Business Risk and Insurance Which an Entrepreneur Need to Know – Basics

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By: Site Engineer, Staff

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Business is a profit-seeking activity organized and directed to provide goods and services to customers. Business like any other aspect of life’s endeavor is subject to risk. For a business to achieve its objective’ making profit and survival it has to be able to manage the various risks it is exposed to.

Risk management is concerned with protecting the business from losses which would jeopardize its solvency. The risk management process involves five steps. This is very important to the firm as risk management can reduce losses and expenses thus increasing profits.

Insurance as one of the methods of handling risks is a social device providing financial compensation for the effects of misfortune, the payments being made from the accumulated contributions of all parties participating in the scheme.

Business firms buy insurance policies to shift risks and to provide employee benefits.

Entrepreneurs are often not aware of the risks they are exposed to the operation of their businesses. They are faced with the possibility of the outcome of their transactions turning out to be a loss rather than profit. There is also the possibility of something catastrophic occurring in their businesses which limits their ability to achieve the desired goals.

The possibility or a chance of a loss occurring in a business venture is called risk. It is the degree of uncertainty or probability of loss to which the business enterprise is exposed.

Risk cannot be completely eliminated in a business operation. The possibility of the failure of the venture and hence loss of investment is ever present. Every asset and every activity of the business enterprise exposes it to the risk of accidental loss. Risk can, however, be managed. The owner of a small business can identify the various risks to which the business is exposed, systematically eliminate some and take measures to control others in order to survive and grow.

Types of Risks

1. Particular Risk

This type of risk is more personal and arises from individual events. Thus, its consequences are comparatively restricted. Examples of particular risk include fire outbreak in a building, burglary, car accident, sickness and an act of persona negligence giving rise to personal injury.

2. Speculative Risk

This is the uncertainty about an event in which there is the possibility of gain as well as loss. Buying securities in the stock market is an example of speculative risk. The market price of a stock or bond could increase or decrease after the purchase.

3. Pure Risk

This is the uncertainty about whether a loss will occur but offering no chance of gain. Examples of pure risks include fire, accident, theft or death.

Pure risks can further be classified into fundamental risk or particular risk.

4. Fundamental Risk

This is impersonal both in nature and consequence. It arises from the social, economic and political pressures occurring within society and from purely physical phenomena which affect a whole community. Examples include war, inflation, earthquake, pollution, political instability, Hoods, windstorms, drought, volcanic eruptions, etc.

These risks have catastrophic characteristics. Where fundamental risks have a widespread disaster potential, they are generally regarded as being commercially uninsurable. Rather, they are considered to be a problem of society as a whole, to be dealt with at a governmental or international level.

Risk Management

Risk exists whenever the future is unknown. Risk is therefore viewed as the variation in possible future outcomes. Consequently, if at least two outcomes are possible risk exists. The less predictable the future outcome becomes, the greater the risk. The adverse effects of risk have plagued human beings since the beginning of time. As a result of this, individuals, groups and societies have developed various methods of managing risk. Since no one knows the future exactly, everyone is a risk manager, not by choice but by complete necessity.

Risk management is therefore concerned with protecting the business enterprise from losses which would otherwise jeopardize its solvency. It involves the identification, measurement, and treatment of risks to which the business enterprise is exposed.

The process includes the following steps.

(i)         Identification

Risk management process begins with the recognition of the existence of various risks. These fewer exposures must be properly identified by the business enterprise. Risk identification is perhaps the most difficult function the entrepreneur must perform. This is because failure to identify all the exposures implies that the entrepreneur will have no opportunity to deal with these unknown exposures intelligently.

In identifying loss exposures in a typical business enterprise the following areas may be identified. There is a possibility of properly loss. Properties like vehicles. Machinery, inventory, cash and other equipment could be lost as a result of any of the following applicable risk exposures1 fire, water damage, floods, burglary, and theft or any other form of accident.

There could also be the possibility that any of the employees in the business enterprise can be of a doubtful character which may expose the enterprise to some financial embarrassment as a result of financial impropriety of such an employee. In another instance, it has to be noted also that an employee may be exposed to the danger of being injured while carrying on his normal duties business enterprise. This list is not exhaustive. So many more risks may be identified depending on the circumstances of the enterprise.

(ii)        Risk Measurement

The next important step is to measure the potential losses associated with the exposures during a given period.

This measurement includes the determination of the followings:

  • Ability to predict to a large extent the losses that will actually occur. This again is based on past experience and if properly done, it enables the entrepreneur to put in place tools to help either prevent these losses should they occur or reduce the severity if they actually occur.
  • The probability or chance that losses will occur. On the basis of the past loss experience of their business enterprises or that of enterprises in similar businesses, the entrepreneurs may be able to estimate future losses that may be expected. For example how frequent is a fire outbreak in the enterprise in the past or vehicle damage through accident, theft, etc?
  • The impact these losses would have upon the financial affairs of the business should they occur. If there is an incident of theft or burglary in the enterprise and some assets are lost, will the entrepreneur be able to” make a replacement and get the business going or can this bring it to a position of not being able to continue?

This process is important because it indicates the exposures that are most serious and consequently most in need of urgent attention.

(iii)       Choice and Use of Methods of Risk Treatment

Once the exposure has been identified and measured the entrepreneur must select the best combination of tools to be used in attacking the problem. These tools include primarily the following:

  • Risk Avoidance: One of the most obvious methods of handling risks is to avoid as many risks as possible. If an entrepreneur does not want to try to predict losses in some areas of his business, some losses can be avoided by various decisions he makes. A person who is exposed to the risk of an airplane accident can avoid the risk by not traveling in airplanes. An entrepreneur who faces the risk of an employee’s (e.g., a cashier) dishonesty may avoid this by collecting the money by himself.

However, avoidance of risk is not a practical solution to the many risks that are involved in normal business activities. Although some unusual risks with a high chance of loss can be avoided, realistically, not all risks can be avoided since the risk is incidental to life. For such other risks that cannot be avoided other solutions can be considered.

  • Diversification: In this method, the entrepreneur ventures into more than one area of business. For example, an enterprise can be involved in producing or selling more than one commodity so that when one line is not moving well the other may compensate for the shortfall in the former.
  • Loss Prevention and Reduction: These two methods are so closely related to each other that they are discussed together. Loss prevention may involve the elimination of the chance of loss and thus risk while loss reduction has the goal of reducing the severity of a loss.

There are so many loss prevention and reduction techniques available to entrepreneurs some of which are mentioned below:

  1. Training of personnel in safety measures
  2. A proper layout of facilities
  3. Adoption of engineering specifications and production procedures
  4. Adequate maintenance of equipment
  5. Installation of fire extinguishers and fire drills
  6. Fencing of business premises
  7. Wearing of protective garments shoes goggles etc by workers

(iv)       Risk Transfer

An entrepreneur can transfer some of his risks to other parties. A good example is that of insurance where the insurance company, in consideration of money paid to it called the premium, agrees to compensate the insured (the one taking up the insurance) in the event of a loss as a result of the risk insured against.

In selecting the proper combination of tools, the entrepreneur must establish the best risk treatment tool for each risk at the time.

(v)        Implementation

After deciding among the alternative tools of risk management the entrepreneur must implement the decisions made. For instance, if insurance is to be purchased, he would establish proper coverage, obtain reasonable rates and select the insurance company he wishes to insure with.

(vi)       Monitoring of Results

Finally, the results of the decision made and implemented must be monitored to evaluate the wisdom of the decisions and to determine whether changing conditions surest different solutions.

Contribution of Risk Management to a Business

Purpose of risk management is to minimize the hurt brought about by risk. In minimizing this hurt, risk management can reduce actual losses and expenses thus increasing profits. It can also limit uncertainty to acceptable levels. The possible contributions of risk management to a business can be divided into five major categories.

These are discussed as follows:

1. Risk Management may make the difference between survival and failure. Some losses such as destruction of a firm’s manufacturing facilities may so cripple the firm that without proper advance preparation for such events the firm’s activities may be grounded to

2. Profits can be improved by reducing expenses as well as increasing income. Risk management can contribute directly to business profits. For example, risk management may lower expenses by preventing or reducing accidental losses as a result of certain low-cost measures.

3. Risk management can contribute indirectly to business profits in some of the ways discussed below:

  • When a business has successfully managed its risk, the peace of mind and confidence this engenders permits the entrepreneur to investigate and assume some attractive business opportunities that he might otherwise seek to avoid.
  • By alerting the management of a firm to the risks associated with some ventures they are going into, risk management improves the quality of the decisions regarding such ventures.
  • Once a decision is made to assume a venture proper handling of the aspect of associated risk permits the business to handle the venture more wisely and more effectively.
  • Risk management can reduce fluctuation in annual profits and cash flows. Keeping these fluctuations within bounds aids planning and is a desirable goal in itself. Investors regard more favorably a stable earnings record than an unstable one.
  • Through advance preparation, risk management can in many cases make for continued operations after a loss, thus retaining customers or suppliers who might otherwise turn to competitors.
  • Following a loss risk management may be able to provide funded human and material resources that will permit a firm with a strong growth objective to continue that growth.
  • Creditors, customers, suppliers all of whom contribute to company profits prefer to do business with a firm that has sound protection against risks. Employees also prefer to work for such firms.

3. The peace of mind made possible by sound management of risk may in itself be a. valuable asset because it improves the physical and mental health of the management and owners of the business.

4. The risk management plan may also help others, such as employees, who would be affected by losses to the firm. Risk management thereby also helps satisfy the firm’s sense of social responsibility, desire for a good public image or both.

Insurance

Insurance, as an aspect of risk management tool, may be defined as a social device; providing financial compensation for the effects of misfortune, the payments being made from the accumulated contributions of all parties participating in the scheme.

Insurance may, therefore, be seen as a kind of fund, into which all who are insured will pay an assessed contribution (called premium). In return, those insured will have the right to call on the fund for any appropriate payment should the insured event.

Whilst insurance exists in principle to combat risk, there are certain conditions must be met for a risk to become insurable.

These conditions are:

  1. The occurrence must be fortuitous. Although it is known that losses will occur and that the frequency of loss can be measured, a specific loss must be unforeseen.
  2. There must be insurable interest to protect. Insurable interest is the legal right on the part of the insured to insure.
  3. The possible loss must not be catastrophic. Very large risks such as earthquake, which affect a large number of people subject to the same kind of losses at the same time may not be insurable. This is because it is a deviation from the principle that losses of the few are borne by the contributions of the many who do suffer loss. These risks are usually handled at governmental or international levels.
  4. There must be a sufficient number of risks of a similar class being insured so as to provide an average loss experience. This is because insurance is based on the operation of the law of large numbers.
  5. It must be possible to calculate the chance of loss. The likelihood of an event or loss occurring may be mathematically calculated or it may be based on the statistical results of past experience.

Types of Insurance Covers Available to a Business

Business firms buy insurance policies for two main reasons to shift risks and to provide employee benefits.

Some of the insurance policies that may be taken up by business firms are:

Fire Insurance

A fire policy covers the policy-holder against loss of, or damage to the insured property, resulting from an accidental fire. The different kinds of insurance covers available under fire insurance are grouped as follows:

(a) Consequential Loss Insurance: Consequential loss or business interruption insurance provides an indemnity to a firm tor loss of profits and on-going expenses following damage to its premises by an insured peril. Within the sum insured policies provide for reimbursement in respect of the followings:

  • Net profit lost
  • Standing charges such as salaries wages rents rates etc.
  • Extra costs incurred in continuing business for example cost of renting temporary premises.

(b) The Ordinary Fire Insurance: This is issued to indemnify the insured against accidental fire damage to the property covered under the policy. Such property may be a building or the content a building.

(c) Special Peril Insurance: This refers to those extra or additional perils which though insurable are not covered by the ordinary fire policy. Common examples are damages due to riots and civil commotion, strikes and malicious damage. It also induces damage resulting from the bursting or overflow of water tanks. If a fire policy is to be extended to include a special peril, an endorsement is issued extending the cover on the existing fire policy.

Accident Insurance

The scope of accident insurance is wide. This class of insurance may be grouped into three categories, namely:

  1. Insurance of property against accidental loss or damage, an example of which is motor insurance.
  2. Insurance of a person’s legal liability arising from accidents’ for example public liability insurance.
  3. Insurance of the person against accidental injury, death or sickness. An example is personal accident insurance

An alternative method of classifying accident insurance is according to the class of business. We will discuss briefly some important types of insurance handled under accident business by adopting the second method of classification:

1. Burglary Insurance: This class of insurance provides cover against loss of or damage to the insured property by burglary or housebreaking.

2. Motor Insurance: Motor insurance business is grouped into sections according to the type of vehicle as follows:

  • Private cars
  • Commercial vehicles
  • Agricultural and forestry vehicles

3. Vehicles of special construction such as mobile cinemas and canteens

4. Motor trader’s vehicles

5. Motorcycles

6. Personal Accident Insurance: This kind of accident policy provides for the payment of specified sums in the event of accidents to the person insured.

7. Employers’ Liability Insurance: The purpose of this class of insurance is to indemnify the employer in respect of his legal liability to his employees for occupational injury or occupational disease. The common law and the workmen’s compensation Acts impose certain legal obligations on employers. An employer may take out an Employer’s Liability or a Workmen’s Compensation insurance policy to protect himself against these risks.

8. Public Liability Insurance: This type of policy ensures its holder against his legal liability to members of the public generally. The insurer in return to the premium paid to him undertakes to indemnify the insured against all claims made on him by third parties who suffer damage as a result of the insured’s negligent or tortuous acts.

For all the different types of motor vehicles specified above, insurers offer alternative kinds of policies depending on the extent of cover required by the proposer.

There are four types of policies available namely:

  • Simple third-party policy
  • “Act” liability policy
  • Full comprehensive policy
  • Policy third party fire and theft policy

Fidelity Guarantee Insurance

The main reason for this class of business is to provide insurance against loss by reason of the dishonesty of persons holding positions of trust. In some guarantees, the protection goes beyond dishonesty to cover loss caused by mistake.

There are different types of policies issued in this class of insurance but the commercial guarantee is the one intended to protect an employer from the financial effects of his employee’s dishonesty.

Good-In-Transit Insurance

Under this policy, goods and other merchandise may be insured against loss damage arising whilst the goods are being transported from one place to another.

Life Assurance

The main purpose of life assurance is to ensure against the loss of future income which may arise as a result of the premature death of the income producer.

There are three fundamental types of policies under a life assurance business. These are:

  • Term Assurance: This is an assurance for a fixed period in which the assurers in return for a premium undertake to pay the sum assured in the event of the life assured dying within the period or term stated in the policy.
  • Whole Life Assurance: Under a whole life assurance contract, the assurers undertake to pay the sum assured whenever the person whose life is assured dies. This class of life assurance is most suitable to the family man or breadwinner who wants to provide for his dependants in the event of his death.
  • Endowment Assurance: Endowment assurance contract provides for payment of the sum assured when the life assured reaches a specified age or when he dies whichever occurs first. The endowment policy provides a saving for a given purpose and also offers protection for dependants in the event of the death of the life assured before maturity.

There are a number of adaptations and modifications of the three basic forms of life assurance discussed above. Some of these are discussed briefly below:

  1. Group Life Assurance: the name suggests these are policies on a collective basis, assuring the members of a particular group of persons, such as the employees of a firm. The sum assured is payable in the event of the death of an employee during his tenor of service with the employer. Employers sometimes arrange these policies on behalf of their employees.
  2. “More than one Life” Assurance: This type of policy may be affected on more than one life. The sum assured is payable either on the death of the first life or on the death of the last survivor. This is particularly useful with certain forms of partnership, where the death of one person can have serious financial repercussions for the others, for example, theatrical performers.
  • Insured Pension Schemes: These schemes provide a variety of benefits for members but the main aim is to ensure that some form of pension is available on retirement. We might safely say that life assurance companies perform a vital role in running pension schemes.

Many employers’ pension schemes are by means of group or master policies issued to the employer or trustees of the scheme. These provide retirement pensions and other benefits in respect of the employees who are eligible for the scheme, usually related to their service and salary.

 

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