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Financial planning for business owners
RISKS associated with an operating business make it imperative for business owners to do financial planning.
In the course of financial planning, insurance is likely to come up as an important tool to hedge risk. A policy's death benefit can be used to enlarge an estate and enhance liquidity, which is a boon for families particularly following the death of a business owner. This is because many assets such as a private business and real estate are not liquid.
One risk that should be covered is that of business loans. The question of which of a family's assets should be used to pay down a business loan is often problematic.
"Oftentimes a family business is involved, which can't be sold or mortgaged without causing financial hardship to the business and to family members who may rely on it for their current and/or future income," said John Elkovich, Prudential's head of HNW solutions.
Business owners often extend personal guarantees to secure loans. If they die, lenders end up staking a claim to the business and its assets, as well as the personal assets of the owner in order to secure repayment of the loan.
Life insurance is a solution to pay off debts that a business owner has accrued, and spares the successors the pressure of finding assets to pay the loans.
Here's an illustration of insurance's role in debt protection:
Mr Lee's financial picture:
- Value of estate: S$25 million (Business value at S$20 million + cash of S$5 million)
- Debts: S$12 million
- Liquidity shortfall in the business: S$7 million
Without cash to cover the debts, Mr Lee's family would be forced to sell assets to create liquidity. But with a life insurance policy with a death benefit of S$12 million (premium S$2 million), this is what the revised estate would look like:
- Revised total value of estate: S$35 million (initial estate value of S$25 million - S$2 million life insurance premium + S$12 million life insurance proceeds)
- Debts: S$12 million
- Excess liquidity in the business: S$3 million
The insurance policy expands the estate value and brings in additional S$3 million in liquidity that Mr Lee's heirs can use to pay debts and for income replacement.
Yet another risk that businesses need to plan for is the loss of a key person through untimely death. This could have a negative impact on the business and its long term prospects, and may even cause the business to close. One solution is key-person life insurance.
This is purchased by the business on the life of the owner or key executive. The company is named as the beneficiary and pays the policy's premium.
Should death occur, the company receives the life insurance proceeds which can be used to run the business until a replacement is found. In this way, creditors have assurance of the business' continuity and are likely to continue to extend credit lines. Should there by debts incurred by the business owner, the policy proceeds may also be used to pay down the debts.
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