Risk and Insurance Part 5 Managing Growth in the Small Business

Looking Ahead After studying this chapter, you should be able to: Define risk and explain the nature of risk. Explain how risk management can be used in coping with business risks. Describe the different types of business risk. Explain the basic principles used in evaluating an insurance program. Identify the different types of business insurance coverage. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Risk Risk is a condition in which there is a possibility of an adverse deviation from a desired outcome. 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 exists in a situation where only loss or no loss can occur—there is no potential gain. In general, only pure risk is insurable. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Risk Management Risk management is concerned with protection of the assets and the earning power of a business against loss. Risk management involves identifying and evaluating the severity of risks, selecting methods for managing risk, implementing the decision, and evaluating and reviewing prior decisions. The two ways to manage business risks are risk control and risk financing. Risk control is designed to prevent, avoid, or reduce risk, while risk financing involves transferring the risk to someone else or retaining the risk within the firm. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Types of Risk Pure risks that face any business fall into three groups: property risks, liability risks, and personnel risks. Property risks involve potential damage to or loss of real property (e.g., land and buildings) and personal property (e.g., equipment). For insurance purposes, property may be valued based on its replacement value or its actual cash value (ACV). A peril is defined as a cause of loss, either from naturally occurring events or from the actions of people. Property losses are categorized as direct losses, arising from obvious physical damage, or indirect losses, which result from inability to carry on normal operations because of a direct loss to property. Liability risks arise from statutory liabilities, contractual liabilities, or tort liabilities. Personnel risks, such as premature death, poor health, and insufficient retirement income, directly affect individuals, Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Evaluating an Insurance Program Basic principles of a sound insurance program include: (1) identifying the business risks to be insured (2) limiting coverage to major potential losses (3) relating the cost of premiums to the probability of loss A firm must first secure risk coverage required by law or by contract. Property should be revalued periodically to be certain that adequate insurance is being maintained. A company should determine the magnitude of loss it can sustain without serious financial difficulty. The cost of insurance is proportional to the probability of occurrence of the insured event. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Types of Business Insurance Coverage A business owner’s policy (BOP) is a business version of a homeowner’s policy, designed to meet the property and liability insurance needs of small business owners. A BOP can cover both real property and personal property; offers named-peril and all-risk options; values property on a replacement-cost basis; and includes: business interruption coverage commercial general liability (CGL) coverage medical payments coverage Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Types of Business Insurance Coverage (cont’d.) Insurers use two approaches to define the perils covered by property insurance: with the named-peril approach, the specific perils covered are identified with the all-risk approach, all direct damages to property are covered except those caused by perils specifically excluded Most property insurance policies contain an insurance to value provision that requires the insured to carry a minimum policy limit relative to the actual value of the property. The most common version of this feature is a coinsurance provision that requires the property be insured for at least 80 percent of its value. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Types of Business Insurance Coverage (cont’d.) Two types of insurance provide coverage for key individuals within a business: key-person insurance disability insurance Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Key Terms risk market risk pure risk risk management risk control loss prevention loss avoidance loss reduction risk financing risk transfer risk retention self-insurance real property personal property replacement value of property actual cash value (ACV) peril direct loss indirect loss workers’ compensation legislation torts reasonable (prudent person) standard compensatory damages economic damages noneconomic damages punitive damages proximate cause personnel risks business owner’s policy (BOP) named-peril approach all-risk approach insurance to value coinsurance provision business interruption coverage commercial general liability (CGL) coverage medical payments coverage key-person insurance disability insurance Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.