© 2008 Cengage Learning. All rights reserved. 21–1

Managing Small Business, 14e

CHAPTER 21

Risk Management

Part 5 Managing Growth in the Small Business

PowerPoint Presentation by Charlie Cook.

The University of West Alabama.

Entrepreneurship: A World of Opportunity

Moore • Petty • Palich • Longenecker

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Looking AHEAD

1. Define risk and explain the nature of risk.

2. Classify the different types of business risk.

3. Identify the steps in the risk management process and explain how risk management can be used in small companies.

4. Explain the basic principles used in evaluating an insurance program.

5. Identify the common types of business insurance coverage.

After you have read this chapter, you should be able to:

© 2008 Cengage Learning. All rights reserved. 21–3

What is Risk?• Risk

The possibility of suffering harm or loss.The possibility of losses associated with the assets

and the earnings potential of the firm.

• Market RiskThe uncertainty of a gain or a loss associated with an

investment decision.

• Pure RiskThe uncertainty associated with a situation where only

loss or no loss can occur—there is no potential for gain (only downside).

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Property Risks• Real Property

Land and anything physically attached to the land, such as buildings

• Personal Property Machinery, equipment, furniture, fixtures, stock, and

vehicles

• Replacement Value of Property The cost to replace or replicate property at today’s

prices

• Actual Cash Value (ACV) An insurance term that refers to the depreciated

value of a property

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Security Threats to Computers21-1

Source: Forrester Survey in “What we’re Worrying About,” Inc., March 2007, p. 36.

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Property Risks (cont’d)• Peril

A cause of loss, either through natural events or through the acts of people

• Direct Loss A loss in which physical damage to property reduces

its value to the property owner

• Indirect Loss A loss arising from inability to carry on normal

operations due to a direct loss to property

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Liability Risks: Statutory Liability• Workers’ Compensation Legislation

Laws obligating the employer to pay the employee for an employment-related injury or illness, regardless of fault

• Contractual Liability Performance or financial obligations (risks) that firms

assume when entering into contracts with other parties

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Liability Risks: Contractual Liability• Torts

Wrongful acts or omissions for which an injured can take legal action against the wrongdoer for monetary damages

• Establishing Negligence A legal duty between parties to act (or not to act) to

cause injury (damage) A failure to provide the appropriate standard of care The presence of actual injury or damages Action that was proximate cause of injury or damage

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Liability Risks: Contractual Liability (cont’d)• Reasonable (Prudent Person) Standard

The typical standard of care, based on what a reasonable or prudent person would have done under similar circumstances.

• Compensatory Damages Economic or noneconomic damages intended to

make the claimant whole, by indemnifying the claimant for any injuries or damage arising from the negligent action

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Torts: Types of Damages• Economic Damages

Compensatory damages related to an economic loss, such as medical expense, loss of income, or the cost of property replacement/restoration

• Noneconomic Damages Compensatory damages for such losses as pain and

suffering, mental anguish, and loss of consortium

• Punitive Damages Damages intended to punish wrongdoers for gross

negligence or a callous disregard for the interests of others and to have a deterrent effect

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Sources of Tort Liability

Premises Liability

Premises Liability

Employee Liability

Employee Liability

Professional Liability

Professional Liability

Vehicular Liability

Vehicular Liability

Product Liability

Product Liability

Directors and Officers

Liability

Directors and Officers

Liability

Sources of Tort LiabilitySources of

Tort Liability

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Business Personnel• Personnel Risks

Risks that directly affect individual employees, but may have an indirect impact on a business as well.Premature deathPoor health Insufficient

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Risk Management and the Small Business• Risk Management

Ways of coping with risk that are designed to preserve assets and the earning power of a firm.

• Risk Management Differences from Large Firms:It is more difficult for small firms to get insurance

coverage.

Large firms can assign responsibilities for risk management to a specialized staff manager.

Risk management is not something that requires immediate attention.

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Risk Management… (cont’d)

1

Implement the decision.

Evaluate risks.

The Process of Risk Management

The Process of Risk Management

Identify risks.

Select methods to manage risks.

2

3

4

Evaluate and review.5

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Risks on the Road to Success21-2

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Risk Management… (cont’d)

Risk ControlRisk

Control

Loss Prevention

Loss Prevention

Loss Reduction

Loss Reduction

Loss Avoidance

Loss Avoidance

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Risk Management… (cont’d)• Risk Financing

Making funds available to cover losses that cannot be managed by risk control.

• Risk TransferBuying insurance or making contractual agreements

with others to transfer risk.

• Risk RetentionChoosing—whether consciously or unconsciously,

voluntarily or involuntarily—to manage risk internally.

• Self-InsuranceDesignating part of a firm’s earnings as a cushion

against possible future losses.

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Tools for Managing Risk21-3

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Risk-Taking Begins Early21-4

Source: © Harley L. Schwadron

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Basic Principles of a Sound Insurance Program

Evaluating an Insurance Program

Evaluating an Insurance Program

Identify business risks to be insured.

Identify business risks to be insured.

Relate premium costs to

probability of loss.

Relate premium costs to

probability of loss.

Limit coverage to major potential

losses.

Limit coverage to major potential

losses.

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Requirements for Obtaining Insurance• The risk must be calculable so that premiums

can be calculated.

• The risk must exist in large enough numbers to allow the law of averages to work.

• The insured property must have commercial value.

• The policyholder must have an insurable interest in the property or person insured.

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Common Types of Insurance• Business Owner’s Policy (BOP)

A business version of a homeowner’s policy, designed to meet the real and personal property and liability insurance needs of small business owners

• BOP Coverage Approaches Named-peril approach

Identifies the specific perils covered. All-risk approach

Defines the perils covered by stating that all direct damages to property are covered except those caused by perils specifically excluded.

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BOP Insurance: Valuation• Valuation

Both real and personal property are valued on a replacement-cost basis; damage and loss will be reimbursed at cost to rebuild or replace the property.

• Insurance to Value Provision Requires the insured to carry a minimum policy limit

relative to the actual value of the property Not contained in most BOP.

• Coinsurance Provision Property must be insured for at least 80% of its value

or a penalty will be applied to any covered loss.

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Coinsurance Example

If an insured building had a replacement value of $500,000, the 80 percent policy limit would require that the property be insured for at least $400,000 ($500,000 x 0.80). If the building was insured for only $300,000 and an insured loss of $100,000 occurred, the recovery would be limited to $75,000, calculated as follows:

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Other BOP Coverage• Business Interruption Insurance

Reimburses for lost income plus continuing expenses due to direct loss impacting business revenues.

• Commercial General Liability (CGL) coverageCovers bodily injury and property damage for which

the business is liable.

• Medical Payments CoverageCovers injuries of customers and the general public,

with no fault required on the part of the insured.

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Life and Disability Insurance• Key-Person Insurance

Provides benefits upon the death of a firm’s key personnel.

• Disability Insurance Provides benefits upon the disability of a firm’s

partner or other key employee.Disability buyout insuranceKey-person disability insurance

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Key TERMS

• risk• market risk• pure risk• risk management• real property• personal property• replacement value of

property• actual cash value (ACV)• peril• direct loss• indirect loss

• workers’ compensation legislation

• torts• reasonable (prudent

person)• standard• compensatory damages• economic damages• noneconomic damages• punitive damages• proximate cause

© 2008 Cengage Learning. All rights reserved. 21–28

Key TERMS

• personnel risks• risk control• loss prevention• loss avoidance• loss reduction• risk financing• risk transfer• risk retention• self-insurance• business owner’s policy

(BOP)• named-peril approach

• all-risk approach• insurance to value• coinsurance provision• business interruption

coverage• commercial general

liability (CGL)• coverage• medical payments

coverage• key-person insurance• disability insurance