is different for each insurer, although generally is likely to include:
- heart attack
- stroke
- cancer
- Parkinson’s disease
- Alzheimer’s disease
- multiple sclerosis
- brain tumour
- kidney or liver failure
- heart conditions and cardiovascular diseases such as coronary artery disease
- major heart surgeries or organ transplants
- blindness, deafness, loss of speech
Insurers will normally transfer the funds to purchase shares within 30 to 90 days following a successful claim.
As with any insurance policy it is important to understand the terms and conditions and possible exclusions.
Why does a small business need shareholder protection if there is already a comprehensive shareholder agreement in place?
A shareholder agreement outlines the rights and obligations of shareholders. It often includes provisions on voting rights, conflicts of interest, and the sale of shares. It ensures that shareholders and the company are protected from various risks.
It may even include provisions that address the death or incapacity of a shareholder. For example, clauses may require that the remaining shareholders purchase an incapacitated shareholder’s shares at “fair market value”.
However, what a shareholder agreement does not do is to provide the necessary funds to buy the affected shares.
Depending on the valuation of the company, the remaining shareholders may be required to find a substantial sum. That can burden the individuals or company with a level of financial risk that is not comfortable to shoulder.
Even if the debt burden is manageable, the bank may not lend the money to purchase the shares. Or, if they do, the loans may require substantial security which may include shareholder’s homes.
Even the most comprehensive shareholder agreement isn’t going to solve the issue of paying for the affected shareholding. Nor will it provide the same level of certainty that shareholder protection insurance can.
When is shareholder protection insurance not necessary?
In some scenarios, shareholder protection insurance may not be a suitable form of protection. A company with only one shareholder doesn’t need this insurance, as there are no other shareholders to consider. In such cases, Key Person Insurance may provide a better level of protection and business continuity.
However, in companies with one active shareholder and several silent partners, shareholder protection can still be valuable. Without it, shares inherited by inexperienced individuals could disrupt business operations.
Family businesses may also have less need for shareholder protection, especially smaller husband-and-wife businesses. However, larger, multi-generational family businesses might benefit more from this coverage.
The size of the business also matters. Larger companies with evenly distributed shares may need less shareholder protection. Whereas small companies with lower valuations might still find it useful to ensure smooth operations.
