Mind Your Business - 8 October 2008

Answers

1. Explain the importance to a business of taking out appropriate insurance when setting up (4 marks)

Any business, no matter how large or small, involves some risk. If there are ways in which a business can minimise that risk then it will do so. Insurance is one way in which it can minimise the risk. The risks to a business come from damage to property, damage to stock, claims against it from employees, suppliers and customers for damages arising from accidents arising when using the business or from damage caused by faulty products. In all these cases the business can suffer, sometimes significant, losses. For example, if an employee falls and breaks a leg, and the fall was deemed to have been caused by the negligence of the business, then the employee could claim damages. This might include loss of earnings and might run into thousands of pounds.

If the business has employee liability insurance the claim is covered by the insurance company; the business does not suffer the financial shock of having to compensate the employee for the damages. The main principle of insurance, is to put back an individual or, in this case, a business, back to the position it was in before the insured event occurred. This is why insurance is so important.

2. To what extent does having adequate insurance cover guarantee the success of a new business start-up? (14 marks)

There is no such thing as a guarantee of success for a new business start-up. If there were, then no new business would fail! Insurance is a means of reducing risk and with the right cover and the right policy it can help to insulate a business from some of the external shocks that can affect it.

Any new business start-up will have to have some form of insurance cover - in many cases, it is a legal requirement for any business. To this extent, every business is operating on a level playing field. Any new business start-up involves an element of risk and insurance helps to minimize some of those risks. If the business has the right insurance cover then they are able to have some form of guarantee that they will be covered in the event some problem occurs for which they are covered.

The risks from new business start-ups go beyond that which can be covered by insurance, however. Most insurance companies will not provide cover against loss of sales, poor quality products, inadequate planning or accounting procedures, lack of cash-flow management, inappropriate location and so on. Getting these factors right are all vital if a business is to have success in the long run. The initial stages of a new start-up are, perhaps, the most important. It is here that the planning, research and preparation will pay dividends in the long run. In addition to this, it is vital for a new business to have the right product or service and that it knows what its market is. To a large extent, this comes from the planning process and the research done before trading actually begins. Starting a new business on a whim rarely leads to success. There has to be a clear idea of who the market is, the size of the market, the costs in meeting the needs of that market and whether those costs are sufficient to yield a return that makes the whole venture worthwhile.

Part of the planning process will involve not only these things but also a consideration of the legal and practical requirements of a business. This includes the extent to which the business has to meet legislation such as that covering disabilities, special needs, employees, health and safety, hygiene and so on but also requirements covering tax liabilities and insurance.

It is clear from this list that the considerations and the ingredients that go into making a successful business are many. Insurance is but one aspect of this. Insurance can help a business reduce risk in some areas but there are limitations as to exactly what can be covered and the amount that cannot represent a significant part of the success of a business.

3. Richard Branson has had to take out ‘third party insurance cover for everyone living within four-and-a-half miles of the proposed spaceport in New Mexico’. Explain what this means and analyse the reasons why this was necessary for the Virgin Galactic project to get approval (8 marks)

Third party insurance means that a business is covered for the effects on an individual not directly involved in the business - a third party. In this particular case, if the space craft that Branson is using happened to explode after take off, it could be that debris from the craft could rain down on local communities in the vicinity of the spaceport in New Mexico. Buildings and individuals could be damaged as a result of this. Those people could make a claim against Branson to recover the damages that have occurred. Third party insurance would provide the cover for this eventuality.

The case study points out that the risks involved in space travel are high; 1 in 64 missions end in disaster and, with this statistic in mind, any permission to start the business would have to show that it had taken this risk into account and had insurance cover for it before the business would be granted a licence to trade. There would have had to be some careful research into the extent to which any possible disaster would have affected those living in the area bounded by the spaceport. It must be assumed that the four and a half mile radius was decided upon based on evidence provided on the extent of the risk.

Once the extent of the risk is calculated then Virgin Galactic would have to approach insurance companies with details of the risk and find a company who would be prepared to underwrite that risk - in other words agree to provide the insurance cover. Without this cover it is unlikely that Virgin Galactic would have been given the right to start trading. The risk to people in the area would have been seen as being too great.

4. Evaluate the problems facing a small business just starting up in getting adequate insurance cover and those of a large organisation like Sir Richard Branson’s Virgin Galactic (14 marks)

All businesses have to get some form of insurance cover such as employer’s liability cover, public liability, and buildings and contents insurance. The size of the premiums that are paid would be reflective of the size of the cover and the extent of the risk involved to the insurer. For a small business, e.g. a local newsagent, the perceived risk might be deemed to be relatively low, especially if they could show that they have adequate security in place to protect their premises and business such as CCTV cameras, alarms and so on.

Despite this, the cost of insurance can be relatively high for small businesses, and can impose a significant burden on them. Many might not be able to afford security equipment, especially if just starting up. It will also depend on where they are located and the level of crime in the area as to the size of the perceived risk. For some small businesses, therefore, insurance can be a high additional cost that they can ill-afford.

For a large organization such as Virgin Galactic, there may be some significant economies of scale that would allow them to reduce the unit costs associated with taking out insurance compared to a small business. Firms operating on a large scale are able to seek out competitive market rates from major insurance firms who are dedicated to providing corporate insurance cover. They can also afford to pay for the high levels of security that help to reduce the risk and thus lower the premiums. Even simple things like having sprinkler systems in offices, back up systems for IT and security staff on duty 24 hours a day can make a big difference to the risk involved. As a result, whilst the cost of the insurance is going to be much higher, this total cost will be spread across a far larger range of output and this lowers the unit or average costs. This gives such firms a competitive advantage.

Despite these advantages, however, there are potential difficulties that face such firms. In many respects, it also depends on what type of business it is. Virgin Galactic is breaking new ground - the risk involved is likely to be much higher than that of a business selling IT equipment, for example. In this case the challenges of gaining adequate insurance cover become much greater. Many companies have been hit hard by insurance claims in relation to things like asbestos; tobacco companies are also facing massive legal costs as a result of their activities in trying to defend themselves against claims against them. If a business is perceived to be too much of a risk, it could be that they will not be able to gain insurance cover at all and if they do only at very high premiums.

In some cases, therefore, it could be much easier for a small business to access the appropriate insurance compared to a large organisation. In general, it will depend on the nature of the business, the extent of the risk involved and the extent to which the business is able to moderate that risk to make the insurance cover easier to provide. Those businesses that can do these things will be the ones who will be in the best position to secure appropriate  insurance cover; it is not simply a case of big is better!