Chapter 2 Related Literature This chapter will present existing literature in business journals and books tackling the problems of small businesses and their insurances and the past trends between these relationships. The experiences and problems encountered by small businesses in managing business risks that are either not covered or scantily covered by insurance policies are highlighted. Introduction Risk is the happening of an unwanted event or the non-happening of a wanted event which affects a business in an adverse way. Risk in a small business is realized when the objectives of the business are not achieved and the assets of the business are not safeguarded from loss. The success of a business, whether it’s a tiny enterprise run out of a basement or a large corporation, is largely dependent on hard work and ingenuity. However, no matter how industrious the businessmen, one disaster can wipe out all the profits and even destroy the business. The key to making sure that all the effort and money invested in a business does not disappear when a disaster strikes is to protect it with the appropriate insurance. Basic Insurance Needs When small businesses pay premiums for insurance coverage, the insurance company accepts part or all of the risk in exchange for a premium payment. Under terms stated in a hazard insurance policy, the insurance company agrees to pay losses that otherwise would be the responsibility of the business owner. To the extent identified in a liability insurance policy, the insurance protects the business from liabilities arising from actions or inactions of the business owner or others who act on the behalf of the company (employees, agents, or others). As a part of the insurance company’s contract with the business owner, the policy, the insurance company usually accepts responsibility for defending the business if a claim or legal action is filed by someone alleging that the business owner did or didn’t do something, and damage and loss resulted. Without insurance, the expense of defense against a claim can be very high and could put a small business owner out of business (Gessaman,1996). Gessaman (1996) identifies some insurance types that are relevant to a small business. Liability insurance is a primary small business need, and the coverage must include product liability, premises liability, malpractice, vehicle accidents, errors and omissions, accidental damage to personal property, business continuation insurance, and Insurance for employees. General liability insurance can be purchased separately or as part of a business-owner’s policy (BOP). A BOP bundles property and liability insurance into one policy; however, the liability coverage limits are generally pretty low. Businesses that need more coverage usually purchase liability insurance as a separate policy. The amount of coverage a business needs depends on several factors including perceived risk. Business owners should first consider the amount of risk associated with their business. For example, a business that manufactures heavy machinery is at a greater risk of being sued than a company that manufactures linens and would therefore need more liability insurance (Insurance,1999). A BOP includes property protection for an office building and its contents as well as other people’s property brought into the office building. BOPs cover standard perils, including fire and theft, although certain exclusions apply, such as damage caused by floods and earthquakes. Under a BOP, a business selects the amount of liability coverage it needs based on its assets. Liability coverage pays for the cost of defending the business in a lawsuit and pays damages if the business is sued for injury or property damage. The liability policy also pays the medical expenses of those injured, other than employees, as a result of business operations. A BOP provides coverage for both business interruption and replacement costs if an emergency disrupts or destroys the business. Business interruption insurance not only compensates for lost income and the expenses incurred when a company is forced to vacate its premises due to disaster-related damage, but it also covers operating expenses, such as payroll, which continue even when business activities have ceased. Replacement-cost coverage pays to replace damaged or stolen property, equipment and inventory without deducting for depreciation. In addition to the basic BOP policy, businesses may purchase add-on coverage based on the particular risks associated with the company. For example, a dry cleaner might purchase additional coverage for mechanical breakdown, which would cover the machinery the business relies on. A retailer with numerous employees might carry coverage for employee dishonesty, which covers loss of business property due to embezzlement, fraud or another criminal act (Insurance, 1999). Business continuation insurance is merely a special use of life insurance and disability insurance which protects the company from financial loss caused by the death or the long term disability of a key employee. Business overhead expense (BOE) insurance provides a means of paying a business’ overhead expenses, such as rent and utilities, during the time a business owner is disabled. Key person disability insurance protects the firm in the event a key employee or partner is unable to deliver critical contributions required for the success of the firm. Key person life insurance provides funds to allow surviving owners of the business to pay for losses incurred by the death of a key employee or partner, such as the need to hire temporary help or consultants or to train a new employee. Proceeds from key person life insurance can also be used in conjunction with a buy and sell agreement to help the business owner, as the surviving owner, to purchase the stock of the deceased without selling the assets (Insurance,1999). Workers’ compensation benefits provide coverage for medical expenses as well as reimbursement for lost wages when employees are injured on the job. Workers’ compensation coverage includes two types of protection: workers’ compensation and employer’s liability. The workers’ compensation portion of the policy pays for claims made by employees, and the employer’s liability portion pays the cost of defending lawsuits filed against the company by an employee or an employee’s family. Workers´ compensation insurance may not be at the top of your list of things to think about, but it should at least be on that list for several reasons, including: workers’ compensation for insurance is required by law in all 50 states; and workers’ compensation insurance, which can protect the business from lawsuits. Without the right coverage, an injured worker might sue the business to recover medical costs, disability costs and damages (Insurance, 1999). Employees of small businesses are significantly less likely to have employer-provided health care coverage than are workers in large firms, despite a variety of state laws designed to make coverage available. In a study conducted in South Carolina, USA, the types of state mandates and incentives that pertain to small employer health plans, the actions of health maintenance organizations (HMOs) in offering products to small firms, and the reasons these firms do or do not choose to offer HMO coverage to employees, were determined. The state-by-state analysis shows which states had rules affecting permissible rate differentials between large and small employers (ratings bands) and other ratings practices, guaranteed right to renew policies, requirements that health plans offer some insurance product to small employers (guaranteed issue), limits on pre-existing conditions exclusions in policies, reinsurance limitations, mandated benefits, and requirements that plans pay out at least a certain percentage of premiums in claims (minimum loss ratio) (Brown Thomas E. et.al, 2000). Small businesses face substantial cost and other barriers in obtaining health insurance coverage for their employees. An analysis of data from the Current Population Survey, performed by the Bureau of the Census, indicates that 28 percent of workers aged 18-64 who are employed by firms with fewer than 25 employees had no health insurance coverage in 1989, compared with 8 percent for firms with 1,000 or more employees. A second study was commissioned to identify and examine strategies that are proving successful in increasing health care coverage for small business employees. High cost was consistently identified by program developers as the most important reason why small firms do not provide health insurance for their employees. Even when the higher marketing and administrative costs associated with providing coverage for small businesses were eliminated–as in many of the case studies–the researchers found that many small businesses that did not already have health insurance did not purchase coverage. The case studies suggest that significant insurance premium subsidies may be required to lower premiums enough for small businesses currently without insurance to provide coverage for their employees. Successful program initiatives for improving small business access to health care had the following characteristics in common: attractive benefit designs that were similar to a traditional benefit plan; managed care and lower than prevailing provider rates; aggressive and creative marketing; substantial community support; and relatively low employer premium rates (Burnette, Joanna Md., Dyckman Zachary PhD, 2000). A study conducted to estimate the extent of health insurance coverage and, conversely, non-coverage among the U.S. population, with a focus on analyzing the uninsured by firm size and employment status, showed the following results. Between 1988 and 1992 the number of uninsured in the United States increased from 31.0 million to 35.5 million people. In 1992, almost 21 million (about 60 percent) of the uninsured were working. Also in 1992, 16.4 percent of private, non-agricultural wage-and-salary workers lacked health insurance. Workers in small firms are significantly more likely to be uninsured than workers in large firms. In 1992, 25.9 percent of private, non-agricultural wage-and-salary workers in firms with fewer than 25 employees lacked some form of health insurance, compared with 10.3 percent of workers in firms with 500 or more employees. Between 1988 and 1992 the proportion of uninsured increased across all firm sizes. The unincorporated self-employed are less likely to have health insurance than are the incorporated self-employed. In 1992, 23.9 percent of the unincorporated self-employed lacked health insurance coverage from any source, compared with 9.1 percent of the incorporated self-employed (Black, Berger and Scott, 1994). While some small businessmen are content with a BOP or a general coverage insurance, experts warn that not everything that a small business needs is usually covered by BOPs. The needs of a business vary from industry to industry, and so does the coverage of an insurance policy for a particular business. Business growth leads to more profit, and with it higher risks. While the basic insurance policies stated above cover some of the items or properties a business owner needs to keep its machinery going, the owners of a rapidly growing business must make sure that the coverage of their insurance policies remains synchronized with other business decisions and growth-related activities. Some business owners balk at the high premium rates for expanded insurance coverage without realizing that wider coverage for their business ensures the long-term security of operations. This literature survey includes previous reports of necessary but oftentimes overlooked insurance coverage offered by some insurance companies, and examples of industries that are directly or indirectly affected by the presence or the absence of these policies. The review of insurance coverage and making sure that a business has adequate protection should be an ongoing task. Expanding Coverage What about off-premises property? Property insurance protects the business against physical damage to, or loss of, assets, covering the cost of repair or replacement. Assets, broadly defined, include the area where the business operates and the property housed there. In the event a notebook computer is swiped while at the airport or in a bus terminal, a business owner is going to want it covered. Insurance providers typically set sub-limits for property that’s in transit or off the premises. With some providers, these limits are built-in, whereas others require the policy holder to add them on as supplemental coverage. Employment practices liability insurance (EPLI) is another area quickly becoming a common supplement for entrepreneurs. Global Protection recently added EPLI to protect against such situations as sexual harassment, age discrimination and wrongful dismissal. Small businesses may also want to check out an important, yet often overlooked, type of insurance that isn’t included in general liability policies (or BOPs for that matter): directors and officers liability insurance, or D&O. If a board member of a company is found to be negligent, his personal assets are at risk. With D&O insurance, business owners can deflect that risk. Auto insurance (or fleet insurance) provides coverage for injury, damage or theft. It’s wise to have coverage even if you don’t have company-owned vehicles in case you (or an employee) get into an accident while driving a personal or rental car on company business. Crime insurance is a type of crime/fidelity insurance that covers the cost of losses arising from employees’ dishonesty or fraudulent acts such as forgery, burglary, computer fraud and extortion (Lee, 2001). Product-related insurance covers manufacturers’ or sellers’ liability for losses or injuries to a buyer, user or bystander caused by a defect or malfunction of their product. Product Liability Insurance is designed to protect the business from liability suits arising from customer use of your product. Depending upon your product or service, this may be quite expensive. When considering a product, business owners should think about its inherent safety or lack of it. There are currently many lawsuits against legal products, which function as they are designed, but which are deemed “bad” products by certain political groups. Some products and events are just too expensive to insure against (Lee, 2001). Umbrella insurance provides additional liability coverage above and beyond the limits of coverage as stipulated in the business’ main policy. Umbrella insurance policies are designed to supplement other insurance, for example BOP. If the limits are reached on other insurance policies, umbrella insurance kicks in and covers the amount owed above the business’ basic coverage (Lee, 2001). Risk Assessment and Insurance Cost The surest way to control insurance costs is to use what insurance professionals refer to as “risk management.” Using risk management methods, a business owner determines the probability of his business facing a loss, and considers whether or not it needs coverage for that loss. This is a process that large companies use, and one that small businesses can practice to ensure they do not over- or under-buy insurance. By using risk management to avoid or reduce losses, small businesses can lower the number of insurance claims they may make. This, in turn, lowers the coverage rates, which are based on claim history. Risk management basically includes several steps. The first is identifying the sources of potential losses. Examples would include casualty and theft losses, fraud and embezzlement, injury claims, etc. Second is evaluation of the financial risk posed by each exposure. How frequently might the event occur? How severe would its impact be? Third is the determination of how to treat the risk. Can it be eliminated or controlled? Can you transfer the risk to your insurance company? And fourth is repeating the risk assessment process annually and in synchrony with business growth. Although most companies have their bases covered should they meet with fire, theft or flood, such hazards represent only a small portion of the myriad risks they face. A 1999 survey of the Fortune 1000 conducted by Mercer Management Consulting in Boston found that 10 percent of those companies suffered a 25 percent or greater loss in shareholder value during a one-month period between June 1993 and May 1998. Fifty-eight percent of companies that suffered a stock drop traced it to strategic risks, most commonly competitive pressures and a customer shortfall. Operational risks accounted for losses at 31 percent of the companies, and the remaining 11 percent attributed their losses to financial risks. None of the businesses cited hazard risks as the reason for their losses because, “for the most part, companies have addressed that aspect of risk,” says Jim Loucks, senior vice president of business development with Marsh Inc., Mercer’s parent company and an insurance brokerage and risk adviser firm in Houston. To begin dealing proactively with financial, operational and strategic risks, organizations can adopt enterprise risk management (ERM). In a nutshell, ERM allows organizations to examine all the risks they face, measure the potential impact of those risks on the long-term viability of the company, and take the appropriate steps to manage or mitigate those risks. In general, the range of risks most businesses face includes hazard risks, such as property damage and theft; financial risks, such as interest rate and foreign exchange fluctuations; operational risks, such as supply chain problems or cost overruns; and strategic risks, such as misaligned products. The key to ERM success is to address all those risks in an integrated fashion. Although businesses may emerge from the risk identification process with a list of 50 or more risks, the ERM team should set priorities and concentrate its efforts only on the five or 10 risks that are significant enough to warrant quantifying and analyzing (Sammer, 2001). New or Modified Insurance Coverage With the birth of e-commerce-related frauds, and the myriad terrorism acts afflicting the country, insurance companies are scrambling to come up with new, or modified, insurance policies to respond to the concerns of big and small businesses. The terms of terrorism insurance changed overnight on September 11, 2001, when carriers suddenly faced an estimated billion to billion in losses. Prior to that date, the risk of losses due to terrorism was so low for U.S. companies that it was automatically covered by most policies. After September 11, the vast majority of insurers immediately excluded coverage; a few offered limited stand-alone policies at exorbitant premiums. “On September 11, we all had terrorism coverage, and on September 12, we didn’t,” recalls Scott R. Adams, director of corporate insurance and risk management litigation for Insignia/ESG Inc., a commercial real estate provider headquartered in New York City. “CFOs had to purchase stand-alone policies with premiums that jumped 100 to 300 percent” (Hansen, 2003) Maintaining adequate insurance has become a top priority for senior finance executives now that the consequences of the Sept. 11 attacks are sinking in. In three hours, the insurance industry experienced its most expensive disaster ever; the terrorists blew away roughly billion of insurers’ capacity and left the worst previous catastrophe, Hurricane Andrew, in the dust. The industry had enough reserves to cover the losses, and insurers bravely stepped up to microphones the next day to say that they could and would pay claims stemming from the incidents, rather than trying to escape under an “acts of war” exclusion. However, their depleted coffers could not withstand a second such attack. The terrorist acts caused a violent spasm of risk aversion among those who make taking risks their business. The huge, concentrated losses hit reinsurers particularly hard, and for months primary insurers were left without any assurance that they could get reinsurance for large claims. Thus, they mailed stacks and stacks of letters to customers that had policies coming up for renewal, putting them on notice that their insurance might not be renewed. Contracts that have been renewed since Sept. 11 contain more exclusions, higher deductibles and lower caps on payouts. And premiums, already rising before the attacks, have taken a steep upturn. While aggregate price increases across all lines and all industries have stayed around 30 percent annually, some difficult coverages have shot up by 200 percent, 300 percent, even 700 percent. No one anticipated or budgeted for this kind of cost explosion. Now finance pros face a no-win dilemma: Spend piles of scarce cash for shrinking protection or accept dangerous amounts of risk. It’s more than an insurance problem; many real estate bank loans require the property to be insured. Lose your insurance, and you could lose your loan or be forced to pay more for it, notes Mike Turner, vice president of marketing for FM Global, a commercial and industrial property insurer based in Johnston, R.I. “The full effects of the Sept. 11 attacks have yet to sink in,” he insists. (Gamble, 2002). Increasingly important and complex information systems, the Internet, e-mail and electronic commerce have opened up new opportunities for business efficiency and opportunity. However, these developments also have created new and different kinds of risk levels. The 1998 Computer Crime and Security Survey conducted by the Computer Security Institute (CSI) in San Francisco found that 72 percent of the 520 organizations responding had suffered financial loss from computer-security breaches. Of the 46 percent that could quantify those losses, the tab exceeded 6 million, a 36 percent increase over 1997. As heavily dependent as most companies are on their IT systems, the risks for loss if something goes wrong are significant. Add in related risks, such as the dissemination of slanderous internal e-mail, and the risks involved with electronic communication and commerce greatly increase. As great as these new risks may be, they do not automatically fall under traditional property and general liability coverage. “General liability wasn’t written with electronic commerce in mind so these policies may not respond to these claims for things like emotional distress caused by malicious code,” according to Nick Economidis, director of information asset protection at CIGNA Property & Casualty, Philadelphia. Traditional property coverage focuses on protecting physical assets from actual physical damage. For example, computer hackers are unlikely to cause direct physical damage to computer systems even though they have a tremendous ability to cause damage to software and a company’s finances. As the economy and business practices become more information based, such gaps in coverage are likely to grow wider. Some new types of coverage relating to e-businesses include: computer fraud, theft of tangible assets or property transferred by computer; and damage to data, including the cost of restoring and re-creating software or data as a result of illegitimate use. Companies should be clear on what constitutes “illegitimate use” because damage caused by employees may not be covered. This could be problematic for companies. A government study found that the most serious financial losses were the result of authorized access by company insiders. Also included is the cost of any interruption to the business caused by a hacker-induced computer interruption (lost revenue minus expenses). Overall, the need for such coverage will depend on the company’s risk exposure. For example, high-profile companies with visible and well-trafficked Web sites are often hacker targets. Companies should also weigh the relative complexity of their IT systems and their importance to the business before purchasing the coverage. (Sammer, 1999). Bibliography: Brown, Thomas E. et.al. (2000). Small Business and Access to Health Insurers, Particularly HMOs. Consult. Inc.: South Carolina Black, Dan A., Berger Mark C., & Scott, Frank A., (1994), Measuring the Uninsured by Firm Size and Employment Status: Variation in Health Insurance Coverage Rates (Part I) Caroline Looff and Associates: Kentucky. Burnette, Joanna & Dyckman, Zachary. (2000). Programs to Improve Health Insurance Access for Small Business: What Works and What Doesn’t. Center for Health Policies: Columbia, SC Gamble, Richard H. (2002) “The Insurance Renewal Marathon”. Business Finance. September 2002. Gessaman, Paul,1996 (On-line), IANRhttp://www.ianr.unl.edu/pubs/consumered/nf277.htm Hansen, Fay (2003) “Terrorism Insurance Returns”. Business Finance, March 2003. Insurance, 1999, (Online) All Business http://www.allbusiness.com/articles/content/3493.asp Lee, Mie-Yun (2001) Entrepreneur magazine, February Issue Sammer, Joanne. (1999). “Riskless Business”. Business Finance. December 2001. Sammer, Joanne (2001)”The Three Faces of Risk Management” Business Finance, December 2001.
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