I don’t know any law firm that doesn’t insure its physical assets. But it’s surprising how many haven’t thought about key person insurance. The loss of a senior employee or partner could have just as big an impact on the firm as fraud, vandalism, fire or theft.
Business protection insurance is there to safeguard the partnership against the effects of the loss of a key person. If someone dies or has a serious illness or accident, there will be an undoubted impact on fee income and day-to-day trading. And the organisation might not be able to repay a business loan.
Partnerships need to consider who will take control if the unexpected happens; what the effects would be on cash flow, creditors, employees, clients and business relationships; and if contracts could be lost, or if lenders could lose confidence in the firm.
Key person protection
Each key person takes out a policy on their own life—they are both the policyholder and life assured. A key person protection scheme must be flexible because people leave and change roles, firms grow and the key person’s value may increase over time. It is worth thinking carefully about who these people are; it might not always be the senior partner. Consider all team members who have vital relationships with and knowledge of clients.
Protecting loans
Another good reason for setting up key person protection is that an important figure within the firm may be a guarantor of a loan. Indeed, it is a condition of many loans that the partners involved protect their borrowing liabilities for themselves and key staff members and fee earners. And that is particularly important for guarantors as a default could have a massive impact on a family’s home and finances.
Partnership protection
In a shareholder or partnership arrangement, the aim is to protect the owners of the firm and their families in the event of death or illness of another shareholder or partner.
The current owners will want to keep control of the organisation to avoid it passing to the spouse or children who may have no experience. This is done by allowing the remaining owners to buy the shares of the party who has died, or can no longer work.
Equally, the policy is there to ensure the spouse or children inherit the value of the shares from the deceased partner. This provision will be set up through a discretionary business trust with a cross-option agreement included that is legally binding.
The cross-option agreement is key because it will oblige the spouse or children to sell the shares they have inherited back to the partnership and it ensures they will inherit the value of them. In other words, if either party wants to sell or buy the deceased partner’s shares, the others must agree. When a partner dies, the insurance policy generates a lump sum for the remaining partners enabling them to buy the shares from the surviving spouse or children and they are obliged to sell them back. A discretionary trust (rather than an absolute one) also allows for changes to the firm’s structure so that the life cover is flexible for future needs as partners leave and join.
In one example, we set up an insurance policy for a firm to cover the cost of recruiting and replacing a partner if one of them died or had a serious illness. Just three months later, that is exactly what happened and £300,000 was paid out, which was vital to the continued health of the firm.
A specialist adviser can recommend the right policy for an individual firm and make sure it is structured correctly for tax purposes, including for inheritance tax.
Joe Sanders is a chartered financial planner at Informed Financial Planning
This article was originally published in Issue 149 of Leeds & Yorkshire Lawyer
