Business insurance is a risk management tool that enables businesses to transfer the risk of a loss to an insurance company. By paying a relatively small premium to the insurance company, the business can protect itself against the possibility of sustaining a much larger financial loss. All businesses need to insure against risks—such as fire, theft, natural disaster, legal liability, automobile accidents, and the death or disability of key employees—but it is especially important for small businesses. Oftentimes, the life savings of the small business owner are tied up in the company, so the owner must take steps to protect his or her family from the financial consequences of events that could disrupt operations, reduce profits, or even cause the business to go bankrupt. Insurance can help a small business be successful by reducing the uncertainties under which it operates. It places the economic burden of risk elsewhere so that managers can focus their attention on running the business. In addition, the premiums paid for many types of insurance are considered tax deductible business expenses.
Many large corporations employ a full-time risk management expert to identify and develop strategies to deal with the risks faced by the firm, but small business owners usually must assume responsibility for risk management themselves. Though it is possible to avoid, reduce, or assume some risks, very few companies can afford to protect themselves fully without purchasing insurance. Yet many small businesses are either underinsured or uninsured.
COMMON TYPES OF LOSSES AND INSURANCE
Small business owners seeking insurance protection should first identify their companies' main areas of exposure to risk. A risk analysis survey or questionnaire, available through many insurance companies and agents, can be a useful tool in this process. Next, the business owner can evaluate the probability of each risk and determine the potential severity of the loss associated with it. Armed with this information, the owner can decide which risks to insure against and the amount of coverage needed. According to the Small Business Administration, the most common types of risks encountered by small businesses involve: property losses; legal liability for property, products, or services; the injury, illness, disability, or death of key employees; and the interruption of business operations and income due to the occurrence of these other losses. Each category of loss can be managed with a corresponding type of insurance.
The types of property losses that can befall a small business include theft, physical damage, and loss of use. Losses from theft can result from the criminal activity of outsiders, as in the case of burglary, or from the illegal activities of employees, including fraud, embezzlement, and forgery. Physical damage can occur due to fire, severe weather, accidents, or vandalism. In analyzing the risk of physical property damage, it is important for the small business owner to consider the potential for damage to the contents of a building as well as to the structure itself. For example, a manufacturing company might lose expensive raw materials in a fire, a retail store might lose valuable inventory in a flood, and any type of business could lose important records to computer vandalism. Although loss of use of property usually results from another covered event, in some instances it can occur without actual physical damage to the property. For example, an office building may be closed for several days due to a gas leak, or a restaurant may be shut down by a health inspector for unsanitary practices.
In insuring against property losses, experts recommend that small business owners purchase a comprehensive policy that will cover them against all risks, rather than just the ones specifically mentioned in the policy. Comprehensive property insurance policies help small business owners avoid gaps in coverage and the expense of duplicating coverage. In addition, they usually allow for speedier settlements of claims. Still, additional insurance may be needed to adequately cover a specific calamity that is particularly likely in the business's geographic area—such as a hurricane in Florida or an earthquake in California. Experts also recommend that business owners purchase a policy that covers the full replacement cost of materials and equipment in order to protect themselves against inflation.
Small businesses may be able to improve their property insurance rates by implementing a variety of safety measures and programs. For example, installing locks, alarm systems, sprinkler systems, and smoke vents may help lower premiums. In addition, some companies can improve their rates by joining a highly protected risk (HPR) classification that is preferred by insurers. The HPR designation is based on stringent property protection programs and involves routine compliance checks.
A small business's legal liability usually comes in two forms: general liability and product liability. General liability covers business-related injuries to employees, customers, or vendors, on the company premises or off, that occur due to the company's negligence. Product liability covers problems that occur due to defective merchandise or inadequately performed services. In both the manufacturing and retail sectors, a company is legally responsible for knowing if a product is defective. This responsibility lasts long after the product leaves the company's control. Indeed, a company that bases its legal defense for a faulty product on the fact that it met safety standards at the time it was sold may still be vulnerable to crippling financial judgments or penalties. Even in the service sector, the service provider may be held liable under certain circumstances—for example, if a repair later causes an injury, or if a poorly prepared tax return leads to an IRS audit.
Whether the determination of the company's liability results from a court decision, a legal statute, or a violation of the terms of a contract, litigation can be time-consuming and expensive. Basic liability insurance is available to protect small businesses against the costs associated with these and other sources of liability. A comprehensive general liability policy, which is recommended for nearly every sort of business, covers accidents and injuries that may occur on the company's premises, or off the premises when they involve a company employee. Such policies generally cover the medical expenses, attorney fees, and court fees associated with the liability. These policies do not, however, cover product liability or automobile accidents. A separate policy can cover product liability, though producers of some types of products—such as children's toys or food products—may find it difficult or expensive to obtain coverage.
A special category of liability coverage pertains to workers' compensation. This type of insurance is mandatory in most states and provides medical and disability coverage for all job-related injuries to employees, whether they occur on company property or not. A few states provide workers' compensation through state-run funds, and companies simply pay a mandatory premium per employee, depending on their line of business. Other states allow private insurers to compete for companies' workers' compensation dollars. Another option available to some businesses is self-insurance, in which the company creates a special reserve fund to use in case a workers' compensation claim is filed against it. In effect, these companies assume the risk themselves rather than transferring it to an insurer. A company's workers' compensation rates depend on its line of business and accident record. The best way to reduce rates is to reduce the risk of employee injuries by improving safety standards.
Company vehicles must be insured, just like vehicles that are intended for personal use. Automobile insurance is usually handled separately from other property and liability coverage. Experts recommend that business owners be sure to list all employees on the insurance policies for company vehicles. In order to determine needed coverage and obtain the most favorable rates, small businesses can consult an insurance watchdog agency.
Key Person Loss
Small businesses often depend on a few key people (owners, partners, managers, etc.) to keep operations running smoothly. Even though it is unpleasant to think about the possibility of a key employee becoming disabled or dying, it is important to prepare so that the business may survive and the tax implications may be minimized. In the case of a partnership, the business is formally dissolved when one partner dies. In the case of a corporation, the death of a major stockholder can throw the business into disarray. In the absence of a specific agreement, the person's estate or heirs may choose to vote the shares or sell them. This uncertainty could undermine the company's management, impair its credit, cause the flight of customers, and damage employee morale.
Small businesses can protect themselves against the loss of a key person in a number of ways. One is to institute a buy-sell agreement, which gives the surviving partner(s) or stockholders the right to purchase the deceased person's portion of the business. Another way a business can protect itself is by purchasing a key person insurance policy. This type of insurance can provide an ill or disabled person with a source of income, and can facilitate financial arrangements so that the business can continue operations in his or her absence. Partnership insurance basically involves each partner acting as beneficiary of a life insurance policy taken on the other partner. In this way, the surviving partner is protected against a financial loss when the business ends. Similarly, corporate plans can ensure the continuity of the business under the same management, and possibly fund a repurchase of stock, if a major stockholder dies.
Life and Health
Some experts claim that since the most valuable asset in many businesses is the employees, ensuring employee welfare is a vital form of coverage. Group life and health insurance are common methods companies use to provide for employee welfare. This type of coverage falls under the category of employee benefits, along with disability and retirement income. It can help small businesses compete with larger ones to attract and retain qualified employees. Life insurance is generally inexpensive and is often packaged with health insurance for a small additional fee. Specialized plans are available to provide survivors with income upon an employee's death. Other plans can protect the firm against financial losses due to the death or disability of a key employee. It is important to note, however, that when the company is named as beneficiary of a life insurance policy taken on an employee, the cost is not tax deductible for the business.
In recent years, many health insurance providers have begun offering affordable plans for small businesses. In some states, businesses are required to provide health insurance if they employ more than five workers. The type of coverage a business needs depends upon its work force. For example, a company with a work force consisting primarily of married people with dependent children will need more comprehensive coverage than a company with a mostly unmarried, childless work force. Many insurance companies offer computer models that enable small businesses to determine the most economical insurance plan for them. Another option that can reduce premiums is pooling insurance with other small businesses through trade associations, chambers of commerce, and other organizations.
The two basic health insurance options are fee-for-service arrangements and managed care plans. In a fee-for-service arrangement, employees can go to the hospital or doctor of their choice. The plan reimburses costs at a set rate—for example, the insurance company might pay 80 percent and the company or employee might pay 20 percent—for all services rendered. This type of plan declined in popularity during the 1990s in favor of managed care plans. These plans, the most common of which are run by Health Maintenance Organizations (HMOs) and Preferred Provider Organizations (PPOs), require participants to use an approved network of doctors and hospitals. They pay the health care providers a predetermined price for each covered service. The employee may have a deductible and a small co-pay amount. It is important to note that a company that employs more than twenty people and provides group health insurance to its employees is obliged to offer an employee who leaves the company the option to continue that coverage for a certain period of time at his or her own expense under the terms of the Consolidated Omnibus Budget Reconciliation Act (COBRA).
Though property, liability, and other types of insurance can provide businesses with protection against specific risks, most policies do not cover the indirect costs associated with losses. When a small business suffers a loss, as in the case of property damage in a fire, it may be forced to shut down for some time or move to a temporary location. A typical property damage policy will cover the cost to repair or replace buildings and equipment, but it will not cover the loss of income the business is likely to experience during its downtime. The business thus may be forced to tap cash reserves in order to pay expenses that continue—such as taxes, salaries, loan payments, etc.—even when the company has no income. In addition, the company may face extra expenses in a crisis, such as employee overtime or rent on a temporary location. Business interruption insurance provides a company with the difference between its normal income and its income during a forced shutdown. The prior year's records or tax returns are usually used to determine the payment amount.
Business Opportunity Plans
A wide variety of specialized insurance packages that cover a custom combination of risks are available to small businesses. One popular option is a Business Opportunity Plan or BOP, which acts as a starting point for many small businesses that require insurance. A BOP provides basic property coverage for computers and other office equipment, plus liability protection for work-related accidents. In some cases, a BOP might also include business interruption coverage that will maintain the company's income stream for up to a year if a catastrophe disrupts business. Many BOPs also offer optional coverage against power failures and mechanical breakdowns, liability for workplace practices (including discrimination, sexual harassment, and compliance with the Americans with Disabilities Act), professional liability, and other risks.
Many people who work out of their homes assume that their homeowner's insurance will cover them against property and liability losses. But in reality, a typical homeowner's policy is not sufficient to cover business equipment and liability. In fact, many homeowner insurance policies limit the amount paid for the loss of electronic equipment to $2,500, and will not cover the business's liability if a client trips and falls on the property. Additional protection is required, although it may be possible to add a rider to the homeowner's policy for business equipment and liability.
In recent years, the Internet has emerged as a major business tool for companies large and small. This has led some insurers to introduce policies that protect businesses in the event that their Internet presence is disrupted by hackers or other problems. Hacker attacks, known as "denial of service" among insurance professionals, are a particular cause of concern for companies that rely exclusively on Internet sales. "The business interruption portion of an e-commerce insurance policy usually will cover the cost of sending consultants to the company to help stop the attack and determine how to prevent future attacks," stated Rose-Robin Lamb in LI Business News. "It also covers loss of income for the time that an e-commerce site was down and unable to accept business."
PROFESSIONAL ASSISTANCE WITH INSURANCE NEEDS
A small business owner involved in risk management should 1) identify the risks faced by the company; 2) seek ways to reduce or eliminate the risks; 3) decide which risks the business can assume; 4) determine which risks should be transferred to an insurance company; and 5) shop around for the best insurance coverage for the money. Obtaining the assistance of a professional insurance agent with all of these steps is highly recommended. To gain the most benefit from a relationship with an insurance agent or broker, experts recommend that business owners write down their needs and expectations ahead of time, avoid withholding information, check the credentials of the agents and their firms, obtain competitive bids, and keep careful records of coverages and losses.
Insurance agents often work independently and may select among the offerings of a variety of different insurance companies. They may be able to offer expertise on the regulations that apply in the small business's home state and tailor a policy to meet the unique needs of a particular business. Many large insurance companies have also begun to focus on the needs of small businesses. These companies offer the advantage of being able to provide legal assistance with liability claims, rehabilitation programs for injured workers, and inspection of facilities for safety. Experts recommend that a small business owner select an insurance professional who offers experience working with small businesses, a knowledge of the particular industry, and an ability to provide needed coverage at a competitive price.
Other helpful hints for small business owners include covering the largest area of exposure first, then adding other coverage as the budget permits; selecting the largest affordable deductible in order to save money on premiums; and reviewing costs and coverages periodically or whenever the company's location or situation changes. Experts also warn small business owners against self-insurance. Although it may be tempting to simply keep some funds in reserve in case problems occur, the pool of funds needed to provide adequate coverage is well beyond the capacity of most small businesses. In contrast, insurance premiums are relatively small, and their cost is often offset by a tax deduction.
Anastasio, Susan. Small Business Insurance and Risk Management Guide. U.S. Small Business Administration, n.d.
"Better Business: Insurance—Prepare for the Worst." Print Week. 8 December 2005.
Gardner, Eileen. "Disaster Preparedness Pays Dividends." Business Insurance. 5 December 2005.
Lamb, Rose-Robin. "Biz Insurance: An Evolving Realm." LI Business News. 28 July 2000.
Luxenberg, Stan. "Sponsors embrace insurance to cut risk." Crain's New York Business. 28 November 2005.
Pasich, Kirk. "Don't get shortchanged on Katrina cover." Business Insurance. 14 November 2005.
Hillstrom, Northern Lights
updated by Magee, ECDI