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You are here: Home > Current Topics > Mind your Business > 10 April 2006 |
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Every business has to think about insurance in one form or another; it is one of the inescapable fixed costs that must be paid. Like domestic insurance, the principle is fairly simple but as a means of covering the potential liabilities of a business should something go wrong, it is vital. Insurance is based on:
The more risky the likelihood of the outcome, the more the premiums will need to be and the less willing insurance companies will be to cover the risk. Imagine, then, the problems facing Sir Richard Branson as he tries to get his latest business venture off the ground - literally. Branson is working on developing Virgin Galactic. The plan is to extend the Virgin aviation business into space. Branson has plans to launch 100 initial flights lasting two and a half hours and including 15 minutes in space, with 5 minutes of weightlessness. 
Richard Branson and Bill Richardson, Governor of New Mexico, show off the proposed spacecraft that will hold passengers going on the Virgin Galactic space tours. Branson plans to build a spaceport in New Mexico and have the first flights in 2009. Copyright: Getty Images, from Education Image Gallery. Branson is committing $240 million (£138 million) to the project. To date, 45,000 people have registered an interest in the tours - but these are not tours that you will find advertised in your local travel agent. The price for the tour is $200,000 (£115,000), paid in advance. 156 people have apparently paid a deposit to register their interest and a few have paid the whole fee. Branson thinks the real competitive advantage will be in the way the aircraft is designed and that the sense of weightlessness is the thing most people are looking for. The cabin has been designed to allow people to be able to float around rather than remaining seated for this part of the flight. Sir Richard scoffs at the sceptics who think that the idea will never 'take off' and sees the chance for ordinary people to be able to take part in space tours in his lifetime. He points to the fact that a flight between London and New York prior to 1939 would have cost the equivalent of $80,000 (£46,000)! The major stumbling block to his plans, however, is not likely to be the technical challenges of the project but securing the necessary business insurance. The risk factor in space travel is high - 1 out of 64 missions have ended in disaster - and this is a risk factor that sends shudders down the spines of insurance brokers everywhere. 
The Space Shuttle Challenger exploded 73 seconds into its launch in 1986, killing all seven crew members. The dangers of space travel are clear and could present a real insurance headache for Mr Branson. Copyright: Getty Images, from Education Image Gallery. Experts believe that Sir Richard would have to get third party insurance cover for everyone living within four-and-a-half miles of the proposed spaceport in New Mexico - just in case debris falls from the sky and hits them. Whether those who actually travel on the craft are able to get insurance cover is highly debatable at the moment. Sir Richard has entered into negotiations with insurance brokers at Lloyds of London to discuss the issues. |
The theory section will focus on the nature and purposes of insurance in a business context.
Lloyds of London - the centre of the UK insurance industry. Copyright: Charis Tsevis, from stock.xchng.
The principle behind business insurance is simple but often misunderstood. The insured risk is that identified as being something that needs some form of cover. Let us take a simple example. A business has a warehouse with a stock of goods. It knows there is a risk that this building could catch fire and it would lose all its stock. The building therefore becomes the insured risk.
An insurance company will be approached to offer a quote on what it will cost to cover that risk. The insurance company will use the services of an actuary to assess the risk involved. The actuary will look at similar buildings, the area, incidents of fire damage and hosts of other data to assess the risk. The insurance company is then able to make a quote to the company based on this risk. The business concerned will then have to pay premiums to the insurance company for the lifetime of the policy. It could be that the business never has to make a claim for fire damage, in which case it will have paid large sums in premiums over the years and never get anything back.
On the other hand, it could be that the day after taking out the policy, the whole warehouse goes up in smoke and the company loses all its stock. The insurance company would have to then pay out, possibly millions of pounds, and has only received one premium! The insurance company therefore have to balance the risk of the event occurring with the number of people taking out policies and the expected payouts that they need to cover over a period of time.
In so doing, they will be looking at the amount of premiums they receive in relation to what they expect to have to pay out. The premiums should cover the expected payouts but the company cannot just aim to cover the anticipated payouts - statistics might give a useful indicator to chance, but reality tends to throw up events at any time. The insurance company therefore has to ensure that it has the funds available to cover all these eventualities and so uses the premiums it receives to invest in a range of financial instruments, including shares and bonds, to build up reserves of funds to cover their liabilities.
The diagram below highlights the basic principle.
Imagine that there are 10 businesses, A - J, each looking to secure insurance on their premises against fire. Each business values the buildings at £1 million. The actuaries have estimated that the risk of one of the buildings being completely damaged by fire and needing replacing is a 1:10 risk. The premiums are therefore set at £100,000 per year for each business. Each business pays the premium to the insurance company, which in turn uses the £1 million received to invest in various financial instruments. The returns from these investments plus the capital sum of £1million represents the fund that the insurance company have to pay out in case of a claim.
Let us assume that business J is unlucky enough to have that fire - the fund is used to pay business J £1 million to rebuild their premises. The fund managers will have to ensure that they have sufficient funds to meet this obligation. Of course, it could be that during the year, none of the businesses makes a claim, in which case the funds are kept in the pot to be built up. In another year, it is entirely possible that more than one firm could be unlucky enough to suffer a loss, in which case the insurance company has to make sure that they have sufficient reserves to cater for this eventuality. It is also possible that a firm makes a claim but that the claim will not be for the whole £1 million.
These are two distinct terms in insurance circles and it is important to understand the difference between the two.
Insurance refers to something that might happen - your premises might get destroyed by fire, a customer might trip up in the store and break their nose on a shelf, one of your employees might have an accident at work and so on.
Assurance refers to something that will happen - you will die at some point in time. We therefore take out life assurance as opposed to life insurance.
Taking out insurance is a gamble against something not happening. Many might see it as a waste of money if nothing ever happens to them but when disaster does strike it is vital and can mean the difference between the business continuing or closing altogether. Copyright: Tori Ognedal, from stock.xchng.
There are some legal requirements for insurance cover that businesses have to take out. Other insurance is advisable but not legally required. The following is a guide to the main ones.
A legal requirement for any business employing at least one person. This insurance covers the employer for any injury, accident, illness or disease sustained by the employee as a result of their work. The current legal minimum cover is £10 million.
Legally required cover for a business in the event that anyone entering the premises of the business sustains illness, injury or disease. This is the insurance that covers the business if a customer slipped and broke their nose on a shelf! The extent of the cover is largely based on what the company expects to have to pay in the event of a claim being made against it. Usually cover is arranged for at least £5 million but can be much higher than that.
This insurance covers the business in the event that causes damage in some way as a result of a faulty product. This damage does not have to be physical but could also include damages suffered by another business as a result of using a faulty piece of equipment. For example, a firm might lose business because they had been supplied with a piece of faulty software.
Taken out to cover a business that might suffer form a loss of goods that are transported by some carrier or delivery firm.
Cover for damage to property or buildings. The reason for the damage might be a factor in the cover: for example, some insurance companies will not provide cover against damage to property caused by riot. Most natural causes of damage such as lightning, flood and storm will be covered but may make the premiums more expensive. Terrorist attacks may also not be covered so it is up to the business concerned to ensure that they specify what cover they want and that the insurance company concerned is prepared to cover that risk - it does vary considerably.
Insurance taken out against damage or loss of contents in a business premises. For example, the firm might have suffered a break-in and had a number of computers stolen or the memory stolen from inside them or had PCs damaged during the break-in.
In theory there is nothing to prevent any firm taking out any insurance cover it likes - the main issue would be whether the insurance company was willing to take on the risk and for the business, whether the size of the premiums would outweigh the benefits of having the cover. Some firms therefore will take out insurance to cover them against absence of key members of staff; others might take out insurance in case the business suffers some interruption to its business activities. For example, a business might have to be closed down while a road or nearby structure was repaired; a business might have to close down temporarily as a result of a police investigation - some businesses were affected in this way following the post July 7th explosions in London in 2005.
There have been a number of news reports in recent weeks about the new Wembley Stadium. The project was meant to have been completed by the end of March 2006. Following this handover, various tests and checks would be carried out to ensure that the stadium was able to get its licence to operate. However, there have been a number of high profile problems that has meant the completion has been delayed.
Look at the following news reports on the issue:
The construction of the new Wembley Stadium has been beset by a number of problems. What role does insurance have in supporting the stakeholders involved? Copyright: Getty Images, from Education Image Gallery.
The problems facing the contractors at Wembley is clearly one issue but for those companies involved in staging events at the new stadium, there are other issues to consider. Not only do sporting events have to be switched but a number of concerts planned for the venue in the summer may have to be cancelled or moved. This includes concerts by Bon Jovi, Take That and the Rolling Stones.
