SMALL BUSINESS INSURANCE CONSIDERATIONS

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1 SMALL BUSINESS INSURANCE CONSIDERATIONS Philadelphia LawWorks, a project of Philadelphia VIP, contributes to Philadelphia s economic development by ensuring that homeowners, nonprofits and small business owners legal needs are met and by educating clients and the community to prevent legal problems. Philadelphia LawWorks prepared this guide to help distribute basic legal information to the community at large. While the information contained in this publication concerns legal issues, it is intended solely to provide general information. This guide is not intended to constitute legal advice or substitute for obtaining the advice of an attorney. It is understood that Philadelphia LawWorks providing of this guide and your reviewing of this information does not establish an attorney-client relationship. No action should be taken in reliance on the information provided in this guide, except after prior consultation with a lawyer. WHAT IS INSURANCE? Insurance can be purchased in a wide variety of forms and for various levels of protection. In all instances, however, insurance is a contract providing that an insurance company will compensate or reimburse someone for a certain type of loss. Generally, insurance will protect a business against a liability a financial obligation up to the amount of the coverage purchased. The liability a business is responsible for in any given situation will depend upon the damage or injury involved and the fault levels of the parties involved. Most insurance policies will protect the insured party against claims and will also require that the insurance company assist with the defense of any lawsuit arising out of the claims. Without insurance coverage, a business would have to pay for the damages or loss, as well as the cost of defending any related litigation. The cost of obtaining insurance is called the insurance premium, which will vary in size according to both the type of insurance and the amount of protection purchased. The cost of insurance will also differ depending on who is purchasing the insurance policy. For example, the premium charged for identical insurance packages will be different across customers if the risk (or predicted cost) of providing that insurance is higher for one customer than another. There are many other factors that will influence the cost and value of an insurance policy, and this guide will discuss some of the options available for small business owners. Often, the decision whether to purchase a specific type of insurance and for what amount will be an individual one, with no definite conclusions to reach. Because all businesses are different, insurance decisions will almost always involve a cost/benefit analysis specific to each business. Such decisions can be difficult, and should not be made without the consultation and advice of an insurance broker and an attorney. Philadelphia LawWorks would like to thank Philip Russell, a 2005 graduate of the University of Pennsylvania Law School, and Jean C. Hemphill, a partner with Ballard Spahr Andrews & Ingersoll, for creating this legal guide.

2 WHY BUY INSURANCE? Insurance provides protection against loss or liability as the result of both foreseeable and unforeseeable events. Some businesses may wish to protect themselves against the risk of future property damage, any employmentrelated claims, potential lawsuit liability, or even theft. In an unpredictable world, most businesses look to insurance as a means of protecting against small to potentially devastating costs or liabilities incurred in the course of running a business. Without adequate protection, a business may fail as a result of costs that could have been covered relatively inexpensively by the right insurance policy. Clearly, not every business will require every type of insurance. For example, businesses in areas unlikely to experience earthquakes or hurricanes might not benefit from the cost of insuring against such unlikely events. In other instances, however, insurance is not only recommended it is required. The State of Pennsylvania requires registered owners of motor vehicles to carry certain minimal amounts of insurance for medical benefits, bodily injury liability, and property damage liability. Therefore, a business with a company vehicle needs to purchase appropriate insurance. Similarly, Pennsylvania law generally requires that any employer who employs more than one worker, full-time or parttime, provide worker s compensation insurance coverage. Worker s compensation insurance basically provides compensation for employees who become either injured or disabled in connection with their employment. 2

3 WHAT ARE THE MOST COMMONLY PURCHASED INSURANCE POLICIES FOR SMALL BUSINESSES? Even though businesses vary immensely, all businesses should at the very least purchase commercial general liability insurance. Commercial general liability insurance is, as its name suggests, very general in its coverage. It will cover a business against the risk that someone becomes injured in the place of business, that a customer is hurt using a product purchased from that business, or that someone sues a business for damages that resulted from dealing with that business. Commercial general liability insurance will also cover a business against negligent (careless or irresponsible) acts of the business or its employees. Because this type of policy is very general, a business will likely need more specific liability coverage depending on its specific needs. As discussed above, Pennsylvania businesses with either cars or more than one employee will be required by law to purchase automobile insurance and/or worker s compensation insurance. Another type of insurance commonly purchased by small businesses is property insurance. If a business owns property a store, a factory, an office, etc. it should be insured to protect it against damage. If the property is mortgaged, almost all mortgage companies will require that a certain amount of the value of the property be insured. Similarly, insurance can be purchased for personal property, such as equipment, supplies, or other items owned in the course of operating a business. Insurance for such items is often purchased by small businesses wishing to protect against loss of or damage to such property. In the case of a corporation with a board of directors, directors and officers liability insurance may be appropriate. Directors and officers liability insurance ( D&O coverage ) provides protection to directors or officers in the event that they become liable in their capacity as directors or officers. Without directors and officers liability insurance, either the director of a corporation or the corporation itself would have to pay the legal costs associated with defending claims made against the director in the performance of his or her duties. It is standard practice for a corporation to agree to compensate or reimburse and hold harmless many of its directors and employees from liabilities incurred in the ordinary course of business. As a practical matter, corporations without such an insurance policy will experience difficulty in attracting qualified individuals to serve on its board of directors. Some small businesses choose to offer their employees health or life insurance. Other small businesses purchase crime or theft insurance. As mentioned earlier, not every business will require every type of insurance. Unless the likely benefit of purchasing a specific plan for a certain level of coverage outweighs the cost of doing so, such an insurance plan should probably be reconsidered. 3

4 HOW MUCH WILL IT COST TO PURCHASE INSURANCE? The cost of insurance will vary greatly depending on the type of policy purchased, the amount of coverage purchased, the amount of deductible you are willing to cover and the type of business purchasing the insurance. As a general rule, however, insurance is not priced on a straight-line basis. This means that it will not cost twice as much to insure against $2 million in losses as it will to insure against $1 million in losses. The reason for this is simply that smaller claims are much more likely to occur than large ones. Consequently, insurance for larger loss amounts will become relatively less expensive per unit of coverage. The market for insurance is relatively competitive. There are many insurance companies competing for the business of potential customers. Accordingly, one should shop around when searching for an insurance policy. It is best to start looking for insurance with an insurance agent or broker. Because insurance agents are trained in assessing the risks involved in running different types of businesses, they should be able to direct you to the right insurance policies and levels of coverage appropriate for your industry. Much like with doctors, it is good practice to get a second opinion from another insurance agent. When using insurance agents, it is important to find out what their market is. Some agents have less limited markets than others, and will therefore have a broader range of insurance companies from which to quote rates. Additionally, it may be possible to find insurance rate quotes on the internet, depending on what area you live in and what insurance companies provide the types of policies you are interested in. Another good source for insurance pricing information is other business owners. If you know of a similar business that is would be willing to discuss its insurance policies with you, this will may provide a good comparison for you. 4

5 WHAT DO I NEED TO CONSIDER IN EVALUATING THE RANGE OF INSURANCE OPTIONS? Various considerations play into the decision to purchase insurance. The most common and important of those considerations are: What amount of liability coverage should be purchased? Most insurance policies have liability coverage limits. This means that there is a specifically contracted-for maximum amount of money that the insurance company will pay if a claim is made that is covered by the policy. Consequently, someone purchasing an insurance policy must determine both what losses are likely and what losses are possible. It is useless to insure for risks greater that what is possible, and it may cost too much to insure for risks that are unlikely to happen. Another important consideration in purchasing liability coverage is whether the coverage includes legal costs. For example, if the liability coverage is for $1 million, a claim for $1 million would only recover $700,000 if the legal costs are $300,000 and the legal costs are included in the maximum liability coverage. If legal costs were not included in the maximum liability coverage, then that same claim would recover the full $1 million. The policy without legal cost coverage for the same amount of total liability coverage will provide the most protection. What other factors will influence the cost of insurance? As mentioned previously, insurance costs can vary greatly according to the amount of liability coverage, the type of coverage, and the risks associated with the business. Costs can vary in other ways, too. For example, the premiums on different policies may be based on different calculations. In some cases, an insurance company will base the premium on some measure of your business payroll, its income, its size, or the size of its properties. The insurance companies may price comparable policies on different measures. It is therefore wise to ask on what basis a company quoting a premium used in determining their premium. In a competitive market for insurance, there may be room to negotiate lower costs for insurance by finding companies that may charge your business less for comparable policies because they use a measure more favorable to your business. Another factor that will influence the cost of an insurance policy is the deductible amount of the insurance coverage. Sometimes the deductible is referred to as the retention level. The deductible amount is the cost that you will have to pay on any given claim before the insurance company has to pay you for your claim. So, for example, if your deductible is $100, and your claim is for $500, you will pay the first $100 and the insurance company will pay the balance of $400. Because the majority of the all claims are fairly small, the deductible reduces the number of claims that an insurance company will have to investigate or settle if the small claims are less than or equal to the deductible amount. Therefore, the higher the deductible for any given policy, the lower the premium will be. Who will be insured under the policy that is purchased? In most cases, the party insured under the policy will be your business or organization. 5

6 In other instances, however, it is going to be the directors, officers, or employees that are named in the policies. In other cases, you should be careful to provide insurance coverage not just to current directors, officers, and employees, but also to future ones. Without such a provision, it will be necessary to renegotiate policies for any additional employees hired by your organization. What types of coverage are typically offered by insurance companies? Claims Made Policies. A claims made insurance policy requires an insurance company to compensate you for claims that occur when the policy is effective and when the lawsuit is filed. In other words, the policy will not cover claims for acts that occur either prior to the effective date of the policy or after the policy has expired. When purchasing insurance for a business that has already been operating, a necessary consideration will be whether a claims made policy will provide enough protection against acts that might have already occurred. If you are not concerned about potential liabilities arising prior to the effective date of the policy, a claims made policy may be sufficient. However, if there is potential for claims to arise based on acts that occurred prior to the purchase of such a policy, it may be necessary to consider the other major type of insurance policy an occurrence policy. It may also be possible to separately purchase either prior coverage or tail coverage to satisfy potential liabilities arising from either liabilities arising prior to the effective date of a claims made policy or after the expiration of the policy. In any case, you should take care to adequately cover yourself on either end of the effective date and expiration date of a claims made policy. Occurrence Policies. An occurrence policy generally provides better protection than a claims made policy because it will cover any liability-creating event as long as the policy was in place at the time of the event. With such a policy, one would be covered for liabilities arising during the time of the effectiveness of the policy even if the lawsuit was filed years after the expiration of the policy. Ideally, a business would like to have an occurrence policy in place throughout the business life of an entity. What exactly is covered by my policy? In reviewing a policy for purchase, it is extremely important to review carefully what exactly is covered by and what is excluded from coverage by a particular policy. Policies will vary from insurance company to insurance company, but many policies will exclude coverage for intentional acts by the insured party. Other policies will exclude liability coverage for acts of pollution or wrongful employment practices. If these types of activities are ones that you would like to have insurance for, such insurance may need to be negotiated separately or paid for with additional premiums. In all cases, you should be sure that you precisely understand your insurance policy and its range of coverage and all of its exclusions. How important is the application for insurance? The insurance application is not to be taken lightly. A failure to provide complete and accurate information in an insurance application may result in loss of coverage, loss of any premiums paid, and even criminal charges for fraud and perjury. You should be absolutely certain that the information provided in an insurance 6

7 application is complete and accurate. If any questions arise in the process of applying for insurance, you should discuss relevant questions with both your insurance agent and an attorney. How will insurance coverage begin? Again, depending on whether or not the policy you purchase is a claims made policy or an occurrence policy, the policy purchased may or may not cover all potentially liability-creating incidents for an ongoing business. Generally, insurance companies also have the right to terminate an insurance policy within 60 days of its effectiveness. During this 60 day underwriting period, the insurance company will be able to review your application and make an ultimate decision with respect to the policy it provided to you. During the 60 day underwriting period, the insurance company may inspect the properties it is insuring or request additional information from you with respect to the operation of your business. The insurance company may revise its assessment of the risks entailed by insuring your business, and may change the premium on your policy. Once the 60 day underwriting period has expired, the insurance company is usually limited in its ability to cancel your insurance policy to either fraud or failure to pay the policy s premium. Most insurance policies are renewable at the end of the insurance coverage period. If for whatever reason the insurance company decides that it will not offer you a renewal on your insurance policy, it must provide you with at least 60 days notice of its intention to terminate. In the event of a claim, what will I recover from the insurance company? When your business purchases insurance for items of property, either real or personal, a choice often exists to either insure for the actual cash value of the property or the cost to replace the property. For certain property the difference between the two values may be substantial. For example, if you were to insure a bicycle that cost $500 to buy, but that had subsequently depreciated to $200 in actual cash value, you would recover $200 under a cash value policy, but you might recover $500 if the only way to replace your bike was to purchase a new one. You should try to estimate whether replacement value or cash value will more adequately cover the costs of reimbursing losses for a specific business properties. What is coinsurance? Coinsurance is a term describing a provision common to insurance policies on most forms of property. Generally, a property insurance policy will require you to insure that property for a specific percentage of the actual value of the property. For example, if a policy requires 75% coverage on a piece of property worth $1,000, then you will be required to insure that property for $750. The actual value will depend on whether you chose to insure your property for either the cash value or the replacement cost. In this example, assume that the replacement cost of the property is $1,000. The $250 dollar difference in this example between the required insurance amount and the replacement cost is the amount that you have coinsured under the policy. In this case, you will have coinsured for 25% of the value of the property. However, if you had only insured the property for $500, you would have coinsured the property for 50% of the value of the property. 7

8 How do I choose an insurance company? As with any other contract, one should be careful to assess the risk of the party on the other end of the contract. This concern is no different when entering into a contract for insurance with an insurance company. Because most individuals are ill-equipped to ascertain the financial condition of insurance companies you should look to outside sources. One well-respected source of information for different insurance companies is A.M. Best Company, Inc. Most insurance agents will be able to guide you in determining which insurance companies have been determined to be the most sound financially and/or which companies have the highest levels of customer satisfaction. Similar information is likely available in your public library. Another source for insurance information is the Pennsylvania Insurance Department, whose contact information is listed on the next page. What is a Risk Manager? Some companies choose to hire Risk Managers whose specific job is to determine the risks associated with a particular business or strategy and advise management accordingly. Most small businesses will not need to hire such a person, at least as long as the business remains small. A more costeffective alternative to a risk manager is to ask your insurance company to provide similar consulting-type services for a fee. 8

9 WHO SHOULD I CONTACT FOR ADDITIONAL INFORMATION? For a wide range of insurance information specific to Pennsylvania, please contact the Pennsylvania Insurance Department toll-free at or visit their website at The Pennsylvania Insurance Department maintains directories of insurance providers in Pennsylvania and is able to assist with specific questions. 9

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