Managing Risk & Insurance Coverage

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CHAPTER
23
Managing Risk

LEARNING OBJECTIVES
By studying this chapter, you should be able to…
23-1 Define business risk, and explain its two
dimensions.
23-2 Identify the basic types of pure risk.
23-3 Describe the steps in the risk management
process and how risk management can be used
in small companies.
23-4 Explain the basic principles used in evaluating an
insurance program.
23-5 Identify the common types of business insurance
coverage.

23-1 WHAT IS BUSINESS RISK?
(slide 1 of 2)
• Risk is the “possibility of suffering harm or
loss.”
• Business risk – The possibility of losses
associated with the assets and earnings
potential of a firm.
• The term assets includes not only inventory and
equipment, but also such factors as a firm’s
employees, its customers, and its reputation.

23-1 WHAT IS BUSINESS RISK?
(slide 2 of 2)
• The nature of business risk can be observed from
two perspectives:
1. Market risk – The uncertainty (gain or loss) associated
with an investment decision.
2. Pure risk – The uncertainty associated with a situation
where only loss or no loss can occur.
• There is no potential for gain.
• As a rule, only pure risk is insurable.

23-2 BASIC TYPES OF PURE RISK
• Pure risks that any business faces fall into
three groups:
1. Property risks.
2. Liability risks.
3. Personnel risks.

23-2a Property Risks (slide 1 of 2)
• Property risks involve potential damage to or loss of
real property and personal property.
• Real property – Land and anything attached to the land, such
as buildings.
• Personal property – Any property other than real property,
including machinery, equipment, inventory, and vehicles.
• Property can be valued in several ways.
• Replacement value of property – The cost of replacing
personal property and rebuilding real property at today’s
prices.
• Actual cash value (ACV) – An insurance term that refers to
the depreciated value of property.

23-2a Property Risks (slide 2 of 2)
• Property insurance also considers two primary features:
1. Perils.
2. Losses.
PERILS
• Peril – A cause of loss, either through natural events or through
the actions of people.
LOSSES
• Property losses may be direct or indirect.
• Direct loss – A loss in which physical damage to property reduces its
value to the property owner.
• Indirect loss – A loss arising from an inability to carry on normal
operations due to a direct loss of property.

23-2b Liability Risks (slide 1 of 10)
• A growing business risk today is the legal
liability that may arise from various business
activities.
• If a business or any of its agents violates individual
rights and freedoms that are protected by law, the
business can be held accountable for any resulting
loss or damage to the affected party.
• Legal liability may arise from:
1. Statutory liability.
2. Contractual liability.
3. Tort liability.

STATUTORY LIABILITY
• Workers’ compensation legislation – Laws that
obligate an employer to pay employees for injury or
illness related to employment, regardless of fault.
• Most workers compensation statutes require employers to
provide the following benefits to employees injured at work:
• Coverage of medical expenses.
• Compensation for lost wages.
• Payment of rehabilitation expenses.
• Death benefits for employees’ families.

CONTRACTUAL LIABILITY
• A common denominator among most contracts that businesses
enter into with other parties is the inclusion of some sort of
indemnification clause.
• Indemnification clause – A contractual clause that requires one
party to assume the financial consequences of another party’s legal
liabilities.
• The idea behind the contractual transfer of liability is to shift the
responsibility to the party with the most control over the risk
exposure.
• Example: A contract for the construction of a new building may
contain an indemnification clause in which the general contractor
agrees to indemnify the property owner for any liability arising from
the construction work. If someone is injured during the building
process, the negligent party would most likely be the general
contractor rather than the property owner.

TORT LIABILITY
• Torts – Wrongful acts or omissions for which
an injured party can take legal action against
the wrongdoer for monetary damages.

• Four elements must be present for someone to
be found guilty of a negligent act:
1. Existence of a legal duty between the parties.
2. Failure to provide the appropriate standard of care.
• The standard of care normally used is the reasonable
(prudent person) standard.
• Reasonable (prudent person) standard – The typical
standard of care, based on what a reasonable or prudent
person would do under similar circumstances.
3. Presence of injury or damages.
• If no injury or damage is sustained by the claimant, tort
liability does not exist.

• The two types of damages that may be awarded in a tort
action are:
1. Compensatory damages – Economic or noneconomic
damages intended to make the claimant whole by
compensating the claimant for any injuries or loss arising
from the negligent action.
• Economic damages – Compensatory damages that
relate to economic loss, such as medical expenses and
loss of income.
• Noneconomic damages – Compensatory damages for
such losses as pain and suffering, mental anguish, and
loss of physical abilities.
2. Punitive damages – A form of punishment beyond
compensatory damages that intends to punish wrongdoers
for gross negligence or callous disregard and to have a
deterrent effect.

4. Evidence that the negligent act is the proximate
cause of the loss.
• Proximate cause – A negligent act that is the clear cause
of damages sustained.
• Tort liability can arise from a number of
business activities, including:
• Premises liability.
• People may sustain injuries while on a business’s
premises.
• Operations liability.
• People may sustain injuries as a result of a company’s
operations that take place away from its premises.

• Professional liability.
• Organizations that have professional liability exposure
include accounting firms, dental offices, and doctors’ offices.
• Employers’ liability.
• In exchange for benefits provided by employers,
employees who are injured on the job are prohibited from
suing their employer in most circumstances.
• However, an employer may be sued by an altogether
different party as a result of an injury to an employee.
• Example: If the employee’s injury in the workplace was
caused by a faulty piece of equipment manufactured by
another firm, the employee may sue the manufacturer of that
faulty product, who, in turn, may sue the employer, alleging
that the employer failed to maintain the equipment.

• Product liability.
• Products manufactured or sold by a business may have a
manufacturing defect, a design defect, or a marketing
defect.
• Manufacturing defect – A defect resulting from a problem
that occurs during the manufacturing process, causing the
product to subsequently not be made according to
specification.
• Design defect – A defect resulting from a dangerous design,
even though the product was made according to
specifications.
• Marketing defect – A defect resulting from failure to convey
to the user that hazards are associated with a product or to
provide adequate instructions on safe product use.

• Automobile liability.
• A business that uses vehicles for various purposes has
automobile liability exposure.
• Completed operations liability.
• The completed operations or completed work of a business
can be a source of legal liability.
• Example: A person leans against the rail of a balcony that
gives way, causing him or her to fall and sustain bodily injury.
• Employment practices liability.
• Current employees, prior employees, and even job
applicants may take legal action against employers and
claim damages arising from discrimination, sexual
harassment, or wrongful termination.

23-2c Personnel Risks
• Personnel risks – Risks that directly affect
individual employees but may have an indirect
impact on a business as well.
• The primary risks in this category include:
• Premature death.
• Poor health.
• Insufficient retirement income.

23-3 RISK MANAGEMENT
• Risk management – Ways of coping with risk
that are designed to preserve the assets and
earning power of a firm.
• It is concerned with finding the best possible way to
reduce the costs of dealing with risk.
• Insurance is only one of several approaches to
minimizing the pure risks a firm is sure to encounter.

23-3a The Process of
Risk Management (slide 1 of 3)
• Five steps are required to develop and
implement a typical risk management program:
1. Identify and understand risks.
• To reduce the chance of overlooking important risks, a
business should adopt a systematic approach to identifying
risks.
• Useful identification methods include:
• Insurance policy checklists.
• Questionnaires.
• Analysis of financial statements.
• Careful analysis of a firm’s operations, customers, and
facilities.

23.1 Risks on the Road to Success

2. Evaluate the potential severity of risks.
• Once the various risks have been identified, they must be
evaluated in terms of the potential size of each loss and
the probability that it will occur.
• At a minimum, risks should be classified into three groups:
1. Critical (losses that could result in bankruptcy).
2. Extremely important (losses that would require investment of
additional capital to continue operations).
3. Moderately important (losses that could be covered with
current income or existing assets).
3. Select methods to manage risk.
• The two approaches used in dealing with risk are:
1. Risk control.
2. Risk financing.

4. Implement the decision.
• Once the decision has been made to use a particular
technique or techniques to manage a firm’s risks, this
decision must be followed by action, such as purchasing
insurance and setting aside dedicated funds to cope with
any risks that have been retained.
5. Review and evaluate.
• Review and evaluation of the chosen risk management
technique are essential because conditions change—new
risks arise, and old ones disappear.
• Reviewing earlier decisions to use a specific method may
identify previously made mistakes.

23-3b Risk Management
in the Small Business (slide 1 of 3)
• Risk management in a small business differs
from that in a large firm.
• In a large firm, the responsibility of managing risk is
frequently assigned to a specialized staff manager.
• In a small firm, the risk manager is usually the
owner.
• A prudent small business owner will take the time to
identify the different types of risks faced by the firm and
find ways to cope with them, through either risk control or
risk financing.

RISK CONTROL
• Risk control – Minimizing potential losses by
preventing, avoiding, and/or reducing risk.
• Loss prevention – Keeping a loss from happening.
• Example: A machine shop that requires all employees to wear
safety glasses.
• Loss avoidance – Choosing not to engage in hazardous
activities.
• Example: A business that hires a common carrier to deliver its
products to the marketplace rather than doing it themselves.
• Loss reduction – Lessening the frequency, severity, or
unpredictability of potential losses.
• Example: A business that installs an automatic sprinkler system
to minimize the damage a fire may cause.

RISK FINANCING
• Risk financing – Making funds available to cover
losses that cannot be eliminated by risk control.
• Risk financing involves transferring the risk or retaining
the risk.
• Risk transfer – Buying insurance or making contractual
arrangements that transfer risk to others.
• Risk retention – Financing loss intentionally, through a firm’s
cash flows.
• Self-insurance – Designating part of a firm’s earnings as a
cushion against possible future losses.

23-4 BASIC PRINCIPLES OF A
SOUND INSURANCE PROGRAM
• Three basic principles should be followed in evaluating
an insurance program:
1. Consider the various insurance policies that may be
appropriate for your business.
2. Secure insurance coverage for all major potential losses.
• Property insurance should cover the full replacement value of a
firm’s buildings and personal property.
3. Consider the feasibility and affordability of insuring smaller
potential losses.
• A small business owner must determine what distinguishes a
“smaller” potential loss from a “major” potential loss and then
decide if it makes sense to insure against smaller potential
losses.

23-5 COMMON TYPES OF
BUSINESS INSURANCE
• Basic insurance policies used by small
companies fall under one of two categories:
1. Property and casualty insurance.
2. Life and health insurance.

23-5a Property and
Casualty Insurance (slide 1 of 8)
• Property and casualty insurance includes:
• Property insurance.
• Commercial general liability insurance.
• Automobile insurance.
• Workers’ compensation insurance.
• Crime insurance.
• Miscellaneous policies.
• Employment practices liability policies.
• Umbrella liability policies.
• Inland marine policies.
• Professional liability policies.
• Cyber liability policies.

23-5a Property and
PROPERTY INSURANCE
• A property insurance policy is used by a business
owner to insure buildings and personal property owned
by the business, as well as buildings not owned by the
business but which the business owner, as the lessee,
may have a responsibility to insure.
• Property can be insured for either its replacement
value or its actual cash value.

23-5a Property and
• When purchasing property insurance, a business
owner must determine which “perils” will be covered by
the policy.
• Named-peril approach – Identifying the specific perils
covered in a property insurance policy.
• With this approach, any damage caused by a peril not named in
the policy is simply not covered.
• All-risk approach – Stating in a property insurance policy that
all direct damages are covered except those caused by perils
specifically excluded.
• In other words, if it’s not excluded, it’s covered.

23-5a Property and
• An important provision in the property insurance policy
is the coinsurance clause.
• Coinsurance clause – A provision in a property insurance
policy that requires the owner to have insurance for at least 80
percent of what it would cost to rebuild the building or replace
the personal property.
• If, at the time of a claim, the building and personal property are
insured for less than 80 percent of their replacement cost, then
the business owner is assessed a penalty by the insurance
company and, in essence, becomes a co-insurer.
• Business interruption insurance is optional coverage
that can be added to a property insurance policy.
• Business interruption insurance – Coverage that
reimburses a business for the loss of anticipated income
following the interruption of business operations.

23-5a Property and
COMMERCIAL GENERAL LIABILITY INSURANCE
• Commercial general liability (CGL) insurance – Coverage for
general liability loss exposure, including premises liability,
operations liability, product liability, and completed operations
liability.
• A commercial general liability insurance policy is the cornerstone
liability policy for small businesses.
WORKERS’ COMPENSATION INSURANCE
• Workers’ compensation insurance – Coverage that provides
benefits to employees injured at work.
• These benefits include coverage for medical expenses, loss of
wages, and rehabilitation expenses, as well as death benefits for
employees’ families.

23-5a Property and
AUTOMOBILE INSURANCE
• Automobile insurance – Coverage designed to provide liability
and physical damage protection for a vehicle.
CRIME INSURANCE
• A small business owner must accept the fact that he or she is
vulnerable to the possibility of employee dishonesty and purchase
the appropriate crime insurance coverage.
• Crime insurance – Coverage primarily against employee dishonesty.
• Elements of crime insurance include embezzlement coverage, funds
transfer fraud coverage, and social engineering fraud coverage.
• Funds transfer fraud – The unauthorized transfer of funds from a
bank account.
• Social engineering fraud – The manipulation of an employee to
voluntarily release unauthorized funds.

23-5a Property and
MISCELLANEOUS POLICIES
• A variety of miscellaneous insurance policies can be
utilized by small businesses, including:
• Employment practices liability policies.
• Employment practices liability policies are designed to protect the
business owner against employment-related lawsuits arising from
discrimination, sexual harassment, or wrongful termination.
• Umbrella liability policies.
• Umbrella liability policies provide supplemental layers of liability
protection.
• Inland marine policies.
• Inland marine policies insure personal property against the risk of
physical damage when such property is located away from a
firm’s premises.

23-5a Property and
• Professional liability policies.
• Professional liability policies are used to protect professionals
(physicians, dentists, accountants, architects, etc.) against
lawsuits arising from errors made while providing their services.
• Cyber liability policies.
• Cyber liability policies protect businesses against the broad range
of loss exposures arising from their use of the Internet and their
holding of confidential information, such as network security
breaches and ransomware attacks.

23-5b Life and Health Insurance
(slide 1 of 4)
• Three types of insurance provide coverage for
employees within a business:
1. Health insurance.
2. Key-person life insurance.
3. Disability insurance.
HEALTH INSURANCE
• Group health insurance policies offer coverage for
medical care at hospitals, doctors’ offices, and
rehabilitation facilities.
• These policies also cover outpatient services,
prescription drugs, and preventive care.

(slide 2 of 4)
• Coverage is usually offered to employees through a
specific group of health care providers, or “network.”
• Types of health insurance plans that fall into this category
include health maintenance organizations (HMOs) and
preferred provider organizations (PPOs).
• Health maintenance organizations (HMOs) – A managed-care
network providing health insurance that is less expensive than
that of a PPO but more limiting in choices of medical care
providers.
• Preferred provider organizations (PPOs) – A managed-care
network providing health insurance that is more expensive than
that of an HMO but offers a broader choice of medical providers.

(slide 3 of 4)
• Out-of-pocket expenses that employees themselves
must pay, regardless of the type of health insurance
plan provided by the employer, generally include the
following:
• A co-pay at the doctor’s office for each office visit.
• A co-pay at the pharmacy for each prescription drug
purchased.
• A percentage of the total cost of the health care provided by a
hospital, usually between 20 and 30 percent, up to a maximum
out-of-pocket cost to the employee.

(slide 4 of 4)
KEY-PERSON LIFE INSURANCE
• Key-person life insurance – Coverage that provides benefits to
a firm upon the death of key personnel.
• Such insurance may be written on an individual or group basis.
• It is purchased by a firm, with the firm as the sole beneficiary.
DISABILITY INSURANCE
• Disability insurance – Coverage that provides benefits to a key
employee upon his or her disability.
• Disability buyout insurance – Coverage that guarantees a
healthy partner enough cash to buy out a partner who becomes
disabled.

Key Terms (slide 1 of 2)
actual cash value (ACV)
all-risk approach
automobile insurance
business interruption insurance
business risk
coinsurance clause
commercial general liability
(CGL) insurance
compensatory damages
crime insurance
design defect
direct loss
disability buyout insurance
disability insurance
economic damages
funds transfer fraud
health maintenance organization
(HMO)
indemnification clause
indirect loss
key-person life insurance
loss avoidance
loss prevention
loss reduction
manufacturing defect
market risk

Key Terms (slide 2 of 2)
marketing defect
named-peril approach
noneconomic damages
peril
personal property
personnel risks
preferred provider organization
(PPO)
proximate cause
punitive damages
pure risk
real property
reasonable (prudent person)
standard
replacement value of property
risk control
risk financing
risk management
risk retention
risk transfer
self-insurance
social engineering fraud
torts
workers’ compensation insurance
workers’ compensation legislation

Managing Risk & Insurance Coverage

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