Managing Risk in the Small Business

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1 CHAPTER OUTLINE Spotlight: Homestead Interior Doors ( 1 What Is Business Risk? Define business risk and explain its two dimensions. Business risk is the possibility of losses associated with the assets and earnings potential of a firm Market risk is the uncertainty associated with an investment decision Pure risk describes a situation where only loss or no loss can occur 2 Basic Types of Pure Risk Identify the basic types of pure risk. Property Risks Real property is land and anything physically attached to the land Personal property is any property other than real property Replacement value of property Actual cash value (ACV) Perils Defined as a cause of loss May be naturally occurring events (windstorms, floods, etc.) Some are related to the actions of people (robbery, employee dishonesty, hacking) Losses Direct loss (physical damage to property reduces its value to the property owner) Indirect loss (loss id due to an inability to carry on normal operations due to a direct loss) Liability Risks Statutory Liability Workers compensation legislation Contractual liability Indemnification clause requires one party (the indemnitor) to assume the financial consequences of another party s legal liabilities (the indemnitee) Idea is to shift the responsibility to the party with the most control over the risk exposure Tort Liability Wrongful acts or omissions for which an injured party can take legal action against the wrongdoer to seek monetary damages Four elements must be present for someone to be found guilty of a negligent act Existence of a legal duty between the parties Failure to provide the appropriate standard of care (reasonable [prudent person] standard) Presence of injury of damages 247

2 Compensatory damages (economic damages and noneconomic damages) Punitive damages Evidence that the negligent act is the proximate cause of the loss Most significant sources of tort liability Premises liability Operations liability Professional liability Employers liability Automobile liability Product liability Manufacturing defect Design defect Marketing defect Completed operations liability Directors and officers liability Personnel Risks Directly affect individual employees but may have an indirect impact on a business as well Premature Death Poor Health Insufficient Retirement Income 3 Risk Management Describe the steps in the risk management process in small firms The Process of Risk Management Five steps required to develop and implement a risk management program Step 1: Identify and understand risks (Exhibit 23-3 Risks on the Road to Success) Step 2: Evaluate risks Step 3: Select methods of manage risk Discuss the many types of risk in a business such as shoplifting (both internal and external), and theft Step 4: Implement the decision Step 5: Review and evaluate Risk Management and the Small Business Risk Control Loss prevention Loss avoidance Loss reduction Risk Financing Risk transfer Risk retention Self-insurance Partially self-funded program 248

3 Specific stop loss limit Aggregate stop loss limit Exhibit 23-4 Tools for Managing Risk 4 Basic Principles of a Sound Insurance Program Explain the basic principles used in evaluating an insurance program. Identify business risks that can be insured Secure insurance coverage for all major potential Consider the feasibility and affordability of insuring smaller potential losses 5 Common Types of Business Insurance Identify the common types of business insurance coverage. Property and Casualty Insurance Property Insurance Named-peril approach All-risk approach Coinsurance clause Business interruption insurance Commercial General Liability Insurance (CGL) Automobile Insurance Workers Compensation Insurance Crime Insurance Package Policies Business owners policy (BOP) Package policy Miscellaneous Policies Life and Health Insurance Health Insurance Health maintenance organizations (HMOs) Preferred provider organizations (PPOs) Key-Person Life Insurance Disability Insurance SOURCES OF AUDIO VIDEO AND OTHER INSTRUCTIONAL MATERIALS Digital 2000, Inc., in Stafford, Texas, offers videos on Safety Behavior, along with a many other safety-related videos. For a catalog, go to the Web site at Training-Videos. The U.S. Chamber of Commerce offers articles of interest to small businesses, many on insurance. Select articles from their Web site, or find a local Chamber office in your state for educational materials. 249

4 ANSWERS TO END-OF-CHAPTER DISCUSSION QUESTIONS 1. Define business risk and then distinguish between pure risk and market risk? Applied to a business, risk translates into the possibility of losses associated with the assets and the earnings potential of the firm. Here, the term assets includes not only inventory and equipment but also such factors as the firm s employees and its reputation. Market risk is the uncertainty associated with an investment decision. Pure risk is used to describe a situation where only loss or no loss can occur there is no potential gain. 2. What are the different types of risk that a business may encounter? Business risks can be classified into two broad categories: market risk and pure risk. Market risk is the uncertainty associated with an investment decision. Pure risk is the uncertainty associated with a situation where only loss or no loss can occur. Generally, only pure risk is insurable. Pure risk falls into three groups: property, liability, and personnel risks. 3. What are the basic ways to manage risk in a business? The two ways to manage business risks are risk control and risk financing. Risk control is designed to prevent, avoid or reduce risk. Risk financing involves transferring the risk to someone else or retaining the risk within the firm. 4. Describe the different sources of legal liability. Statutory liability results from those laws that create a statutory obligation on a business. Contractual liability is the liability arising from a contract with another party. Tort liability arises from torts, which are wrongful acts or omissions where an injured party can take legal action against a wrongdoer for monetary damages. 5. Why would a business owner want to insure against smaller potential losses? Smaller potential losses present a smaller threat to businesses. However, the entrepreneur must decide if the potential loss could be absorbed by the business. If the entrepreneur determines that several small losses could not be absorbed by the business then such risks should be insured against. 6. What are the common types of property and casualty insurance? Common types of property and casualty insurance include property insurance, commercial general liability insurance, automobile insurance, workers compensation insurance, crime insurance, and package policies. 250

5 7. What are come of the key provisions that should be considered when purchasing property insurance? Key provisions that should be considered when purchasing property insurance include named-perils, the all-risk approach, the coinsurance clause and business interruption insurance. The Names-peril approach identifies and covers specific perils. The all-risk approach states that all direct damages to property are covered unless there are perils specifically excluded by the policy. A coinsurance clause requires the business owner to have insurance that will cover a certain percentage (usually 80 percent) of what it would cost to rebuild the building or replace the personal property. Business interruption insurance is a type of optional coverage that may be added to a property insurance policy that will reimburse a business for the loss of anticipated income following the interruption of business operations. 8. What are the common types of life and health insurance? The common types of life and health insurance include basic health insurance, health maintenance organizations (HMOs), preferred provider organizations (PPOs), key-person life insurance, and disability insurance. Health insurance is a basic and valuable benefit that a small business can offer to employees. Two types of group health insurance plans are the HMO and the PPO. The HMO is a managedcare network that limits employees choices of medical care providers more than a PPO does. However, the PPO requires higher out-of-pocket expenses than the HMO. Key-person life insurance is provided for firms to protect themselves against the death of key personnel. Disability insurance provides a portion of the disabled person s normal monthly income for a period of time after the disability occurs. This insurance protects the person, not the business. 9. Describe a business owner s policy, including the types of insurance coverage available with a BOP. List he advantages of this type of policy. The business owner s policy (BOP) is a business version of the homeowner s policy that is designed to meet the property and liability insurance needs of small business owners. The eligibility criterion for the BOP is fairly broad, with the only excluded classes being manufacturers, financial institutions, and auto repair facilities. The BOP is intended to be a comprehensive contract that needs few enhancements. The BOP can be used to cover both real property and personal property. The perils covered can be defined using the named-peril approach, or the all-risk approach. Both real and personal property are valued on a replacement-cost basis; all property damage and loss will be reimbursed at the rate required to rebuild or replace the property. It contains no insurance to value feature, which requires the insured to carry a minimum policy limit relative to the actual value of the property. BOP provides business interruption coverage, which reimburses a business for the loss of anticipated income plus continuing expenses that cannot be met because of the negative impact of a direct loss on business revenue. It also contains commercial general liability coverage, which provides payment for bodily injury and property 251

6 damage for which the insured business is liable. BOP medical payments coverage provides payment for injuries sustained by customers and the general public; it requires no fault on the part of the insured. 10. What is the purpose of a coinsurance clause and how does it work? A coinsurance provision, the most common version of the insurance to value feature, requires the property be insured for at least 80 percent of its value. If that minimum is not carried, there will be a penalty applied to any covered loss. COMMENTS ON CHAPTER YOU MAKE THE CALL SITUATIONS Situation 1 1. Do you agree that the type of customer to whom the Amigo Company sells should influence its decision regarding insurance? Yes. Alden Thieme is simply assessing the amount of risk and is certainly correct in his assumption that juries are influenced by such considerations. 2. In what way, if any, should the outcome of the current litigation affect Amigo s decision about renewing its insurance coverage? The Amigo Company should be prepared to seek additional insurance coverage if it loses the current suit, because this may be a sign of future litigation results. Premiums may be higher for this coverage, or insurance could even be denied. If Amigo wins the suit, it should not let its joy cloud its risk-management decisions and suddenly drop its current coverage. Some form of self-insurance might be coupled with its current insurance coverage. 3. What options does Amigo have if it drops all insurance coverage? What is your recommendation? Amigo, just like any other business, has the option of going bare. This is a very risky option for managing a small firm s liability risks. It is not recommended for Amigo unless the company simply cannot afford coverage or has unusually large cash reserves which is unlikely. Situation 2 1. What types of business risk do you think Essman might have overlooked? Be specific. Essman may be overlooking product liability risks. Recent product liability decisions favoring the injured parties have broadened the scope of this form of risk. 252

7 Essman has definitely targeted a high-risk market! She may also be overlooking several property-centered risks such as fire and burglary. Since Essman is a key executive, she should evaluate the merits of key-person insurance. 2. Would a risk-retention insurance program be a good possibility for this company? Why or why not? Essman should investigate the merits of a risk-retention group. The decisive factor will be whether or not several other businesses with common risks can be assembled. 3. What kinds of insurance coverage should this type of company carry? Each of the different types of insurance discussed in the chapter is a possibility. Essman s personal and business situations will ultimately dictate which coverage she should obtain. Situation 3 1. What are the major types of risk faced by a firm such as H. Abbe International? What kind of insurance will cover these risks? H. Abbe primarily faces property-centered risk involving offices and equipment. To a lesser extent, it is exposed to personnel-centered risk resulting from employee dishonesty, possible competition from a former employee, and losses that could occur in the event of Abbe s death. Types of insurance that should be considered include commercial property insurance, dishonesty insurance, key-person insurance, and business-interruption insurance. 2. What kind of insurance would have helped Abbe cope with the loss resulting from arson? In purchasing this kind of insurance, what questions must be answered about the amount and terms? Business interruption insurance would have helped Abbe, as Abbe s loss resulting from arson was mainly a business interruption cost. In order to buy a suitable level of coverage and avoid unnecessary coverage charges, Abbe would have to determine how much coverage would be adequate, as well as the magnitude of the loss that it could bear without serious financial difficulty. 3. Would you have recommended that Abbe purchase insurance that would have covered the losses in this case? Abbe should only insure against major potential losses. The goal is to insure against what the firm cannot handle financially. Thus, we would have to compare the potential loss against the cost of the coverage to make a decision. However, based on the limited information available, it would appear that business-interruption insurance would have been good. 253

8 SUGGESTED SOLUTION TO CASE 23: JACK S RESTAURANT: INTELLECTUAL PROPERTY RIGHTS 1. Do Sophia and Hal have valid grounds for asking Jack to sign a noncompete agreement? Indeed they do and they are smart to consider these options and establish rights to them at this point. Jack contends that he has no plans to open an new restaurant so if that is truly the case, then he should object to signing an non-compete agreement. 2. Assume Jack signs the non-compete agreement. Two years later, he opens a restaurant five miles away. If Hal then sues for breach of the noncompete, what arguments might Jack raise? Jack could raise the issue of proximate cause. That is, he could require Hal to provide proof that the breach of contract actually caused the damages sustained. There may be a breach of contract and there may be losses but if no link can be established between the two, there is no tort liability. 3. Are Hal and Sophia s demands reasonable? Do you think the recipes constitute trade secrets? Hal and Sophia s demands seem reasonable with the exception of Sophia s belief that she shares some of the intellectual property rights to the recipes. As a paid employee of the company she relinquished ownership rights to these recipes. Had she felt she was entitled to a share of these rights, she should have negotiated this with Jack back when the recipes were first developed. 4. What compromise might be met that would be legal, ethical, and fair? Can you think of a business solution that would help Jack, Hal, and Sophia resolve their differences? Students answers will vary on this but might include: Establishing the right for both parties to market the frozen food items. Pay Jack a royalty for the right to sell the frozen food items in the restaurant thereby adding to his desire for residual income in his retirement. Modifying the length of time with the non-compete agreement. 254