Running a business can be an exciting way to earn money, provide useful goods and services to your community, create jobs, and serve as a platform for personal creative expression. However, in addition to the opportunities it provides, business is also full of risk. Successful businesses use a variety of tools to manage their risks.
What is Insurance?
Insurance is a risk management tool that helps reduce financial risk for businesses. Your business (also called the policyholder) signs a contract (also called a policy) with an insurance company. Your company pays a small amount of money called a premium to an insurer. In exchange for your premium, the insurance company agrees to protect your company against financial losses if certain disasters or accidents listed in the contract happen.
Insurance is available for a wide variety of disasters or accidents, from fires and mudslides, to car crashes, lawsuits against your business, or even trade credit insurance which protects against the bankruptcy of a customer who has not yet paid. Insurance contracts are very specific about the types of events they cover, so it is important to read the contract and verify with an insurance professional that your risks are appropriately covered.
The most common types of insurance for businesses are property insurance, liability insurance, and business income insurance. Property insurance covers damage or loss of property that you use in your business. Liability insurance covers your business if it is sued for causing injuries to another party. Business income insurance helps your business continue to pay its bills and employees in the aftermath of an accident or disaster. Many other types of insurance are available for different kinds of businesses, and you can read about them in our article Types of Business Insurance.
If a disaster were to occur without insurance, your business would need to come up with the money to pay for repairs, replace property, or to pay for lawsuits. This can cause serious cash flow problems for your business if you do not have sufficient cash or profits. If the loss is large enough, it can drive your company out of business.
Pricing and Pooled Risk
Insurance operates on the principle of pooled risk. Insurance companies gather together many companies that face similar risk exposures and pool together their premium payments. Losses are paid out of these pooled funds plus the insurer’s capital that it raises from investors.
Although similar risks are pooled together, each policyholder’s business is different, so the insurance company will adjust each business’s pricing based on the risk factors unique to each company. For example, a software company and a chemical plant may both be exposed to the risk of fire, but a fire is much more likely at the chemical plant, so the plant’s premiums will be higher to cover the risk of fire.
Choosing an Insurance Company
There are three major factors to consider when choosing an insurance company to insure your business.
The first factor is the financial strength of the company. Since insurance claims are paid out of the money that an insurance company has available, you want to choose a company that has enough money to pay for potential claims. If an insurance company does not have enough money to pay claims in the event of a disaster, it may fail, and money may not be available to pay for your losses when a failure occurs. An insurance contract is a promise to pay, and you want to ensure that the insurer can fulfill its promise.
Major rating agencies, including A.M. Best, Fitch, Moody’s, and Standard & Poor’s provide letter grades evaluating the financial strength of insurance companies. Generally, it is safest to choose from insurance companies with ‘A’ letter grades.
A second factor in choosing an insurer is pricing. Different companies have different models for pricing risks. You may find differences in premium rates for similar coverages from different insurance carriers. No insurer will have the cheapest rates all of the time, so it is worthwhile to shop around or work with an insurance broker to compare quotes.
A third factor in choosing an insurance company is their reputation for customer service. If you have to file a claim, make changes to your policy or billing address, or otherwise interact with the insurer, you will want an insurer with good customer service. Some insurance companies spend more than others on investments in technology and customer service. This can make a difference in your customer experience, especially when filing claims.
Direct Writers, Agents & Brokers
You have several options when choosing where to purchase insurance: brokers, agents, and direct writers.
Direct writers are insurance companies that will sell you insurance directly, without the use of agents or brokers.
Insurance agents are independent companies that represent insurers in the sale of insurance. Captive agents represent only a single insurance company. Independent agents can represent more than one insurer, and can help you shop around with different companies.
Insurance brokers are independent companies that represent your company rather than representing the insurer. Brokers can also help you compare prices and policies from competing insurers.
Brokers and agents are paid by the insurance company through commissions for the insurance policies they sell. The commissions are a percentage of the premiums that you pay, and the brokers and agents are paid for every year that you renew your policy.
Usually, the price of the same insurance policy from the same insurance company will be the same whether you buy it through a broker, agent, or direct writer. However, in some cases, brokers will charge your company a fee, which they should disclose to you in advance.
Many insurance contracts for business last for one year periods, and need to be renewed annually, although other policy periods (such as every 6 months) also exist. At the time of policy renewal, the insurance company may raise or lower the price, or even decide not to renew the policy. However, if the insurance company decides to not renew, the law usually requires them to give your company advance notice.
Your company can usually cancel an insurance policy at any time, although advance notice is required for most policies. If you have prepaid premiums for the policy period, the insurance company will refund you for the portion of the policy period that has not elapsed yet. If you are late on paying your insurance premiums, you usually have a grace period as specified in the policy to make up the payments. If the grace period has passed, the insurance company can cancel the policy after giving you advance notice.
Limit of Insurance
Insurance policies usually have a limit of insurance, which is the maximum amount that the insurance company will pay out for losses during the policy period. The limit of insurance can be negotiated between your company and the insurance company. Premiums increase as the limit of insurance increases.
On many commercial insurance policies, it is common to have a separate limit “per occurrence” as well as an “aggregate” limit. An “occurrence” is an accident or disaster specified in the policy that leads to a payout from the insurance company, while the “aggregate” is the total amount paid by the insurance company in a policy period. For example, if your policy has limits of $2 million per occurrence and $4 million per year, the maximum it will pay for a single disaster is $2 million, and if you have multiple disasters during the policy period, the maximum it will pay is $4 million total for the year.
When an accident or disaster occurs, it is important to notify the insurance company as soon as possible. After you have notified the company, the insurance company or your insurance broker or agent will assist you in filing a claim. The claim is a formal request to the insurance company to pay for a loss that is covered in the policy. After the insurance company receives the claim, they will investigate, and if the loss is covered by the policy contract, the insurer will pay the claim.
For property insurance, your company must have an insurable interest in the property, which means you receive some kind of financial or non-financial benefit from the continued existence of the property. You can purchase property insurance on a building you own, but you cannot purchase property insurance on your neighbor’s property that you do not own. Also, the maximum amount you can be paid is the value of the property, as insurance is meant to restore you to the financial condition you were in prior the accident or disaster, and is not intended for you to profit.
For many property insurance policies, if the value of a property is not fully insured, the insurance company may impose a penalty (called the coinsurance penalty) on the claim paid if a loss occurs. Since partial damage to properties is more common than total destruction of the property, policyholders may be tempted to purchase less than the full value of the property in order to save on premiums. The coinsurance penalty discourages underinsurance of the property.
Most property insurance policies have deductibles. Deductibles usually don’t apply to liability insurance policies except for umbrella and professional liability insurance.
When your company experiences a loss, the deductible is the amount of money your company is responsible for paying before the insurance company’s coverage begins. For example, if you have a deductible of $500, and your company experiences a loss of $700, the insurance company will only pay you $200, which is the amount of the loss minus the deductible. The deductible applies to each loss individually, so your company would be responsible for the first $500 of each loss in this example.
The deductible is a form of risk-sharing. Rather than transfer all of the risk to the insurance company, having a deductible means that your company retains some of the risk of loss. This incentivizes your company to take measures that help prevent losses from occurring.
Occurrence and Claims-made Policies
Insurance policies can be written on an occurrence basis or a claims-made basis. Property, general liability and business interruption insurance are usually occurrence policies, while specialty coverages like Errors & Omissions and Directors & Officers insurance are more commonly claims-made policies.
Occurrence policies cover events that happen during the policy period, regardless of when a claim is filed. For example, if someone is exposed to hazardous chemicals in a given year (for example, 2007), but does not develop cancer and sue until many years later (for example, 2017), a liability insurance policy that is an occurrence policy for the year they were exposed to the hazard would cover the claim.
Claims-made policies, on the other hand, will only cover claims if they are filed while the policy is still active, even if the exposure occurred while the policy is active. For example, if a financial advisor’s client suffers losses in 2016, and the advisor drops insurance coverage in 2017, when the client sues the advisor in 2018, the claims-made policy will not cover the claim filed in 2018.