Yesterday, I wrote about personal finance risk for three broad categories. Today, I wanted to discuss some of the credit proofing options and tools available to manage risk (remember again, that I define credit proofing to include risk management and not just in the conventional sense of protecting one self against creditors)…. and what would a post be without a disclaimer! Please remember that these are general outlines of credit proofing options; the law varies from jurisdiction to jurisdiction so please seek qualified advice on the options raised herein.

There are primarily three sets of options that one can do in order to credit proof themselves, I generally describe them as:

1. Contracts
2. Structuring
3. Insurance

Ideally, all three options should be done. However, given that we all have finite resources, my favorite credit proofing tool is insurance. It is relatively cheap and it immediately shifts risk away from you and your family and to a third party (with a lot more money than you and I). There’s a lot of bad press about insurance but, if you read the fine print carefully, a contextual and well-drafted insurance policy should provide ample protection.

Contracts

The primary function of a contract is to set out the terms and conditions between parties and, if well-drafted, also minimizes risk. For employee with manageable debt and those without manageable debt (see yesterday’s post for how I define this term), there are two primary situations where a contract can minimize the largest risk factor of job loss:

1. You are part of a union and your employment is evidenced by a contract between yourself and your union (in a unionized context, your employer is your union). In most unionized environments, the primary risk factor that any employee faces, job loss or you cannot make money for any other reason, is minimized in some part by generous severance packages (compared to non-union counterparts), a package of insurance entitlements (health and, depending on the union, disability and critical illness insurance). The down-side is that most unions are found in older industries and, after the generous severance is paid, it is not a guarantee that one can find an equivalent position.
2. You have an employment contract in a non-unionized environment. Depending on the jurisdiction you live in, the law may provide very poor severance entitlements (in Ontario, it is generally one week of working notice or payment in lieu of notice for every year of service). If you are in a white collar environment, however, the courts have stated that middle management is entitled to more service than the law allows (generally between 2-4 weeks of working notice or payment in lieu of notice for every year of service depending on a wide variety of factors). Obviously, the best way to ensure you are paid a reasonable amount of severance is to have it stated in an employment contract rather than fight for it in court. The best approach is credit proofing is to review an employment agreement to see how much of a financial cushion one has in the event of termination and, along with some of the options below, devise a strategy to minimize the shock of job loss to the household financially.

The point is that although a contract cannot prevent an employee from being terminated, a contract can set out sufficient monetary protection to ride out the short-term financial impact of job loss until a new job is found.

The use of contracts for entrepreneurs basically deals with minimizing the business risk of any relationship by reducing or eliminating liability from the transaction. This is a completely separate topic so I am not going to address it here.

STRUCTURING

Structure is a catch-all phrase to describe how one can organize their financially affairs to protect assets and minimize risk. There are variety of structuring options one can take:

• Legal structures: Incorporation shields entrepreneurs to the extent that the corporation is a separate legal entity from the owner-manager and liability do not spill over to the owner-manager. However, lenders are increasingly asking for personal guarantees which nullifies some of the benefits of incorporating. Employees traditionally have no idea to incorporate but employees and entrepreneurs alike could consult their advisors about the possibility of establishing trust structures ranging in complexity from informal trusts to full-out family trust incorporating holding companies which owns the corporation which conducts business (which many well-off entrepreneurs set up). Trusts, depending on how they are set up, minimize the risk of paying too much tax and avoid the concentration of wealth in one family members hands. If wealth is concentrate in one person’s hands, the risk is always something may happen to that person and jeopardize the family’s finance affairs. Family trusts are one way around this issue although I readily admit not a contextually appropriate option for most middle management employees.
• Rich spouse, poor spouse: A take on the Rich Dad, Poor Dad brand, this strategy is related to the above and is appropriate for entrepreneurs and employees with unmanageable debt. The primary purpose of this strategy is to place resources into the less risk exposed partner and protect the family resources and expands on my point yesterday that good credit proofing isolates risk not expands it. The strategy is quite simple- put all the resources of the household into the name of the spouse who has smaller risk exposure (i.e. is not the spouse running the business or has bad debt management) and keep the financial affairs of the spouses separate (i.e. no joint accounts, no co-signing anything). Above all, always keep one spouse “safe” by not exposing them to the other spouse’s risk. This includes not co-signing loans, credit cards, personal guarantees etc. To avoid triggering unnecessary tax liability, speak to your accountant before you transfer anything to anyone. What happens if you don’t trust your spouse… well, legally, your lawyer can give you options but you probably have a larger issue which is not part of this blog’s topic….
• Build up your financial parachute. This option is applicable to everyone. Make sure you have a financial parachute/money you can access easily for the worse case scenario whether that be job loss (employees with manageable debt and unmanageable debt), a sudden financial crisis (everyone) or a required infusion of cash into the business (entrepreneurs). Have a source of money you can tap into. I know there is some debate between an emergency fund vs. a line of credit, the point is have one or the other or both before a crisis occurs. If you are an employee with a long employment history, apply for a LOC now.

INSURANCE

I suspect somewhere there is job loss insurance being made available to someone but for those of us without the resources to find and pay for this here are some insurance policies to consider:

• Disability and critical illness insurance: I have written about these types of insurance before and it is appropriate for all with particular importance of disability to entrepreneurs.
• Life insurance: This is pretty self-explanatory. The only note I would add is that most people think of life insurance as a means to look after their dependents, which is certainly true, when dependents are quite young. However, as one’s net worth increase, life insurance should be seen as a option to minimize tax liability for the estate upon death since the proceeds of insurance would be used primarily to pay off taxes. For entrepreneurs, remember that life insurance is collateral in a loan if structured correctly which may, depending on negotiations, eliminate or minimize personal guarantees.

This is some debate on what to get first: life insurance or disability or critical illness insurance. It really depends on the circumstances. An employee regardless of debt levels may have greater need for disability insurance if they are the sole bread-winner and has a family history of poor health. Alternatively, an employee with unmanageable levels of debt may use disability insurance as a forced savings vehicle if they buy a return of premium rider (an expensive savings vehicle but one nonetheless).

Just a few concluding notes:

• if the “barbarians are at the gate” (i.e. creditors are at the doors), there are laws which prohibit the implementation of some of the options above since they could be deemed to be “fraudulent conveyances”. Thus, please consult a lawyer if you are in this situation
• The point of credit proofing is not to eliminate risk (since risk can never be eliminated) but to set up appropriate options to ensure your loss is minimal and survivable financially
• everything is contextual, take a look at yesterday’s post and figure out which category you fit in and assess your risk accordingly. Then see if any of these options fit the bill and see a qualified advisor to discuss.

Good luck.