The Best Policy: Be Prepared
Hurricane season has rolled around again, all too soon for small-business owners vulnerable to flooding and storm damage. How much insurance should entrepreneurs purchase to cover their risks? What risks are best handled by in-house reserve accounts? Dr. Robert Klein follows developments in the insurance sector as director of the Center of Risk Management & Insurance Research at Robinson College of Business, Georgia State University.
He spoke recently to Smart Answers columnist Smart Answers (no relation) about catastrophe insurance, the new hurricane season, and the importance of risk management for even the smallest firms. Edited excerpts of their conversation follow (see BusinessWeek.com, 6/12/06, "Preparing Your Finances for Disaster").
How does a small company know how much and what kind of insurance to purchase?
My inclination—whether you're a mom and pop or an employer of 100—is that every business owner should do some kind of overall risk management assessment and disaster plan. That means you identify where your risks are, what they are, and how you might most efficiently deal with them.
Part of that plan is to determine where purchasing insurance makes sense and where it doesn't. You may be able to do this on your own, or you may need the assistance of an insurance broker or consultant. A medium-sized company might consider having its CFO take on the role of risk manager.
What would a risk-management analysis take into account?
There is a set of principles that govern how to manage various risks most effectively. For instance, you want to purchase insurance for risks that are low frequency but high severity. You don't expect these things to happen very often, if at all. But if they do they can be devastating. We're talking about things like high winds, fires and hurricanes.
Insurance can be very efficient for these risks because the premiums will be relatively cheap due to the low probability of occurrence, and you'll be paying for true insurance protection, as opposed to paying for servicing smaller claims that you could better pay for out of your operating income or reserves.
What would be examples of risks that wouldn't be candidates for insurance coverage?
Those risks that are low-frequency and low-severity, such as minor damage to your facility due to an accident. It's not efficient to insure against something like that because you'd just be paying the insurer to pay you back for small losses that you could save for yourself in a reserve account.
Let's take the issue of theft. Do you want to buy insurance that covers things like employees taking home office supplies? Probably not. But if you're a retail jeweler and a burglar could make away with a large amount of cash or inventory from your store, you'd want to insure against that kind of loss.
Are there special categories of insurance for certain companies?
There are high-frequency, high-severity risks that are tough to insure against. For instance, small businesses sometimes put out new products that could result in product liability lawsuits.
If your company is releasing a new product, or doing something potentially dangerous like taking people skydiving, you must take steps to guard against harm coming to one of your customers, and you have to factor insurance into your business plan. If there's a significant probability of a major accident, your insurance is going to be costly. You may need to reconsider whether the product or the company is economically feasible.
What are some lessons learned for small companies from last year's devastating hurricanes?
The first thing is that you must really know your coverage. People say insurance policies are too hard to understand or too boring to read, but those dull details could be vitally important to your firm and your personal financial viability. Take time to learn what your policy covers or find an agent or broker you trust and have him explain it to you.
If your broker says you've got coverage for A, B, and C, get him to write that down for you in a letter and keep it with your insurance files. If he's not willing to write you a letter to that effect, don't do business with him. If you get a promise of coverage in writing and then it turns out your policy does not cover that area after all, you can sue the broker. These agencies are required to carry errors and omissions insurance coverage, so there would be funds available if you prevail in the lawsuit.
A lot of small companies were devastated by Hurricane Katrina in New Orleans because they didn't have flood insurance. How important is that?
Unless you're located on a mountain top without any water at all nearby, you should buy flood insurance. There's a federal flood insurance program with subsidized rates for homes and businesses located within 100-year flood plains, but the maps are outdated and flood risks change rapidly due to construction and development.
There's also talk in Congress about changing or even eliminating that federal insurance. For the time being, if you can, buy up to the limit of the federal insurance and then buy additional flood insurance, or multi-peril insurance that includes flooding, on the private market. Here in Atlanta, there are homes and businesses nowhere near rivers or creeks. But when we get heavy rain storms, the drainage system doesn't always work efficiently and they get flooded.
Business-interruption insurance is usually mentioned in disaster planning. How important is it?
If your business is not able to operate for a while, you're going to have loss of income plus expenses to relocate your operations. So, you do need business-interruption insurance for that possibility. There is a lot of play in terms of how much it costs, and negotiating it can be tricky.
A good broker can help you decide how many months of interruption should be covered and what percentage of lost net income will be covered. There's also the issue of after-the-fact low-balling over what your net income would have been if your business had continued without the interruption: You might show them projections or financial history on your company, but the insurer could try to claim your numbers aren't valid. Get a broker who will structure the terms of business interruption insurance as much in your favor as possible.
What resources exist to help small companies navigate the process?
An excellent resource is the Insurance Information Institute,. The U.S. Chamber of Commerce has information on insurance for small companies online. There are also more technical texts, and course materials on risk management available through industry groups like The National Underwriter,(see BusinessWeek.com, 6/12/06, "An Eye on the Storm").
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