978-1305405745 Chapter 23

Chapter 23: Managing Risk in the Small Business

CHAPTER 23: MANAGING RISK

CHAPTER OUTLINE

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1) What Is Business Risk?

LO1: Define business risk and explain its two dimensions.

i) Business risk is the possibility of losses associated with the assets and earnings

potential of a firm

ii) Market risk is the uncertainty associated with an investment decision

iii) Pure risk describes a situation where only loss or no loss can occur

2) Basic Types of Pure Risk

LO2: Identify the basic types of pure risk.

a) Property Risks

i) Real property is land and anything physically attached to the land

ii) Personal property is any property other than real property

iii) Replacement value of property is the cost of replacing personal property and

rebuilding real property at today’s prices.

iv) Actual cash value (ACV) is the depreciated value of the property for insurance

purposes.

v) Perils

(1) Defined as a cause of loss

(2) May be naturally occurring events (windstorms, floods, etc.)

(3) Some are related to the actions of people (robbery, employee dishonesty,

hacking)

vi) Losses

(1) Direct loss (physical damage to property reduces its value to the property

owner)

(2) Indirect loss (loss id due to an inability to carry on normal operations due to a

direct loss)

b) Liability Risks

i) Statutory Liability

(1) Workers’ compensation legislation

ii) Contractual liability

(1) Indemnification clause requires one party (the indemnitor) to assume the

financial consequences of another party’s legal liabilities (the indemnitee)

(2) Idea is to shift the responsibility to the party with the most control over the

risk exposure

iii) Tort Liability

(1) Wrongful acts or omissions for which an injured party can take legal action

against the wrongdoer to seek monetary damages

(2) Four elements must be present for someone to be found guilty of a negligent

act

(a) Existence of a legal duty between the parties

(b) Failure to provide the appropriate standard of care (reasonable [prudent

person] standard)

(c) Presence of injury of damages

(i) Compensatory damages (economic damages and noneconomic

damages)

(ii) Punitive damages

(d) Evidence that the negligent act is the proximate cause of the loss.

(3) Most significant sources of tort liability

(a) Premises liability

(b) Operations liability

(c) Professional liability

(d) Employers’ liability

(e) Automobile liability

(f) Product liability

(i) Manufacturing defect

(ii) Design defect

(iii)Marketing defect

(g) Completed operations liability

(h) Directors and officers liability

c) Personnel Risks

i) Directly affect individual employees but may have an indirect impact on a

business as well

ii) Premature Death

iii) Poor Health

iv) Insufficient Retirement Income

3) Risk Management

LO3: Describe the steps in the risk management process, and explain how risk

management can be used in small companies.

a) The Process of Risk Management

i) Five steps required to develop and implement a risk management program

(1) Step 1: Identify and understand risks (Exhibit 23.1 Risks on the Road to

Success)

(2) Step 2: Evaluate risks

(3) Step 3: Select methods of manage risk

(a) Discuss the many types of risk in a business such as shoplifting (both

internal and external), and theft

(4) Step 4: Implement the decision

(5) Step 5: Review and evaluate

b) Risk Management and the Small Business

i) Risk Control

(1) Loss prevention

(2) Loss avoidance

(3) Loss reduction

Chapter 23: Managing Risk in the Small Business

ii) Risk Financing

(1) Risk transfer

(2) Risk retention

(3) Self-insurance

(4) Partially self-funded program

(5) Specific stop loss limit

(6) Aggregate stop loss limit

4) Basic Principles of a Sound Insurance Program

LO4: Explain the basic principles used in evaluating an insurance program.

i) Consider the various insurance policies that may be appropriate for your business.

ii) Secure insurance coverage for all major potential losses.

iii) Consider the feasibility and affordability of insuring smaller potential losses.

5) Common Types of Business Insurance

LO5: Identify the common types of business insurance coverage.

a) Property and Casualty Insurance

i) Property Insurance

(1) Named-peril approach

(2) All-risk approach

(3) Coinsurance clause

(4) Business interruption insurance

ii) Commercial General Liability Insurance (CGL)

iii) Automobile Insurance

iv) Workers’ Compensation Insurance

v) Crime Insurance

vi) Business Owner’s and Package Policies

vii) Miscellaneous Policies

b) Life and Health Insurance

i) Health Insurance

(1) Health maintenance organizations (HMOs)

(2) Preferred provider organizations (PPOs)

ii) Key-Person Life Insurance

iii) Disability Insurance

(1) Disability buyout insurance—Coverage that guarantees a healthy partner

enough cash to buy out a partner who becomes disabled.

ADDITIONAL DISCUSSION QUESTIONS

1. Define business risk and then distinguish between pure risk and market risk?

2. What are the different types of risk that a business may encounter?

3. What are the basic ways to manage risk in a business?

4. Describe the different sources of legal liability.

Statutory liability results from those laws that create a statutory obligation on a

5. Why would a business owner want to insure against “smaller potential losses”?

6. What are the common types of property and casualty insurance?

7. What are some of the key provisions that should be considered when

purchasing property insurance?

Key provisions that should be considered when purchasing property insurance

include named-perils, the all-risk approach, the coinsurance clause and business

8. What are the common types of life and health insurance?

The common types of life and health insurance include basic health insurance,

license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 23– 5

9. Describe a business owner’s policy, including the types of insurance coverage

available with a BOP. List the advantages of this type of policy.

The business owner’s policy (BOP) is a business version of the homeowner’s

policy that is designed to meet the property and liability insurance needs of small

10. What is the purpose of a coinsurance clause and how does it work?

SUGGESTED ANSWERS TO YOU MAKE THE CALL EXERCISES

Situation 1

1. Do you agree that the type of customer to whom the Amigo Company sells

should influence Thieme’s decision regarding insurance?

2. In what way, if any, should the outcome of the current litigation affect

Thieme’s decision about renewing the company’s insurance coverage?

license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 23– 6

3. What options does Amigo have if it drops all insurance coverage? What is your

recommendation?

Situation 2

1. What types of business risk do you think Essman might have overlooked? Be

specific.

Essman may be overlooking product liability risks. Recent product liability

2. Would risk retention be a good strategy for this company? Why or why not?

3. What kinds of insurance coverage should this type of company carry?

Situation 3

1. What are the major types of risk faced by a firm such as H. Abbe International?

What kind of insurance will cover these risks?

H. Abbe primarily faces property-centered risk involving offices and equipment.

2. What kind of insurance would have helped Abbe cope with the loss resulting

from arson? In purchasing this kind of insurance, what questions must be

answered about the amount and terms?

Chapter 23: Managing Risk in the Small Business

license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 23– 7

determine how much coverage would be adequate, as well as the magnitude of the

loss that it could bear without serious financial difficulty.

3. Would you have recommended that Abbe purchase insurance that would have

covered the losses in this case?

Abbe should only insure against major potential losses. The goal is to insure

SUGGESTED SOLUTION TO CASE 23: JACK’S RESTAURANT:

INTELLECTUAL PROPERTY RIGHTS

1. Do Sophia and Hal have valid grounds for asking Jack to sign a noncompete

agreement?

2. Assume Jack signs the non-compete agreement. Two years later, he opens a

restaurant five miles away. If Hal then sues for breach of the noncompete, what

arguments might Jack raise?

3. Are Hal and Sophia’s demands reasonable? Do you think the recipes constitute

trade secrets?

Hal and Sophia’s demands seem reasonable with the exception of Sophia’s belief

with Jack back when the recipes were first developed.

4. What compromise might be met that would be legal, ethical, and fair? Can you

think of a business solution that would help Jack, Hal, and Sophia resolve their

differences?

Students answers will vary on this but might include: Establishing the right for