Managing Risk (LC 2027) (Leaving Cert Business): Revision Notes
Insurance
Insurance is a crucial risk management tool that allows businesses to transfer potential financial losses to an insurance company in exchange for regular payments called premiums. It serves as a financial safety net, protecting businesses from unexpected events that could otherwise cause serious financial damage or even business closure.
What is insurance?
Insurance is a method of spreading or transferring risk from one party to another. When a business purchases insurance, it transfers the risk of financial loss to the insurance company. In return, the business pays a premium - a regular fee that provides this financial protection.
The insurance system works through risk pooling - the insurance company collects premiums from many customers and uses this money to pay out compensation when claims are made. This system is effective because not all customers will need to claim at the same time, allowing the insurance company to cover losses while still making a profit.
Why insurance is important for businesses
Insurance plays several vital roles in business operations:
Survival and continuity
Insurance enables businesses to survive unexpected financial shocks. Without insurance, a single major incident like a fire or accident could force a business to close permanently. With adequate coverage, businesses can recover and continue operating.
Improved liquidity
Insurance helps businesses maintain healthy cash flow by covering large unexpected expenses. Rather than having to find substantial amounts of money quickly to cover losses, businesses can rely on insurance payouts to maintain their financial stability.
Enhanced safety focus
Having insurance allows businesses to focus on their core activities rather than constantly worrying about potential risks. This peace of mind enables better decision-making and more effective business operations.
Legal compliance
Many types of insurance are legally required. For example, businesses must have employer's liability insurance and motor insurance for company vehicles. Insurance helps businesses meet these legal obligations.
Better financial planning
Insurance makes financial planning more predictable by converting uncertain large losses into certain small regular premium payments. This stability helps businesses budget more effectively.
Key insurance terms
Understanding insurance terminology is essential for making informed decisions:
Actuary - A specialist employed by insurance companies who uses statistical data to calculate the probability of losses occurring. Actuaries help determine appropriate premium levels.
Premium - The fee charged for insurance coverage. Premiums are calculated based on the level of risk involved and information provided in the application form.
Insurance policy - The legal document that outlines the terms and conditions of the insurance contract between the business (insured) and the insurance company (insurer).
Principles of insurance
Insurance operates on three fundamental principles that govern all policies and claims. Understanding these principles is essential as they determine whether claims will be paid and under what conditions.
1. Financial interest (insurable interest)
A person or business must have a financial interest in the item being insured. This means they must benefit from its existence and suffer financially from its loss. The item must have monetary value to the policyholder.
Example: Someone can insure their own house but cannot insure their neighbour's house, as they have no financial interest in it.
2. Utmost good faith (Uberrima fides)
The insured must make full disclosure of all material facts to the insurer when applying for coverage. A material fact is any information that would affect the level of risk the insurer is being asked to cover. Failure to disclose important information can make the insurance policy invalid.
Example: A business applying for property insurance must declare any previous fire damage, even if repairs have been completed.
3. Indemnity
The principle of indemnity ensures that the insured receives compensation for their actual loss but cannot make a profit from the insurance claim. The purpose is to restore the insured to their financial position before the loss occurred, nothing more.
Types of insurance
Businesses can choose from various types of insurance coverage depending on their specific needs:
Property insurance
Buildings and contents insurance protects business premises and equipment against risks like fire, theft, and storm damage. This covers both the physical building and the contents inside, including stock, equipment, and fixtures.
Motor insurance
All businesses using vehicles must have motor insurance. At minimum, this includes third-party coverage, but comprehensive policies also cover damage to the business's own vehicles and theft.
Legal Requirements vs Optional Coverage
Some insurance types are mandatory by law:
- Employer's liability insurance
- Motor insurance (minimum third-party)
Other types are optional but recommended:
- Buildings and contents insurance
- Public liability insurance
- Product liability insurance
People-related insurance
Employer's liability insurance is legally required and covers compensation that may need to be paid if an employee is injured or becomes ill due to work activities.
Public liability insurance covers compensation for injuries to members of the public on business premises or damage caused by business activities.
Product and service insurance
Product liability insurance protects against claims for compensation due to damage or injury caused by the company's products.
Financial protection insurance
Cash in transit insurance covers money being transported, typically when taking daily takings to the bank.
Goods in transit insurance protects against loss or damage to goods while being transported.
Fidelity guarantee insurance provides protection against dishonesty or fraud by employees, particularly important when employees have access to cash or valuable assets.
Specialist insurance
Plate glass insurance covers the cost of replacing broken windows and glass displays, particularly relevant for retail businesses.
Special insurance concepts
Underinsurance
Underinsurance occurs when a business has inadequate insurance cover relative to the actual value of what they're insuring. If underinsured, the business may not receive full compensation for losses, even for partial claims.
Worked Example: Underinsurance Calculation
A house worth £500,000 is only insured for £400,000, and suffers £20,000 of fire damage.
Step 1: Calculate the proportion insured Proportion = £400,000 ÷ £500,000 = 4/5 (or 80%)
Step 2: Apply this proportion to the claim Compensation = £20,000 × 4/5 = £16,000
The insurance company will only pay £16,000 because the house was only insured for four-fifths of its actual value.
Subrogation
Subrogation means that if an insurer pays out full compensation for an item, they become entitled to take possession of that item. This prevents the insured from receiving compensation and keeping the damaged item.
Example: Subrogation in Practice
If a car is written off in an accident and the insurer pays the full value, the insurer can take the wrecked car and sell it for scrap value. This ensures the insured cannot profit from both the insurance payout and the salvage value.
Contribution
When an item is insured with multiple insurance companies (over-insurance), the principle of contribution applies. Each insurer pays compensation proportional to their share of the total coverage if a claim occurs.
Example: Contribution Calculation
A camera worth £500 is insured for £300 with Company A and £200 with Company B (total coverage = £500).
If the camera is stolen:
- Company A pays: £300 (their full coverage)
- Company B pays: £200 (their full coverage)
- Total compensation: £500 (the actual loss)
Common Pitfall: Underinsurance
Many businesses fall into the trap of underinsuring their assets to save on premium costs. However, this can result in significant financial losses when claims occur, as compensation will be reduced proportionally. Always ensure insurance coverage matches the true replacement value of your assets.
Key Points to Remember:
- Insurance transfers risk from businesses to insurance companies in exchange for regular premium payments
- Three key principles govern all insurance: financial interest, utmost good faith, and indemnity
- Multiple types of insurance are available to cover different business risks, with some being legally required
- Underinsurance can be costly - ensure coverage matches the true value of assets being protected
- Full disclosure of material facts is essential when applying for insurance coverage to avoid policy invalidation