Shareholder Protection Insurance Guide

What are the benefits of shareholder protection insurance?

In the unfortunate event that one of the shareholders named on the insurance policy dies or is diagnosed with a terminal illness (or a critical illness if this option is part of the policy), the three main benefits of holding a shareholder protection policy are:

• Cost – The cost to acquire 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 finance to acquire the affected shares.
• Control – Ensures that the control and direction of the business remain with the remaining shareholders and 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. Additionally, since the company’s valuation method is agreed upon, it also creates certainty for shareholders; in the event of their own death, terminal or critical illness, they can rely upon their shareholding being purchased for a pre-agreed, definable sum.

Together, these three benefits greatly assist with business continuity planning, risk management, and, to some degree, the succession planning of the business.

What risks does shareholder protection insurance help mitigate?

There are countless different scenarios and risk factors that shareholder protection insurance helps to mitigate. Primarily, shareholder protection insurance eliminates the risk of company shares falling into the hands of a third party. While a shareholder agreement may have specific clauses that seek to prevent this too, since a shareholder protection policy is intended to payout the required funds to acquire the shares, it also eliminates the risk that the remaining shareholders are unable to raise finances or face higher bids coming from outsiders. Additionally, since

These mainly stem from a loss of control and the subsequent issues this can cause.

Even a minority shareholding in a small or medium-sized business that is bequeathed to a third party can easily cause severe disruption and even have the potential to force the company’s closure. Ensuring the issued shares of a company 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: Life of Another, Own Life, and Company policies. Each has different characteristics and important tax implications that should be discussed and understood 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 simplest type of shareholder protection and is paid for personally by each shareholder. It has a very straightforward structure, with each shareholder taking out a policy on the life or lives of the other shareholders. In the event that another shareholder dies, the remaining shareholder(s) will receive a tax-free cash lump sum payment to purchase the affected shares.

As this type of protection requires each shareholder to have a policy on the life of every other shareholder, it is generally considered more suitable for small businesses with just two or perhaps three shareholders. 

Tax: Since the insurance premium is paid for by the individual and not the company, there is no benefit in kind for tax purposes or tax considerations for the company.

Own Life

This type of policy is more complex in its structure, requiring the creation of a business trust. However, it is likely to be more suitable for companies with four or more shareholders and where shareholders may change more frequently, since adding or removing shareholders is relatively straightforward.

As the name suggests, each shareholder takes out a policy on their own life, which is written into trust with the company being the beneficiary. Should any of the shareholders die, the policy pays out to the business trust, which is used to acquire the affected shares.

Tax: Own Life policies are generally paid for by the company, and it is possible that premiums may be deductible against corporation tax. However, the premiums are normally seen as a benefit in kind, meaning shareholders are likely to be required to pay tax on the premiums.

Company

More straightforward in structure than an Own Life policy, here it is the company that takes out and pays for the shareholder protection insurance on the lives of each individual shareholder. This structure does not require the creation of a business trust.

Should a shareholder then die or become terminally ill, the policy pays out the necessary lump sum directly to the company, enabling the company itself to buy back the affected shares. Rather than redistributing the purchased shares, the shares are then simply cancelled.

Tax: The lump sum is not likely to be subject to corporation tax, and equally, the premiums are unlikely to be eligible to be offset against corporation tax. HMRC generally does not look upon this as a benefit received by the shareholder.

There are, however, some related complexities that require consideration before taking a company policy. These are broadly related to the length of time the shares have already been owned, capital gains tax, and any significant creditors the company may have.

Cross Option Agreement

When setting up any shareholder protection policy, it is crucial that the policy is not in conflict with either an existing shareholder agreement or the company’s articles of association.

Once this has been established, if required, a ‘Cross Option Agreement’ can be put in place. This is a simple agreement that creates the necessary obligations so that the remaining shareholders have the option to acquire the affected shares, and the affected shareholders have the option to insist that the remaining shareholders make a compulsory purchase.

Premium equalisation

When setting up shareholder protection policies, it is important to consider differences between shareholders, such as age and health issues. These differences can affect the cost of premiums, potentially resulting in higher costs for older shareholders.

Premium equalisation is a method that divides the cost of insurance equally among shareholders. This approach can help to ensure that HMRC does not view the policy as a ‘gift’ to younger shareholders or those with smaller shares in the business.

How much does shareholder protection cost?

Annual premiums are determined by many factors which include but are not necessarily limited to:

1. 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.
2. Company industry – The market sector in which the company operates can influence the risk and, therefore, the premiums.
3. Shareholders – Just as with a standard life insurance policy, there are many personal factors that contribute to the cost of the premiums. These can include: Age, Occupation, Lifestyle, Smoking status, and Medical history.
4. Critical Illness Cover – Policies that do not cover Critical Illness are likely to be significantly cheaper than policies which offer extended protection. This is because it is far more likely that a shareholder protection policy will pay out during the term of the policy.
5. Policy Type – Whether the policy is set up as an Own Life, Life of Another, or Company Policy will contribute towards the overall cost of the premium(s).
6. Term of Policy – Whether the policy is set up for 5 or 10 years will also likely affect the overall annual premium.

Valuing the shares for the purpose of the policy

One of the advantages of setting up a shareholder protection policy is that it requires the shareholders to agree on both the valuation method to be applied when calculating the value of the business and any additional formula as to how much each group or class of shares is worth. Minority holdings are often considered to be less valuable than a majority stake since the majority stake may carry with it much more control. Equally, if there are multiple classes of shares paying different dividends or carrying different rights, each class will need a separate valuation.

The value of the shares will determine how much cover is required and contribute towards the cost of the policy’s premiums.

Valuing a business can be an extremely complex task with multiple methods that can be applied and various factors that require consideration. Accountants are often best placed to advise on the most suitable valuation method for any business.

Shareholder Protection Insurance Quotes

Acquiring a quote and advising on the most suitable shareholder protection policy requires the insurance consultant handling the enquiry to possess a high degree of commercial acumen.

When making an enquiry into shareholder protection with Black Lion Insurance you can be assured that you will be placed in the hands of a qualified insurance consultant with a demonstrable level of knowledge the required to help businesses protect themselves against future disasters.

Case Study: Shareholder Protection

Small business with just two shareholders.

Company: Example Limited
Shareholders: Sam (50%) and Jordan (50%)
Company Valuation: Circa £150k
Shareholder Protection: None

Disclaimer: This case study is a hypothetical scenario created for illustrative purposes only. It does not constitute advice. For specific advice tailored to your business needs, please consult with a qualified financial advisor or insurance consultant.

Sam and Jordan jointly set up Example Limited as equal shareholders and are both directors. After 12 months of hard work, the company starts to turn a respectable profit and pays the shareholders its maiden dividend.

As the company grows, Sam and Jordan pay themselves a basic salary, make pension contributions, and claim expenses, although a sizeable percentage of their financial reward comes in the way of dividends.

Unfortunately, after 5 years of steady growth, Jordan is diagnosed with a terminal illness. This is a significant challenge for the company, Sam, Jordan, and Jordan’s family.

With Jordan unable to work, Sam is managing a much larger workload and is back to working 70 hours a week to keep the business running and reassuring Jordan’s clients. Jordan’s skills, like Sam’s, are hard to replace, and the company relies heavily on them.

After a short illness, Jordan sadly passes away just a few months after the original diagnosis. This means that Jordan’s family inherits 50% of Example Limited’s ordinary shares and now have equal voting rights to Sam.

Sam wants to do what is best for Jordan’s family, although not to the detriment of the company. There is no clause in the Shareholder Agreement that forces Jordan’s family to sell their shares to Sam and only a standard pre-emption clause. Jordan’s family has become sleeping partners.

As 50% shareholders, Jordan’s family is legally entitled to continue receiving dividends from Example Limited even though it is Sam who is still shouldering the workload left by Jordan.

Sam is able to find someone suitably qualified to take on Jordan’s work, although the cost of salary, national insurance contributions, and additional benefits package needed to attract the right candidate is high and eats into the company’s profits. This subsequently means that dividend payments are going to be far less in the short term, and so Sam stands to earn less money, at least in the short term.

At the right price, Sam would be prepared to buy the shares from Jordan’s family, although the bank will not lend the business the money to buy back the shares. Sam secures some personal finance (an offer in principle to remortgage the family home) and makes Jordan’s family an offer based on what he has been advised is a fair value for the shares, given that the company has lost Jordan’s input. Jordan’s family refuses Sam’s offer, believing the shares to be worth much more based on conflicting advice given by an accountant friend who suggests that their shares are worth 3 – 5 times last year’s profits. However, this is an unrealistic valuation given how highly dependent the company is on Sam’s skills and input and how having recently lost Jordan, future profits are likely to be less. Inevitably, relations begin to become strained.

Jordan’s family, while still sleeping partners and not contributing to the running of the company, starts taking a greater interest in Example Limited. Sam finds this to be intrusive as well as another drain on his precious time and an unwanted distraction with daily calls and questions.

In a move to rebalance the overall distribution of compensation, Sam looks to increase the basic salary of the company directors (which is now just Sam). However, any change to directors’ pay at Example Limited is a matter that requires all the shareholders to agree. This means that even though Jordan’s family are not directors themselves, they are still able to block Sam’s proposed increase in basic salary. Based on advice they received via the internet, they argue that it will further erode any dividends and that they may even have to look at litigation to resolve the issue that Sam has been claiming certain expenses that they believe unfairly prejudice them.

Sam can’t just leave and set up a new business since the non-compete and restrictive covenant clauses in the shareholder agreement forbid this and would bring about litigation.

After a difficult 12 months, Sam has had enough and provides 3 months’ notice of his intention to leave the company, having been offered full-time employment elsewhere. Sam offers up his 50% shareholding of Example Limited to Jordan’s family at the same fair value price he had offered to purchase their holding, although unsurprisingly they pass up on the opportunity to take full control of the company.

Eventually, the company is sold at a distressed price to a competitor. Both parties have failed to realise the maximum value of Example Limited’s shares, with many years of hard work and effort going to waste.

How could Shareholder Protection Insurance have helped?

1. Upon Jordan’s diagnosis of terminal illness, the shareholder protection policy could have enabled either the company or Sam (depending on how the policy was created) to make a claim.
2. The right insurance policy would have paid out the necessary funds to enable the purchase of Jordan’s shares using a pre-agreed valuation.
3. The company would have benefited from not having the additional distractions that may have otherwise been brought about and can focus on growing the business.
4. Because Sam would be receiving 100% of Example Limited’s dividends in future, the hiring of the necessary staff to replace Jordan is ultimately made more affordable and helped assure the company’s continued growth.
5. Neither Sam or the business would have had to borrow money to purchase the shares.
6. Jordan and his family would benefited from a pre-agreed valuation and prompt payment for the shares.

In addition to the above, in the time before the diagnosis of terminal illness, the business, the shareholder, and their families would have had the peace of mind that, should the worst happen, any disruption to the business would be minimised and that there was a pre-agreed valuation.

Frequently asked questions on Shareholder Protection Insurance.