BCom Notes Part I Business Reducing Risks Through Insurance

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Reducing Risks Through Insurance

Business Risks Risk is the danger that something will happen to destroy the best-laid plans. The more venturesome the enterprise, the greater the profits or losses that can be expected.

Despite the return for risk taking, the businessman prefers to eliminate as many hazards to successful operation as possible. Some he must assume while others he can reduce to a minimum.

Kinds of Business Risks

Hence, the risks that confront a business may be divided into 2 types:

1. Uninsurable Risks

2. Insurable Risks

1. Uninsurable Risks

Some risks may be due to external causes over which little or no control can be exercised. These are uninsurable risks and few of them are as follows:

a. Fluctuations in Price Level

A business firm typically produces goods in anticipation of demand and incurs expenditure on raw material, wages and various other costs with a view to sell goods at profit. In the meantime of the prices of the product fall, the firm will have to bear loss.

b. Changes in Distribution Method

The recent development of chain stores, supermarkets and shopping centers has had an impact on small, independently owned stores. Many of them have been forced to shut their doors.

c. Changes in Laws

Often changing of laws also affects business e.g. if the government bans the import of certain items for any reason or plates excessive duties on their import, the dealers of such items will be forced out of business.

d. Change in Technology (Advancement)

The development of new products or new brands of better quality, new production techniques etc constitute a continuous hazard for those who do not keep up with time.

e. Change in Consumer Tastes

A company produces goods keeping in view the tastes of customers. A shift in the whims and fancies of customers and consequently a fall in demand constitute a risk and bring loss to the company.

2. Insurable Risks

Not all risks are insurable. Only those that are economic in character can be insured. But not all economic risk is insurable either. They can be divided into SPECULATIVE and PURE RISKS. Speculation consists of chances and can result in either gain or loss. Insurance is limited to pure risk because in it there is not chance of gain.

By definition, insurance is a system devised to reduce the burden of financial loss due to some specified but uncertain event.

a. Risk of Fire

A factory or office building may be damaged by fire. This risk is insured with the insurance company, whereby the insurance carrier agrees to make goods any loss sustained by a person on property destroyed by fire.

b. Risk of Theft

A business may be robbed by burglars or a dishonest employee may steal money or goods handled by the business.

c. Transportation Risk

Maritime perils like sinking, capsizing, damage by sea water etc, and risks due to rains, accidents etc faced by goods while in transit come under this category.

d. Casualties

A business may suffer losses due to each casualties as wind store or earthquake, employee accidents, suits against directors and officers by disgruntled stockholders etc.

Other Risks

1. Marketing Risks

Risks are involved in marketing a new product. Even after a product is successfully introduced to the market, risks continue to plague its existence. To minimize these risks, many companies often use the means of test marketing.

2. Equipment Risks

The purchase of special facilities and equipment can involve great risks. The expensive equipment required to produce that new wonder drug may prove useless, if the drug has dangerous side effects. Practically any major purchase decision involves risks.

3. Credit Risks

Each time a company extends credit to a customer, there is danger that the customer will not pay his bill. If the credit manager becomes too careful and screen out everybody who has ever been late with a payment, he runs the risk of restricting company sales.

4. Inventory Risks

Inventories also present the businessman with a dilemma. If he fails to buy adequate supplies, there is the danger of running out of stock. Yet, the maintenance of large inventories means heavy storage costs plus potential dangers of theft, deterioration, price declines of obsolescence.

5. Government Risks

Certain Federal laws add to the risks associated with being a businessman. Product Liability means that the manufacturer may be held liable if someone is injured because of a defective part in his product and so on with other government laws and conditions.

Methods of Handling Risks

Risks are inherent in business. Some risks must be assumed while others can be minimized. Following are the five general risk management techniques:

1. Risk Avoidance

A manufacturer can avoid the risk of product failure by refusing to introduce the new products. But this risk avoidance would be at a very high cost. The business that does not take a chance on new products will probably fail when the product life cycle catches up with it.

There are however situations in which risk avoidance is a practical technique. Individuals who stop smoking or jeweler stores that lock up their merchandise in vaults are avoiding risks.

2. Risk Reduction (Protective Measures)

If a risk cannot be avoided, perhaps it can be reduced. A manufacturer can reduce the risk of product failure through careful product planning and market testing.

Among the techniques used to reduce risks are:

1. Establishment of employee safety programs.
2. Use of proper safety equipment.
3. Burglar alarms, security guards etc.
4. Fire proof building, fire alarms, sprinkler system etc.
5. Accurate and effective accounting and financial controls.

3. Self Insurance (Risk Assumption)

A firm takes on certain risks as part of doing business e.g. a firm assumes that some creditors will not come up with payments. Risk assumptions is then the act of taking on responsibility for the loss or injury that may result from a risk.

This usually means setting aside a financial reserve that can be drawn upon, should the loss occur. (Self-insurance is the process of establishing a monetary fund that can be used to cover the cost of a loss) e.g. companies maintain an allowance for bad debts.

Self insurance does not eliminate risks, it only provides a means for covering losses. it is more appropriate for large organizations than for the small businesses.

4. Business Adaptation and Flexibility

Another method of dealing with risks seeks to reduce the potential impact of an undesirable event. Business firms confronted by risk due to rapid changes in technology should stress on maximum adaptation of production facilities, organizational structure and procurement method. By hedging they can minimize the losses due to fluctuation ins price levels.

5. Shifting Risks (Insurance Coverage)

The most commonly used method of dealing with risks is to shift or transfer the risk to professional risk taker the insurance company.

The insurance company is a firm that agrees, for a fee, to assume financial responsibility for losses that may result from a specific risk. The fee charged by an insurance company is called Premium. A contract between an insurer and the person or firm whose risk is assumed is known as an Insurance Policy. Generally an insurance policy is written for a period of one year and is renewed each year.

Insurance is thus the protection against loss that is afforded by the purchase of an insurance policy. Insurance companies only assume insurable risks. These estimate on the basis of past experience, the amount that will have to pay in case losses occur. In addition to covering the losses, it must also recover its own costs of operation.

Types of Insurance Coverage

Life Insurance

Life insurance does not insure life, as this replacement is impossible. Practically it provides insurance either to the assured or beneficiary on agreed amount of money that becomes payable either maturity of the period or in case of death of the assured. In case if the assured amount becomes payable to the assured on the expiry of certain period it is known as endowment policy. In case if the insured amount becomes payable on death only, it is known as whole life policy. In whole life policy the some of the beneficiary must be specified or mentioned by the insured so that payment could be made to correct person in case of this death. For the benefit and facility of the insured, there is limited payment plan policy also that also permits the insured to pay insurance premium to a limited number of years. After that period the policy comes the paid up policy for the full value of the insured amount. In life insurance, group life coverage is also gaining popularity due to its sizeable fringe benefits employees. Employers obtain group life insurance policy to cover all employees less expensively than employees could buy individual polices for themselves.

Fire Insurance

Fire insurance policies protect property owners against losses resulting from damage to property used by fire, Now its scope has been widened to cover losses from windstorms, hail, riots earthquake, explosion, flood, chemical or smoke. The amount of premium chargeable by fire insurance companies depend upon the amount of coverage obtained, type of property, and fire fighting arrangements made by the company obtaining protection.

Marine Insurance

Marine insurance protection is available to merchandise in transit. In fact international trade owes to it. Had there been no marine insurance, perhaps foreign trade would not have expanded to the extent which we find today. By offering protection to shippers and foreign traders, marine insurance is playing a vital role in international commerce. It insures cargo, ship and freight.

When a ship sinks in ocean, three things are lost. Firstly, we lose cargo, secondly the ship itself and thirdly the freight that would have been earned by the shipping lines. Cargo is insured by the trader, while ship and freight are insured by the shipping company.

Burglary, Theft and Robbery Insurance

The insurance company draws fine distinctions among burglary, theft and robbery. Burglary is taking of property by forcible entry, theft is the unlawful taking of property and robbery is the unlawful taking of property from another person by force or threat of force. Insurance premium rates vary for these different types of risks. Where all three risks are covered by insurance the insured pays an average premium and is protected against any losses that do occur.

Automobile Insurance

Automobile insurance offers protection against fire, theft, bodily inquiry, property damage, and collision. It also covers public liability or damage to the insured automobile. Bodily injury liability insurance under it will pay the policy holder legal liability, for injury to one person or to a group. If a driver hits a pedestrian or causing injury to person in other car, the insurance company will pay damages up to the amount of coverage carried.

Workmen’s Compensation Insurance

The purpose of workman’s compensation insurance is to guarantee medical and salary payments to workers who are injured on the job unless it can be show that the employees injury or death was will full or caused by intoxication. This insurance is now required in many countries of the world as a part of legal requirement. The cost of insurance is born by both employers and employees, but the major share is assumed by employers.

Fidelity and Surety Bonds

Fidelity bonds are usually written to cover employees occupying positions of trust in which they have jurisdiction over funds. The employer is guaranteed against loss caused by the dishonesty of such employees and the insurance company will reimburse the policy holder for loss up to the amount specified in the policy.

Surety bonds are written to protect the insured against loss from the non-performance of a contract. A building contractor, for example, who agrees to erect a factory according to specification and within a certain time, might be required to furnish surety bonds guaranteeing performance of the contract. Such fidelity and guarantee are covered by insurance company.

Title Insurance

Title insurance guarantees the title to real estate that is purchased by a firm or by an individual. There are many examples on record of people who build homes on plots that were not theirs. With title insurance, losses that result under such circumstances are covered by the title insurance company. Title insurance, therefore, is essential on all real estate owned by a business.

Credit Insurance

This insurance is designed to protect a business firm against excessive, losses from accounts receivable that are owned to the firm. Most policies of this type cover only losses that exceed the normal rate of loss on such debt and the rate is specified in the policy. This insurance is taken up by business firms to protect against excessive bad debts.

Aviation Insurance

Air travel has now become a common means of transport. It involves passengers, cargo and aircraft itself. They need insurance and for which aviation insurance has come up in action. The insurance of aircraft relates to airplanes, gliders and helicopters. The comprehensive policy issued in respect of airplane covers loss or damage to the aircraft itself and third party legal liability including legal liability for accidents to passengers. Beside the aircraft it also offers protection to air traveling passengers and crew members. Further, goods sent by air could also be insured against loss.