Small Business Insurance Checkup: A Guide For CPAs

To prepare themselves for the financial risks they face, small business owners, CPAs included, need to ensure the health of their organization by doing an annual review of insurance coverage including employee benefit plans, property and casualty and other business policies.

Preventive maintenance is essential to an organization’s financial health.

By Mark Papalia, CLU, ChFC, CFP

Published in Journal of Accountancy in March 2004

For most people a preventive visit to the doctor for an annual checkup has become routine. Similarly, each year drivers have their cars inspected to ensure safe and reliable transportation. But too often, small business owners—including CPAs—don’t take similar measures to ensure the financial health of their organizations by conducting an annual insurance checkup to make sure existing coverage is still providing needed protection against unforeseen risks.

INSURE DAILY RISKS

CPAs can help small business clients do an annual review of all insurance policies they have in place. Start by examining property and casualty insurance, including business property, general liability, business interruption and workers’ compensation coverage. While most people select their property and casualty insurance carriers based merely on premium, encourage clients to look at more than policy costs. Check deductibles to see whether the client still can afford the amount of loss he or she is obligated to cover or can afford to raise the deductible to save some premium dollars.

In addition to the nature of the policy and its terms, CPAs should look at the insurance company the client has selected as well. Check insurers’ quality ratings through independent services such as A.M. Best or Standard & Poor’s. Throughout the year CPAs should clip any news stories they read about a client or employer’s insurance company. Some companies’ claims handling has come into question in recent years, resulting in coverage disputes. At renewal time CPAs should recommend clients ask the carrier about claims procedures and other concerns before they renew. If they don’t get the right answers it may be time to switch insurance companies.

The most important step CPAs can take with clients is to review each policy point carefully. Look for new exclusions; property and casualty losses can have a devastating impact on a small business, and some of those losses may no longer be covered or adequately protected. For example, fires often destroy more than inventory and machinery; they take with them key business records the company hasn’t saved in off-site storage. Many insurers haven’t updated property and casualty coverage to allow for the personnel costs of record reconstruction. In addition to making sure clients have backup procedures and files in place, review their business property insurance to see that computers, software, machinery, inventory and the like still are covered for full replacement cost.

Liability insurance, which encompasses errors and omissions and professional liability coverage, protects business assets in the event a company is sued. CPAs should make certain clients have enough coverage to meet the potential exposure. Putting an exact number on that exposure is difficult, but here are two guidelines:

• Learn from history; research a recent liability settlement against a similar business and use it as a guide.
• Base the amount of coverage on the business’s potential exposure; determine a worst-case scenario and buy sufficient insurance to cover it.

Business interruption insurance covers the loss of income an entity and its employees might experience if the business is temporarily interrupted by a natural disaster, loss of power or something as simple as the city’s closing a street to install new water mains. The coverage pays expenses such as rent and mortgage and related costs until the business is back on its feet.

One of the benefits of being a small business owner is that he or she can use business assets to protect family members and build personal wealth. Many of the means CPAs can recommend to accomplish this goal are funded by insurance. CPAs should emphasize this important goal as they help clients review their disability protection, business life insurance, 401(k) and other retirement plans, as well as their succession plan.

Disability insurance. Disability insurance has two key aspects: business overhead and key person coverage. Business overhead disability insurance is coverage a company holds on its owner. If the owner suffers an accident or illness it pays the entity’s monthly expenses, allowing the business to survive while the owner recovers. In reviewing this coverage each year CPAs should make certain the amount of overhead insurance is still sufficient to cover current and projected business expenses.

A business purchases key person disability insurance to protect it from losses it may incur should a key employee become disabled. CPAs should help clients determine annually the value each key employee provides. How much would the company lose if a key employee was unable to work? Could it replace that person? If so, at what cost? The company may need to adjust its insurance, perhaps adding new key employees to the policy or dropping others who no longer qualify.

Life insurance. Recognizing that the death of a key employee or certainly the business owner could mean the end of the business itself, most small businesses own life insurance policies on these individuals. CPAs should look at the face amounts of these individual life policies to see whether the face amounty will adequately cover the cost of replacing the deceased individual, taking into account and his or her the individual’s years of knowledge and customer goodwill. Too often, life insurance policies are purchased solely based on the business owner’s or key professional’s personal needs, ignoring the financial demands of the business. It’s incumbent upon the CPA to also think about the amount of cash a business will need to meet its liquidity demands in the event of a key person’s death.

If the business wants to ensure it continues, CPAs should help it make certain life insurance provides sufficient cash to meet liquidity needs as well as the owner’s personal needs.

CPAs also should remember to routinely check all life insurance policies to see that the interest rates the carrier assumed and the investment returns variable life policies achieved are reasonable and on target with original projections. As interest rates change and stock and bond returns fluctuate, the investment assumptions of a life policy change as well. The CPA should make certain the premium payments are still on target to fund the necessary coverage. Checking a life insurance carrier’s rating with an independent rating service also is a critical part of any policy review.

Succession planning. Every small business needs a succession plan if it is to survive after an owner’s death. Life insurance traditionally is used to fund such plans. If there are partners in the business, an appropriate buy/sell agreement is crucial. The insurance death benefit provides the funds for the remaining partners or successor to purchase the deceased owner’s business interest from his or her heirs. The amount and terms of this coverage will depend on what type of buy/sell agreement--stock redemption or cross-purchase—the company has in place. If the company has changed its business structure since the last review, CPAs should make check to see if the entity needs a new agreement with the proper insurance funding to accompany it.

Retirement planning. Many small business owners purchase life insurance to fund retirement benefits. This can be done through a deferred compensation plan using corporate-owned life insurance or as part of a qualified retirement plan. In fact, the increasingly popular IRC section 412(i) plans, also known as fully insured plans, are a form of defined benefit pension plan funded exclusively by life insurance, annuity contracts or a combination of the two.

Because a 412(i) plan allows significantly greater contribution levels than regular defined contribution plans, these arrangements have been especially popular for small business owners age 45 and older. A small business owner may be able to contribute up to $300,000 to his or her 412(i) plan each year. That amount is a substantially higher tax-deductible contribution than the $4041,000 maximum the business owner can put in a defined contribution plan.

When setting up a the insurance funding for a 412(i) plan, the small business owner must decide how much he or she wants to receive annually upon retirement, up to a maximum benefit stipulated by law, and fund the plan to meet that goal. An insurance company guarantees those benefits provided the business meets the required funding guidelines. Because funding requirements can change based on interest rates, small business owners need to annually review their 412(i) plans to make sure the amount they contribute will indeed meet their benefit target.

A privately held business often is the largest asset in the owner’s estate. Recognizing that, savvy small business owners have funded some level of insurance to cover the income and estate taxes that will be due to the government in the event of their death. As an important part of an annual insurance checkup the CPA should analyze increases (or decreases) in the business’s value and assess whether the insurance policies currently in place will cover the taxes heirs may face. This may be a particularly difficult task in light of changing estate tax rates and the possibility federal estate taxes may disappear altogether.

At renewal time CPAs should remind clients there is much more to check when evaluating policies and carriers than simply the premium. An annual insurance review should include making sure the carriers still are reliable and well-rated and that coverage limits and deductibles still make sense. The time the client invests today in reviewing coverage is well-spent. Yesterday’s plans were made with yesterday’s view of the future. And that perspective inevitably has changed.

Mark Papalia, CLU, ChFC, CFP, is president and founder of Papalia Financial in Danville, Pa. The company works with CPAs to design and fund compensation and retirement plans and business succession programs. His e-mail address is mpapalia@papaliafinancial.com

Reprinted from the March 2004 issue of the Journal of Accountancy.