Structuring contingent liability insurance

By: Kobus Engelbrecht, Marketing Head of Sanlam Business Market

Few entrepreneurs are lucky enough to grow their business into a large enterprise without external funding or incurring some kind of debt.

Many business owners therefore have to sign surety on behalf of their businesses at some point. While this reality is something business owners have to live with, it is risky to sign surety without contingent liability insurance. At worst, it can place the personal estate of the business owner at the mercy of creditors, leaving little, if anything for his family to inherit.

Most surety contracts actually bind the business owner as a co-principal debtor. This means that the creditor can choose from whom he wants to claim repayment of the loan. So if one of the co-principal debtors dies, the creditors can claim from their estate. In the winding up of the estate, all creditors must be paid first this means the business owner’s heirs only receive what is left after all claims and taxes have been paid. So if there isn’t enough cash in the estate to repay creditors, the business owner’s assets, including his family home, can be sold by the executor.

Having contingent liability cover on the other hand ensures that creditors will be paid from the proceeds of the insurance pay out. This type of cover usually takes the form of an insurance policy with life and disability cover. It is taken out on the life of the business owner for an amount equal to the debt for which the owner had stood surety. The policy is often ceded to the funding institution for security.

There are two ways of structuring contingent liability cover: It can either be owned by the business itself or by the business owner in his personal capacity. Engelbrecht’s recommendation is that the business should own the policy, mainly because of complications which may arise if the business owner is the policyholder.

Where the business owner is the policyholder, the policy is paid out to his personal estate. The estate will have to pay the estate duty and then claim it back from the company and this may delay the process of winding up the business owner’s estate.

Contingent liability cover becomes even more important where there are two or more partners in a business. In the event of death or disability of one partner, especially if it is the partner who was more involved in the day-today running of the business, the bank can decide to call in the debt. Since the business is unlikely to have enough cash lying around to settle the outstanding debt, the bank can claim it from the deceased partner’s estate, without having to first claim from the business.

This also means that the bank can claim the full amount from the deceased estate instead of claiming half of the debt from the other partner. If the deceased business partner does not have enough cash in his estate to repay the company’s debt, the bank has a right to sell his assets including his family home.

When business partners sign surety, they should negotiate with the bank to limit their liability and align it with their proportional share in the business. They should also make sure that they have contingent liability cover even if they have a buy-and-sell agreement in place because the insurance pay out from a buy-and-sell policy may only be sufficient to buy out the deceased or disabled partner from the business, and not enough to cover debts.

It is also important to note that if a business-owner exits the business (for example due to retirement) this does not cancel his or her suretyship. That issue should be addressed with the creditor institution.

As in the case of a sole business owner, the company owns the policies on both business partners’ lives. The partners will then enter into a contingent liability agreement with the company, obligating it to repay the bank’s debt in the event of death or disability of one partner from the policy proceeds.