Chapter 17 Risk Management and Insurance Small Business Management 4660

1. Meaning and nature of business risk For business owners - risk is real likelihood - business may not succeed – lose part – lose all Some – seek risk - most entrepreneurs - risk adverse. If they cannot reduce level of risk, they are likely to: Insure Share 17-2

Business risk Level of probability that the future economic state of the business will be worse than expected. E.g. Sales projections are not met Products do not meet spec. Investments* go bad.

Most Commonly Identified Sources of Risk Financial risk Nonpayment of debts Changes in technology Injury and illnesses suffered by employees Injury from accidents incurred by customers Misbehavior by employees Loss or harm – use – product or service Theft of business property Violation of laws Natural events (storms, floods, fire, earthquakes) There are many things that can go wrong: just ask the victims of 2005 hurricane Katrina in New Orleans. Other risks may be special to certain industries such as tools stolen off a construction job site, customer injury in a rock climbing gym, or illnesses from hospital employees.

2. Risks Associated with Specific Business Operations 3 general events: Property of the business Personnel Customers and others

a. Events Related to Property Every business owns thing of value A retail – inventory A manufacturing business – production machinery Other businesses – furniture, office equipment, vehicles, buildings, land, intellectual properties.

Each of these types of property involves specific forms of risk Inventory - be stolen Machinery - break Buildings - be damaged / destroyed Land - become contaminated Patents - be infringed upon

b. Events Related to Personnel i. Theft ii. Violation of governmental regulations ii. Loss of key employees

i. Employee theft – a fact of life May be a direct act of removing property from a business e.g. small items or an illegal act that provide personal benefit at a cost to the business e.g. embezzlement or fraud

ii. Loss of key employees occurs if someone quits, retires, dies or becomes disabled. In some cases - could lead to bankruptcy and business dissolution. Competition – constant risk Especially – understand business – skilled – tempted to become competitors

iii. Law and governmental rules - limit the freedom of business owners to manage their businesses as they please. It has become a source of significant business risk over the last 30 years.

Given the complex, ambiguous and sometimes contradictory nature of the regulations - violation could occur (inevitable) . LHDN (Inland Revenue Board of Malaysia) and Labor Department are known as agencies - to cause most headaches for small businesses

FOUR strategies regarding compliance: To stay small - regulations do not kick in. Some owners try indifference – not to spend time on compliance, when the face government action, close the business. ***The riskiest – government agencies can come after the owner

Others – proactive - seeking help from the professional do assessments to check for compliance. Fight for what you believe is right. It is not suitable for a faint of heart – short of cash.

iii. Events Related to Customers and Others Events related to customer and others (vendors and even trespassers) occur in several ways: Injuries may be suffered while upon business property. May or may not be your fault. Even - a customer does something unreasonable – like climbing on shelves to reach something – can be liable.

Injuries / damaged by the use of products or services. ***product liability. Magnitude of losses has increased greatly – manufacturer Lawsuits may be individual or class action suits (a large group of people) - the latter being more common.

Risk of nonpayment by customers - experienced by all businesses that offer credit Must balance: giving credit to customers - increase your sales offering credit - guarantees sooner or later some customers will not pay as promised.

3. Techniques to Manage Risks? Limit both the possibility the risk will occur and the damage that will occur if it does. Think of it this way: In a car you drive defensively to prevent and accident. But you also wear your seatbelt to minimize the risk of injury should you be in an accident despite your preventive measures.

Best strategy - develop a business environment that MINIMIZES: Cannot be avoided – they can be managed. Best strategy - develop a business environment that MINIMIZES: Probability of the event occuring Amount of loss - can be experienced if the event does occur Limit both the possibility the risk will occur and the damage that will occur if it does. Think of it this way: In a car you drive defensively to prevent and accident. But you also wear your seatbelt to minimize the risk of injury should you be in an accident despite your preventive measures.

How? Making specific plans and arrangements to deal with foreseeable events Creating and enforcing an appropriate code of conduct Ensuring valuable assets are physically secured Actively working to get rid of any physical hazards (chemicals, poisons etc)

a. Managing risks to tangible property - depends on nature of asset. Buildings and land: Protect from fire with smoke alarms, sprinkler systems and being near a fireplug. Protect from flood by not locating on a flood area - inspecting plumbing systems. Protection from storms by rigorously enforcing building codes. E.g. choice of materials

Computers and data: Firewalls, Anti-virus, Anti-spyware programs Encryption Taking care of the human element: Train employees - only safe surfing. Download from trusted sources. Passwords should be complex - hidden away if written. Automatically lock down when inactive for a period of time. Back up data daily

Intellectual property can be done through patents, copyrights and other registration procedures. Intellectual Property Corporation (myipo.gov.my) Responsible to regulate and supervise issues or matters relating to Intellectual Property Must be prepared to make immediate written objections to the infringement.

Intellectual property rights comprise - legal rights to use unique features of products or services - competitive advantage.

Guarding against obsolescence - watching what is going on in the industry. Protection – property - from theft can occur in several ways: Adverse possession – legal way - allowing a non-owner to use property as if it were his own – period of time. Institute separation of duties – to make it difficult for an employee to steal.

Managing Risk Resulting from Events Involving Personnel Starts by careful screening and hiring practices. PREVENT tempting employees by instituting business practices - make theft difficult: Internal control - a set of rules and procedures to limit opportunity for employee theft. Separation of duties - a form of internal control - separates physical control of an asset from the person accounting for that asset. Keeping valuable property in a secured location - reduces temptation.

Sources of Business Theft Figure 17.2

Percentage of Frauds by Method of Detection Figure 17.3

Risk of losing key personnel can be done through employee contracts: Limit the employee’s freedom to go into competition (e.g. non-compete agreement). Contain employee’s specific promise to not disclose sensitive or confidential information. Provide rewards for providing adequate time termination notice - replacement. Cross training of employees - reduces shock to the business should a key employee leave unexpectedly.

An internal audit – a way to keep risks at a manageable level. Should consider outsourcing to an expert. A properly conducted audit - give business owner valuable information - various risks and recommendations for more effective and efficient use of resources. Once it’s determined to use an external company, steps should be taken to carefully describe his role.

A properly conducted, ‘independent internal audit’ – benefits: An evaluation of overall level of business risk. An objective evaluation of risk control structure. A systematic analysis of business processes and controls. Information on irregularities detected during the audit process.

Managing Risk from Violations of Tax Regulations Keep complete, accurate accounting records Establish a relationship - an accountant and a lawyer who are expert in tax issues Make paying taxes the first financial priority

Managing Risk from Employee Violation of Government Regulations: Ignorance of employee actions is not a defense. The only defense to ever hold an employer harmless is: Having a written policy provided to each employee. Conducting training to each employee. Having immediately and consistently acted upon receipt of any complaint.

4. How to Use Insurance ? Insurance - tool to minimize the loss from potential risks. Key - buying enough coverage, but not wasting money by buying too much. Not every loss is insurable.

Insurance A contract between two or more parties in which one party agrees, for a fee, to assume the risk of another. Takaful - a mutual assistance scheme based on the spirit of brotherhood and solidarity, where participants agree to assist each other financially in case of predefined events taking place. With this intention in mind, participants pay contribution on the basis of ‘tabarru’ (donation) to the General Takaful Fund managed by Takaful company (e.g. Etiqa Takaful Berhad).

Developing a comprehensive insurance policy means: E.g. car insurance Understanding risks to which your business is vulnerable. Amount of loss you could suffer. Finding competitive rates for this coverage.

Determining which risks to cover: Mandatory coverages : Vehicle liability – Property, Injury Unemployment insurances* Desired coverages : Product liability – harmed by product Malpractice – harm caused – during performance by professionals Credit – only applicable for manufacturers*

Theft insurance For most assets - covered under property insurance. Cash cannot be insured. Two types of ‘insurance’ bonds – Fidelity and Surety.

Fidelity bonds Bonds - called dishonesty bonds - repay employers for losses caused by dishonest or negligent employees. Cover losses from employee fraud, theft, forgery, and embezzlement

Surety bonds e.g. bank guarantee A surety bond - a promise to pay one party (the obligee) a certain amount if a second party (the principal) fails to meet some obligation, such as fulfilling the terms of a contract. Surety bond protects the obligee against losses resulting from the principal's failure to meet the obligation.

Property insurance - cost is determined by: Insurable value Amount of an asset for which a company will write an insurance policy Amount of deductible loss An amount of loss that will not be paid by an insurance company E.g. Pay amount of loss – a deductible

Property insurance (continued…) Amount of co-insurance A contract requirement that works to prevent property owners from deliberately underinsuring

A math formula: A building actually valued at RM1,000,000 has an 80% coinsurance clause but insured for only RM750,000. Since the insured value < 80% of its actual value, when suffers a loss - insurance payout will be subject to the underreporting penalty. E.g. It suffers a RM 200,000 loss. The insured would recover 750,000 ÷ (.80 × 1,000,000) × 200,000 = RM 187,500.

Credit insurance - manufacturer Covers abnormal losses from credit customers not paying their bills Buyout insurance Insurance that provides money to owners of a business to buy the shares of any deceased owner from that owner’s heirs.

Personnel insurance Key person insurance (SOCSO) protects you in the event that a key employee dies or is disabled and cannot work Life insurances provided to employees to provide security for their families Medical coverage

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