Insurance is a risk reduction tool used in our private and business lives. It is founded on the basic premise that a large group of individuals will cover a catastrophic event for one of the members sometime in the future. In general, the insurance company uses actuarial science (law of large numbers) to calculate the financial cost of accidents over a given period of time. That cost is then shared by all the members of the pool needing that form of insurance.
Insurance is an interesting business deal. In effect, the insurance company is gambling that you will NOT make a claim and you are gambling that you WILL make a claim. You are basically paying money to get it back later on when you have an accident or some detrimental event.
For the small business owner, insurance is an additional expense that takes away from the overall profitability. Naturally, anyone starting out would love to avoid this additional cost of conducting business. However, all states do require insurance for certain aspects of operations such as auto or workman’s compensation. Therefore it is unavoidable for just about everyone in business.
So what types of insurance do you need in business? This article introduces the small business entrepreneur to the concept of insurance and the various types of insurance most small businesses need and want. The following sections introduce the reader to these types of insurance. Future articles will go into detail about the respective types of insurance.
History and Concept of Insurance
Insurance began with the use of risk distribution. Merchants transporting wares across dangerous zones or large bodies of water would use several vessels or caravans to limit losses if any single transport were lost due to weather or from thieves. As time progressed, insurance developed into written documents as exemplified by Lloyd’s of London. When a ship’s owner would bring the ship’s manifest (list of cargo) a member would sign his name on certain pages to cover those items. In exchange, this member would receive a fee for taking this risk.
During the Middle Ages, guilds formed to develop trades. The members would each contribute an annual sum and these proceeds were used to help defray burial costs or provide for the widow and orphans of a member upon accidental death. This also led to ‘Benevolent Societies’ whereby groups would agree to help the family of a deceased member. This was the precursor to modern life insurance.
Benjamin Franklin formed the first insurance company in the former colonies back in 1751. The company issued fire policies in Philadelphia. Although no claims were made, the risk factor was high due to the concentration of the policies in a single geographical area.
Modern day insurance uses actuarial science (law of large numbers) to determine the overall cost of claims for a given pool of members. As an example, a pool of non-smoking males age 35 has a certain death curve for its membership over a period of 50 years. Based on the expected remaining lives of the pool, the actuary (the numbers guy) could calculate the overall monthly premium needed to cover the members of the pool over the 50 year period. As the premiums are received, the money is invested and the growth of financial reserves begins to accumulate. Over time, massive amounts of dollars become available to pay out the face value of the policies as members begin to pass away.
Insurance companies have gotten smarter over time. Many limit their respective risks based on types of policies issued. As an example, flood insurance is essential for real estate along the coastline in the Southeast. The premiums are high, but most companies limit the actual number of homes insured and make sure there is no significant percentage of concentration in any given area. This allows the insurance company to greatly reduce their exposure from hurricane damage.
There are two types of insurance companies. Stock (or equity based) and mutual based companies exist. A stock company is in it to make a profit at the end of the day. They are there to reward the initial investors by paying out dividends and increasing the value of the share price for the stock. Mutual companies work differently. Here the insured is a member of the mutual company and when a mutual company pays out less than expected claims, they return the excess amounts back to the policy holders via direct payments or reduce premiums in the following year. Back in the 70’s, I remember watching ‘Wild Kingdom’ on TV. It was brought to us by Mutual of Omaha. Other mutual insurance companies include Nationwide, Liberty, and State Farm.
Each company strives to be an expert in one of the areas of insurance. For businesses, there are many insurance companies. Based on the type of policy needed, determines the insurance company as the provider of the policy.
The following are the generally required insurance:
Auto – unlike individual auto insurance, business auto insurance is more expensive. This is due to an increased risk that the employees will not treat the operation of the vehicle as they would their own personal car. Auto insurance is required by law in all 50 states.
Workman’s Compensation Insurance – generally required by law in all states. This insurance covers the cost associated with an employee’s injury. In general it is a percentage of the payroll associated with that particular work environment. As an example, clerical staff are assessed at around 2-3% of the payroll associated with the office staff, whereas, the guys working on a residential roof will average greater than 13% of the associated payroll. Look at the risk factors facing the two groups. In addition, the injury sustained by the roofing guy is more likely to be expensive over an injury in the office environment. Paper cuts are not that expensive to address.
Most states have a threshold of the number of employees you must have prior to mandating insurance. As an example, in South Carolina, the law requires insurance once the employer employs four or more staff.
General Liability – you will notice that workman’s compensation insurance protects the employee. General liability protects you from an accident involving a vendor or customer. This type of insurance covers injury and slander if inflicted onto a customer or a vendor while these folks are on your premises. In addition, if one your employees hurt an innocent bystander while out in the field, it protects you by covering damages associated with the incident. Most states require this insurance by law.
Property – this type of insurance covers the real estate, the associated facilities, equipment, and inventory from damage (fire, hail, accidents and water). My first experience with this type of insurance occurred back in the mid 90’s when an RV dealership experienced a hail storm. It is something to see when you look out onto a lot and watch golf ball size hail assault RV’s. It was ugly afterwards. So many dents and this was way back before dent pulling was a common way of fixing minor dings in autos. The insurance company sent out four adjusters to catalog the damage and work with the manufacturers and the RV dealership to get the units repaired. Property coverage is generally not required by law, but is required via terms of loan agreements or financing agreements for the respective property.
Professional (Errors and Omissions) – many states require professionally licensed individuals to carry professional liability. The most common type is in medicine for improper practice or conduct by a physician. Other professionals such as lawyers and accountants purchase errors and omissions professional insurance to compensate in case of making a mistake in their practice.
Other Common Forms of Business Insurance
These following insurances are designed as risk reduction for the small business and are generally desired but not needed or required by law:
Key Man – this type of insurance covers the accidental loss of the key person in the organization. Often this is you, but sometimes you have somebody who carries the license or has most of the knowledge about the business. Read The Key Man if you desire to better understand this issue in business.
Life Insurance – many businesses will purchase a master life insurance policy on their entire company. Most often these are $50,000 policies on each and every employee contingent upon working a minimum period of time (like 90 days). The face value is paid out to the designated beneficiary as assigned by the respective employees. This is considered a great benefit to entice higher quality and skilled candidates for employment.
Umbrella – this additional coverage (in increments of $1,000,000) protects the management and the company in a large lawsuit situation. It is generally associated with liability coverage, professional insurance, and sometimes with workman’s compensation. The fee structure in most cases is inexpensive (less than $500 per year) for an additional one million dollars of extended coverage. As an example, suppose your liability policy covers up to $2,000,000. If you own an umbrella policy for an additional $1,000,000 than any adjudicated lawsuit up to $3,000,000 is covered.
Health Insurance – many employers provide health insurance access. The most common form of coverage is 50% of the employee’s premium. Any additional coverage e.g. family or spouse is entirely the employee’s responsibility. Most often the employee takes advantage of the discounted price and purchases family coverage. The employee has the premium deducted from their gross wages. Many plans are held in a Section 125 plan. The new health care law changes much of the common coverage and takes effect January 1, 2014.
Disability/Long – Term Care – often offered at group rates without any premium payment by the employer, access to disability and long term care insurance are additional benefits for employees. Some employers offer a small disability package after so many days of an inability to work related to an injury. These policies are generally more expensive than other forms of insurance and so are rarely offered in the small business world. They are only cost effective once the business exceeds 100 employees on the payroll. Even then, the cost is expensive.
Loss of Revenue – most property policies do not cover the loss of profits during the recovery stage of a major catastrophe. Imagine a hurricane destroying your business operations for a period of several weeks. Loss of Revenue coverage allows the business to continue to pay those fixed hard costs during the recovery period including rent, utilities, and associated profits. Some policies will cover the payroll during this period.
Fidelity – most of these policies are performance based. In effect, if the company fails to perform on a contract, the insurance company will pay to complete the contract. Other types of fidelity (or bonding) cover the professional and administration staff to carry out their fiduciary duties to customers or the employer.
Some forms of insurance are required by law. So be sure to seek advice from legal counsel or your Certified Public Accountant as to which forms of insurance you must have. Other types of policies reduce risk associated with being in business. Some of these are appropriate given the nature of some business operations. As an example, it would be beneficial for a delivery service or a jeweler to have a fidelity policy to cover losses associated with failure to deliver on time or protect a customer’s keepsake. Seek out guidance from others in your industry, ask questions of your attorney, and talk to your insurance representative to get an idea of what is appropriate for your type of business. The goal of insurance is to share the cost of an act of God or human error with others in your pool (membership). Act on Knowledge.
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