Chapter 10 - (6 Exam questions) Financial Protection Needs And Factors

Question 1

What is Key person insurance?

Answer 1

Insurance taken out by businesses to protect them against the financial impact of a key person within the company becoming seriously ill or dying

It is set up on a ‘life of another’ basis

The different types of Key Person Insurance are:

Term
Whole Of Life
Critical Illness Cover
Income Protection Insurance
Sickness and Accident Cover

Question 2

All Key person Insurance is set up on a ‘life of another’ basis. What does this mean?

Answer 2

The business is the assured or owner of the policy

The key person is the life assured on whose illness or death the policy would pay out

And any policy benefit would be paid direct to the company.

Question 3

Do employers have insurable interest over employees?

Answer 3

Yes

Question 4

In relation to Key Persons Insurance, from the businesses perspective it can be difficult to know exactly how much cover they should arrange as multiple factors can be taken into account

See image for main factors that are taken into account…

However, when calculating a required sum assured on death there are two methods that can be used: WHAT ARE THEY and what are the downsides of both methods

Answer 4

Method 1: Salary multiple
Method 2: Proportion of profits formula

Method 1 =
The policy sum assured will be a multiple of the key person’s salary by perhaps, 5 to 10 times. SEE IMAGE FOR EXAMPLE

Downsides of method 1: takes no account of the key persons contributions to profits and takes no account of key persons age and how close they are to retirement. The closer they are, the less value they can potentially provide

Method 2 =
Considers a variety of factors such as the key person’s salary, the company annual profits, total salary bill and the number of years to replace the key person

The formulae used is:
(Key person’s salary x last year’s profits x estimated number of years to replace key person) divided by the total salary bill. SEE IMAGE FOR EXAMPLE

Question 5

Answer 5

This is because it infers that the business is using the Proportion of profits formula which is only relevant to key persons insurance

Question 6

How is key person insurance’s premiums taxed?

Answer 6

Premiums are able to be allowable deductions for the business but only if certain rules are met. NOTE: OBVS businesses want them to be allowable expenses as this reduce its tax bill.

The rules that must be met are as followed: SEE IMAGE

Rules Summed up:

Must be employee and employer

Cover must be reasonable to that company

Must be short term (max of 5 years)

Premiums spent are solely for the benefit of the trade (if life assured is a shareholder this does not satisfy the rule because they are benefiting too)

If any one of these rules are broken premiums are no longer allowed to be classed as an allowable expense

NOTE: if tax relief is given on premiums as seen above, the proceeds will normally show on a company’s balance sheet as a trading receipt, and therefore be liable to corporation tax.

Question 7

What are the different types of Key Person Insurance

Answer 7

Term
Whole Of Life
Critical Illness Cover
Income Protection Insurance
Sickness and Accident Cover

Question 8

The different types of Key Person Insurance are:

Term
Whole Of Life
Critical Illness Cover
Income Protection Insurance
Sickness and Accident Cover

All of these are insurance products that you already know of

Answer 8

Term: Sum assured remains level
Used where a key person may leave the company or be working on short-term projects, so the need for cover may only be for a set term. Premiums are cheaper. It can include renewable or convertible options where the term ends up being longer than expected

Whole of Life:
Used where the individual is likely to stay with the company for a long time, such as a founding director.
Two options of cover: maximum cover (Higher cover that lasts 10years. Premiums are reviewed after this time period) and Standard Cover (lasts whole policy/builds investment value/lower cover)

Critical Illness Cover:
Protects financial fall-out because of the critical illness of a key person. Lump sum paid after end of survival period of 14 to 30 days.. Can be a standalone policy

Income Protection Insurance:
Pays company regular payments if the key person is ill long-term. To calculate cover amounts, the company has the same two options as we covered with life cover (Salary multiple or Proportion of profits formula)

Sickness and accident cover:
Protect the company against key person illness. Cheaper than IPI. Benefits are payable for max of 2 years. Policy has an annual contact so the insurer could cancel it

Question 9

Benefits and Drawbacks of the various forms of Key Person Insurance

Answer 9

Question 10

Insurers will always check how ‘reasonable’ the sum assured or benefit being applied for is, in relation to the key person’s salary and company profits.

What do they ask for to do this?

Answer 10

They may ask for additional information from the company which could include:

a copy of recent company accounts

business plans

any loan or overdraft agreements

additional financial information, via a supplementary questionnaire.

Question 11

Why does Medical underwriting for business protection like Key Persons Insurance, tend to be more rigours?

Answer 11

Risks are higher because cover amounts tend to be very high

Question 12

What are underwriting Limits?

Answer 12

Underwriting limits are the maximum amount of cover available without extra information or medical examinations being requested by an insurer. ‘Extra information’ could involve a GP’s report, additional tests, or a medical examination.

If 2 policies have the same term but one insurer has less strict underwriting limits, it is obvs more ideal. This is somethings both businesses and individuals looks at when applying for insurance

Question 13

If a group of individuals from the same company are looking for cover, the insurer also needs to take contingency risk into account. What is this?

Answer 13

This is the risk associated with several key individuals in a company all travelling together by car or on a plane and being killed. Obvs the higher the contingency risk = higher risk in general

Question 14

What is reinsurance?

Answer 14

It is insurance for insurance companies

Where an insurer offloads risk to another insurer. It can be common in business protection because of the high sum assured amounts involved

Question 15

Are trusts used in relation to Key Person Insurance?

Answer 15

Very rarely because of how the polices are set up

KPI is established on a life of another basis, which effectively means the company own and are paid any proceeds, be these a sum assured, critical illness lump sum, or regular income protection payments on the death/illness of the life assured (THE KEY PERSON) so there is no benefit to using trusts

Question 16

Summary of KPI

Answer 16

Question 17

What is a Partnership?

Answer 17

A partnership is where two or more individuals set up in business together

Each partner will be entitled to a share of the profits (not always an equal share) and will be responsible for paying their own income tax and NICs liabilities.

Two types:

traditional

limited liability

Question 18

What is Partnership Protection?

Answer 18

Policies taken out to protect Partnerships against the financial impact of a partner dying or falling seriously ill

Question 19

Answer 19

The remaining partners may have insufficient funds to repay any debts due.

They find themselves in business with the partner’s family, who know little about the business, but are entitled to a share of profits with little or no contribution to them. They may not be ‘backward in coming forward’ with opinions on how they think the partnership should be run.

The family find they have been left the partnership share, when they would far rather have had cold hard cash.

Question 20

How do partnerships calculate the amount of cover they need on either a partners death or a partner falling seriously ill?

Answer 20

Cover for serious illness:

Should provide a lump sum commensurate with the partner’s needs but also consider any loans or overdrafts and their repayment. (remembers partnerships can borrow money and if a partner falls ill this could lead to massive issues for any remaining partners

Cover for death:

The sum assured on any policy should take into account the value of the capital account share, plus the value of the partnership share, plus any personal loans made. This will be closely linked to partnership profits.

Question 21

Partnership Policies can be set up on a life of another or own life basis. Tell me the differences

Answer 21

Own life basis (in trust)

Each partner would insure their own life and put the policy in trust either;

to the other partners, to enable them to buy back the partnership share from the estate, or
to their estate, to compensate loved ones for the loss of the partnership, when left to the remaining partners. (remember partners own their share so on death it will be moved into their estate)

In both cases, a suitable partnership trust would need to be used.

Life of another basis

Where each partner insures the other partners for the value of their partnership share.

The proceeds from policies are then used to purchase the deceased partnership share from their estate.

Question 22

Having decided to take out partnership protection cover on death there are three options in terms of how the arrangement can be made. What are they?

Answer 22

It can be set up as 1 of the following:

Buy and sell agreement.

Double or cross option agreement.

Automatic accrual.

Question 23

Partnership protection cover on death can be set up in 1 of 3 ways which are:

Buy and sell agreement.

Double or cross option agreement.

Automatic accrual.

Tell me about the buy and sell agreement

SEE IMAGE FOR AN EXAMPLE OF THIS AGREEMENT IN ACTION:

What is the big disadvantage of this arrangement

NOTE: THESE 3 ARRANGEMENTS ARE THE EXACT SAME FOR SHAREHOLDER PROTECTION POLICIES except a shareholder trust is used rather than a partnership trust

Answer 23

Buy and sell agreement

Under this form of agreement, on death the late partner’s share passes to their estate and the life policy pays out via trust to the surviving partners.

The estate SELLS the share back to the remaining partners.

The remaining partners must BUY the share from the estate.

This is a binding contract on both the beneficiaries of the estate (to sell) and the partners (to buy)

Main Disadvantage: All business relief is lost (this is the relief that means you pay no IHT if you own a share for 2 years). Losing this relief could massively increase any IHT bill so using this agreement must be considered in detail. Note: A Double or cross option agreement can be used to prevent this.

Question 24

What is business relief?

Answer 24

BR is a relief against inheritance tax (IHT)

Where if you own a share for at least two years at the date of death it is not added to the estate meaning there is NO IHT

Question 25

Partnership protection cover on death can be set up in 1 of 3 ways which are:

Buy and sell agreement.

Double or cross option agreement.

Automatic accrual.

Tell me about the Double or cross option agreement

SEE IMAGE FOR AN EXAMPLE OF THIS AGREEMENT IN ACTION:

What is the big disadvantage of this arrangement

THESE 3 ARRANGEMENTS ARE THE EXACT SAME FOR SHAREHOLDER PROTECTION POLICIES except a shareholder trust is used rather than a partnership trust

Answer 25

Same initially as the Buy and sell agreement. ie, on death the late partner’s share passes to their estate and the life policy pays out via trust to the surviving partners but with this agreement:

The estate has the option to sell the partnership share.

and The remaining partners have the option to buy the partnership share from the estate. All partners must agree to buy.

To sum up: There is no binding agreement to buy or sell, it is an option

Because there is no binding contract it enables Business Relief to be retained which can dramatically reduce any IHT bill

Disadvantage: All partners must agree which can prove difficult

Question 26

Partnership protection cover on death can be set up in 1 of 3 ways which are:

Buy and sell agreement.

Double or cross option agreement.

Automatic accrual.

Tell me about the Automatic accrual option

SEE IMAGE FOR AN EXAMPLE OF THIS AGREEMENT IN ACTION:

THESE 3 ARRANGEMENTS ARE THE EXACT SAME FOR SHAREHOLDER PROTECTION POLICIES except a shareholder trust is used rather than a partnership trust

Answer 26

On death of a partner their share automatically passes to the remaining partners rather than into the estate

The life cover taken out by the deceased partner is in trust payable to his/her estate.

This has two benefits:

The estate/beneficaries get what they prefer: the cash.

The partnership get what they prefer: the partnership share

Business relief is maintained

Question 27

Partnership protection cover on serious illness can be set up on a single option agreement

What is this?

Remember a partnership protection policy can be set up on 1 of 3 ways: Buy and sell agreement. Double or cross option agreement. Automatic accrual.

Answer 27

Question 28

What are the different types of cover available for partnership protection policies. (It is the same as Key Person Protection Polices)

Answer 28

Question 29

Often Partnerships borrow fund through loans to help run the business

When a partner dies, the lender often requires the full repayment of the loan from the other partners

What are the main cover options available for partnerships to repay any loans?

Answer 29

If repayment of loans is required on the death of a partner, it is sound financial planning to take out cover.

This could be done in a variety of ways:

Using individual policies
These could be adjusted if individuals join or leave the partnership.

Utilising a joint-life, first-death policy
This may prove to be less expensive than the use of single-life individual policies, but it is likely to be less flexible, as partners leave and join, and the policy is likely to have to be rearranged each time. This will involve further underwriting and applications.

Cover could be apportioned amongst partners
If a partnership has, for example, four partners and a £1,000,000 loan, each partner takes out a policy for £250,000. A lender may require the whole loan repaid on illness or death of a partner, so this could be a risky approach.

Question 30

How are partnership protection polices taxed?

Answer 30

No tax relief on premiums
The rules are relatively simple for partnership protection. No tax relief on premiums is available, whether premiums are paid from the partnership bank account or from the partner’s personal accounts.

Proceeds paid tax-free
Proceeds are usually tax-free as they are either paid from personal policies (IPI, AS or CIC) or left in trust if providing life cover benefits.

Question 31

Benefits and Negatives of all of the partnership protection arrangements on death or illness (single option agreement)

Answer 31

Question 32

REMEMBER: Binding contracts cause Business Relief to be lost. READ ABOVE FOR MORE DETAIL

Question 33

Summary of partnership protection:

Answer 33

Question 34

What is Shareholder Protection?

Why is it used?

Answer 34

Shareholder protection provides the monies to enable a company to buy back some of its shares on the illness or death of one of its shareholders.

It is aimed specifically at small, privately-owned companies where shareholders also tend to be directors, rather than public limited ones.

Used because in most cases beneficiary’s will rather cash than any share value and exiting shareholders will want to retain the ownership rather than new inexperienced shareholders gaining ownership. This are the same reasons for partnership protection too. Also many small privately owned companies Articles of Association will not allow the sale of shares so both shareholders and beneficiaries can be left in a catch 22 situation

Question 35

How are companies established?

Answer 35

A company is established using a Memorandum and Articles of Association. (MAA)

This establishes who does what within the company, and what happens on the death of one of the shareholders. This is virtually a ‘Company Will’.

The MAA should be the starting point if one of the shareholders dies. Common clauses in place in MAAs include the right of the company to have first refusal on purchasing the deceased’s shares, though there is no obligation for them to do so

Question 36

There are three main ways to arrange shareholder protection (it is practically the same as partnership protection)

What are they?

Answer 36

Buy and sell agreement.
Double or cross option agreement.
Automatic accrual agreement.

The only real difference is that a shareholder trust will be used rather than a partnership trust.

Question 37

How are cover levels calculated for Shareholder Protection Policies

Answer 37

Generally, the market value of the shares is used for the sum assured.

This is likely to consist of tangible and intangible asset values.

Tangible values are far easier to calculate: assets like company property or machinery.

Intangible values pose a far greater problem: assets such as company goodwill.

Question 38

What are the types of policies available for shareholder protection?

Answer 38

Shareholders can choose between 2 options only:

term assurance
(Cheaper, short term (up to 5 years). Renewability or convertibility options are available.

a whole of life plan
more expensive, Shareholders have a choice between maximum and standard cover

Question 39

Shareholder policies can be written on a life of another or own life in trust basis

Answer 39

Life of another
Each director takes out cover on the lives of their fellow directors. On death, the sum assured is paid out, giving the shareholder the funds to purchase the shares from the deceased’s estate.
This arrangement can become very complicated where there are more than two shareholders.

Own life in trust
Here each director takes out a life assurance policy on their own life and places it in trust for the other directors and shareholders or the family of the deceased, depending on the type of shareholder agreement that is being used.
Directors could be joint trustees with family members, to ensure all have some element of control over the policy proceeds.

Question 40

Who pays the premiums of shareholder policies and what is its tax treatment

Answer 40

Premiums can be paid by the shareholder/directors themselves or the company itself

Like with partnership protection, premiums are more likely to be paid by shareholders/directors out of their own income. (No tax relief, but no additional tax)

If it is the company paying the premiums on behalf of a director, this will be a benefit in kind for the director (and therefore taxable). EXTRA BUT NO NEED TO REMEMBER: In this arrangement, the company could benefit from corporation tax relief by offsetting these costs as a business expense, but will have to pay more Class 1 employer NICs so

Question 41

What is ill health cover?

What types of policies can be used for this?

Answer 41

This can provide monies to shareholders, to enable them to buy out another shareholder if the ‘other’ shareholder develops a serious illness.

There are three options in relation to types of policy that can be utilised:

whole of life policy, which also includes critical illness cover

term policy, which includes both cover types

standalone critical illness policy

Question 42

Summary

Answer 42

Question 43

Context

Answer 43

Question 44

Answer 44

Question 45

Question 46

Summary

Answer 46

Question 47

For what product group can commission still be charged, and the adviser giving the advice doesn’t need to be level 4 qualified?

Answer 47

pure protection products

It didn’t fall under the remit of RDR

Question 48

What is free asset ratio?

Answer 48

measures the financial strength of a life office.

This measures the surplus assets over and above an insurer’s liabilities, expressed as a percentage of assets. The calculation is ‘(Assets minus Liabilities) divided by Assets x 100’.

The higher this is, the more financially-strong the provider.

Question 49

Summary

Answer 49

Question 50

Joe is a single parent with two young, dependent children. He needs life cover but has a limited budget. Which of the following policies would best suit his needs?

A family income benefit policy.

A whole of life plan.

An endowment.

An income protection insurance policy.

Answer 50

A family income benefit policy.

FIB is a form of decreasing term assurance; therefore, premiums should be cheaper, whilst providing Joe with the cover he needs.

Question 51

Jack, Peter, and Sam are partners in an electronics business. They have a buy and sell partnership agreement in place should any of them die. The main disadvantage of this agreement in relation to their partnership shares is that they will…

be liable to NICs.

be liable to CGT.

not qualify for Entrepreneur’s Relief.

not qualify for Business Relief.

Answer 51

not qualify for Business Relief.

A buy and sell agreement is a binding contract for the sale of a partnership share. As a result, it will not qualify for Business Relief in relation to IHT.

Question 52

Sarah has a large shareholding in a small, privately-owned electronics company. She has a valid will. On her death, her shares will…

automatically pass to the other shareholders.

always qualify for Business Relief.

pass into her estate and be distributed according to her will.

pass into her estate and be distributed according to intestacy laws.

Answer 52

pass into her estate and be distributed according to her will.

Sarah has a valid will, therefore, on her death, her shares will pass into her estate and be distributed according to her will.

Question 53

Joe and Annie are married, with young children. They are both trainee accountants earning £15,000 currently. This will increase to £45,000 when they qualify in four years’ time. Which of the following would best suit their current protection needs?

Standard cover whole of life plan.

Maximum cover whole of life plan.

Endowment plan with CIC included.

Term assurance with terminal illness benefit.

Answer 53

Maximum cover whole of life plan.

A maximum cover WOL will provide Joe and Annie with the most cover for the lowest premium. When the plan is reviewed in 10 years’ time, they will face a choice. Either increase the premium to keep the cover or decrease cover to keep the premiums the same. As their income will be greater at this point, this may not be an issue for them.

Question 54

Janet holds a key position in her company, XANEX LTD. Her company has taken out key person cover on her life. The policy is best set up on which basis?

Life of another, with Janet as the assured.

Own life, with Janet as the assured.

Life of another, with XANEX LTD as the assured.

Own life, with XANEX LTD as the assured.

Answer 54

Life of another, with XANEX LTD as the assured.

A key person policy will be set up on a life of another basis with XANEX LTD as the assured and Janet as the life assured.

Question 55

Which of the following types of financial protection usually involves an aspect of free cover?

Individual.

Family.

Group.

Business.

Answer 55

Group.

Again, this question could technically have two correct answers, group and business. Group cover is the most likely as this is cover provided by an employer for an employee. Business protection could be to help the business itself, such as key person.

Question 56

A local veterinary practise wishes to ensure against their main vet dying. Which of the following cover types would be MOST suitable?

Key person life cover.

Key person critical illness cover.

Partnership protection.

Shareholder protection.

Answer 56

Key person life cover.

A key person life cover policy should be set up by the veterinary practice, with the main vet as the life assured.

Question 57

A firm has taken out key person cover on Bob and Stan, two of their senior researchers. This cover provides which of the following types of protection?

To cover illness before either of them retire.

To cover the death in service payment to family should either die.

To find a replacement should either die in employment.

To cover any loss of profits should either die in employment.

Answer 57

To cover any loss of profits should either die in employment.

There are two possible correct answers of those given. Key person cover can help with the costs of finding a replacement on death of a key person. The main purpose however is to cover any loss of business profits because of this death.