Preparing for the unexpected

Successful business owners accept that bad things are inevitable in business – so they’re always prepared for the unexpected. Managing risk is one of the key disciplines for business success, but requires careful planning.  

There’s no doubting that New Zealand’s small and medium enterprises (SMEs) are the engine room of the economy. But it would seem that the economy is at risk because, according to the Insurance Council of New Zealand (ICNZ) only one in four Kiwi businesses has adequate insurance cover. That’s remarkable, and worrying.

I’m in the North Shore office of Cecilia Farrow, founding director of Triplejump, a provider of risk advice technology solutions and systems, looking for answers as to why business owners are failing to grasp the importance of insurance and risk management.

Farrow starts by explaining how business owners can best approach their risk management strategy.

“First you must understand your exposures – fire, theft, equipment failure, accident, illness, death, and so on. Then ask yourself what the consequential effect would be if one of those happened. At Triplejump we categorise risk events as catastrophic, major or minor.

“I use that framework because, depending on how a business owner sees risk sitting, helps them decide what their risk management strategy will be.”

Risks, such as your building burning down, are generally low probability “never or one-in-a-lifetime” catastrophic events and are the most easily understood. But what if there was just some smoke damage and the business could carry on? That scenario is far more probable and maybe would warrant some insurance transfer and some retention strategies, explains Farrow.

However, when business owners are asked to consider the ‘people risks’ of running a business, clearly there is a greater need for education.

“We’re not good at estimating the probability of these human capital risk events. It’s much more complex for people to determine the probability, the effect and whether they need to cover themselves,” says Farrow.

People see the proliferation of specific disaster images on TV screens and start believing that those types of events are common, she says. They don’t see the “less glamorous events”, such as people suffering from life-threatening of disabling illnesses and accidents.

“The fascinating thing about the concept of human capital risk – death, disablement, and so on – is that it seems to break some of the rules in the theory of risk management. Because on a statistical basis, not only is there high probability, but for a business owner there is a catastrophic risk.”

The risks are real – Farrow points to the working life (ages 18 to 65 years) risk percentages*. For a sole non-smoking male the risk of dying is 11 percent; a sole female’s chances are seven percent; for a couple it jumps to 17 percent, and if there are four partners involved in a business, there’s a 31 percent chance of one of the business partners dying before age 65. The numbers relating to temporary disablement (unable to work for six months) are understandably much higher if there are more of you in the business – ten or 11 percent if it’s just you; 46 percent if there are four partners.

“There’s probably no other risk for a SME that is anywhere near the level of probability and potential of impact as human capital risk,” says Farrow.

However, she adds, when it comes to human capital risk, sadly it’s a bit of a Kiwi trait that we underplay our own importance. Most leaders attribute their success to their teams (think All Blacks captain Richie McCaw) but in business the reality is that a business enterprise will most probably not survive if the owner was suddenly no longer there. “Just ask your staff how they would feel about their job security if you were no longer there,” suggests Farrow.

There’s also the challenge small business owners have when weighing up risks to their business in making a fair judgment on the impacts and the costs, and therefore
the right way to manage those risks on a limited budget, she explains.

“Unfortunately there’s an attitude out there that an insurance premium is ‘wasted’ unless a claim has been made. “But if you’re using your insurance appropriately then you’ll minimise its costs by only protecting against catastrophic or infrequent events.”

Take the example of total and permanent disability. When you consider how much cover you can buy with a human capital risk policy, it becomes a very cheap product to buy, she says.

The key is to get good advice on how to use your insurance dollars to maximise the spread of your risk, and ensure you put the appropriate level of protection in place against those risks through your purchasing decisions.

Never approach any business protection insurance from a budgetary position until you first understand what the risks are; how much you’re prepared to let your business retain, and how much you want to transfer to another party. That’s Farrow’s key advice.

“Understand what’s going to cause problems for you around the loss of key people in your organisation; quantify that by looking at what it would do to your bottom-line. Ask yourself how long will you be solvent for? How long will it take before you default on your debts? How much will it cost for you to get out of the business? And will you be able to wind the business up gracefully?”

Fortunately, says Farrow, when owners sit down with someone who can take them through the risk discovery process the implementation rate is exceptionally high.
“So when business owners understand these risks, and what to do about them, then they take them seriously.”

The problem is, not enough owners are taking the whole subject seriously – and the stats back that up. In 2013 Zurich Australia published a report that found 91 percent of Aussie businesses do not have any protection around shareholders, key people or business liabilities. “Many had heard about the risks, but not taken action.” Farrow says she’d like to think that the New Zealand statistics are better, largely thanks to businesses like Triplejump that have made human capital risk their core focus for the past seven or eight years, as well as insurers such as OnePath and Partners Life that have developed bespoke solutions for the financial risks small businesses face.

But there’s still a long way to go here and overseas (the global insurance capital insurance market is estimated at US$350 billion).

An insurer’s perspective
Approaching business insurance from an insurer’s point of view provides some interesting insights. When talking to a new potential client, David Poninghaus, technical manager for QBE Insurance says they need to have a clear understanding of the business, its activities and expectations, both now and in the future, including the business’s expectations of the insurance. They also require details of the assets that the business owns, leases and is responsible for, including their replacement and indemnity values and how these values were arrived at; details of the revenue generated over the past 12 months, along with budgeted growth over the next 24 months; details of key suppliers, customers, locations, plant and people, and any overseas markets.

“Most importantly, in the event of the ‘worst’ happening, we need to know what their plans are,” he says.

A mistake some business owners make is that they focus on the cost of insurance and implementing risk management recommendations, rather than the benefits of both.
“Risk management practices eliminate or control risk and the insurance provides the financial support if things go wrong.”

Others mistakes may include:

• Not having a business contingency plan which sets the theme for the insurance requirements of the business.
• Not understanding the basis of settlement and setting the sums insured accordingly.
• Property sums insured not reflecting their current replacement cost.
• The indemnity period of the business interruption policy not adequate enough to cover the time that it may take for the reinstatement of the property and, importantly, achieving the revenue figures in line with the pre-loss budget.
• The limits of indemnity of liability policies not being adequate to protect the business against a ‘worst case’ scenario – for example, a fire spreading to the neighbour’s property.
• Not considering the impact on the business of something happening to key staff.

Poninghaus acknowledges that under-insurance is still a concern.

“Underinsurance is often the result of not appreciating the need to protect the business against a major loss and setting sums insured accordingly,” he says. “Sufficient time needs to be allocated to establish the values at risk when the covers are first taken out, and then at each subsequent renewal.”

He says often underinsurance only becomes apparent at the time of a major loss, which is too late. A couple of simple examples of getting it wrong are:

• Providing the book value of plant and contents and insuring for this value when in the event of a loss the insured would want to purchase new plant or contents.
• The indemnity period of the business interruption policy not being adequate enough to allow for the business to get back to the position it was enjoying immediately before the loss – which invariably is well after the damage has been reinstated. Price is always a consideration, and Poninghaus says business owners should seek advice on how best to structure the insurance programme to fit their budget. “This may include taking higher deductibles or relinquish covers that the business can fund internally,” he says. “Key is having insurance that will adequately respond to the worst possible event.”

Tailored solutions
Tailored solutions that meet the needs of the business insurance market are becoming increasingly popular. QBE, for example, is developing policies and packages that meet the specific needs of business groups, which may include extending covers to deal with a specific concern or the bundling of covers.

“An example of this is QBE’s General Liability policy which can now cover both defective workmanship and property being worked on, says Poninghaus. “Previously businesses involved in manufacturing, trades, construction, installation, service or repair had often suffered a gap in their general liability cover – with damage to third party property that is being worked on traditionally being excluded, regardless of whether the damage was caused by an accident or poor workmanship.”

This additional cover does not extend to the leaky, or mouldy, building issue, he adds.

In terms of popular policy initiatives, he says there’s been a lot of interest in the inclusion of the Indemnity Period Deferment extension in QBE’s Business Interruption policy. “It allows the insured to defer the start of the indemnity period for up to 12 months pending the reinstatement work starting.”

Whichever way you look at it, managing a business in the 21st century is a riskier proposition than it has ever been. There is greater risk today around legislative compliance – workplace health and safety in particular – as well as the ever-present cyber-risk and risk caused by bigger and more frequent natural disasters.

If you haven’t got a risk management strategy in place – don’t you think it’s high time you at least made a start?

*NZ life tables, Davies Financial and Acturial, 2013.