Insurance is an issue every business owner needs to consider. Insurance is especially important to the small business owner because of the often close relationship between business and personal assets.
Your view of insurance, particularly if you have recently gone into business, may be that it is a luxury that big, thriving companies can afford to purchase but something you can't worry about right now. After all, you have tight cash flows, you have employees (or at least yourself) to pay, and you need to market your product and so forth. Basically, you're thinking along the lines of "I'd rather spend money dealing with what I know will happen, rather than what could happen."
To some degree this attitude is not such a bad thing. Many small businesses have starved themselves for cash by paying insurance premiums to insulate against casualty losses that never happened.
However, we'd like to get you out of the mode of thinking of insurance as only protection against casualties. In fact, the most important reason you may need insurance is for protection from legal hazards.
In any event, once you understand how insurance is important to your business, you will be in a better position to determine the how much of it you need.
The importance of insurance to the health of your business
Life is full of surprises: some good, some bad. A tornado may drop a bag of money on your driveway, although it's more likely to drop a tree limb on your roof! Such unpleasant events are risks that we often choose to insure ourselves against. By paying an insurance premium, you can avoid most of the economic impact (known as a "loss" in the insurance industry) of such unfortunate events.
When you cut through the mumbo jumbo of any insurance policy, you basically have this: In exchange for premium payments, one party (the insurance company) promises to pay to another party (the insured) a specified sum of money upon the happening of a covered economic loss.
Example: A violent storm uproots a tree on your property, which falls on your house, and floods your basement, causing $5,000 worth of damage. If you have a homeowners policy, the insurance company — which has agreed to bear the economic consequences of such a risk — will pay you the $5,000, less any deductible amount (the share that you must pay).
As a business owner, you're going to have to weigh the cost of insuring against a variety of risks against the economic impact of an uninsured loss. Insurance premiums can make a substantial dent in any business's budget. However, we can't stress enough that insurance takes on a new dimension of importance when you go into business. As a matter of fact, the most important coverage that you'll purchase will probably be to insulate you from liabilities associated with what you — or your employee — might do to someone else, rather than to insulate against something happening to you.
The economic connection between the owner of a small business and the business itself is obvious and because of it, any large, uninsured loss that hits either of the following may threaten the continued operation of the business and threaten the owner's financial well-being:
- the business itself
- the business owner or owner's personal property
Understanding Your Liability for Uninsured Business Losses
The impact of an uninsured loss on a business and the owner can be devastating. If an uninsured loss hits a business itself (such as the accidental destruction of the business's computer system, or a lawsuit based on a "slip-and-fall" that happened on the business premises), the business's owner could be affected in two ways.
- First, the loss may cut business profits, or make it necessary for the owner to pour more money into the business to keep it afloat.
- Second, the owner may have legal liability to others to pay for the business's loss. The extent to which a business owner can be held financially responsible for debts and legal judgments of his or her business depends on several things, including the legal form in which the business owner owns and operates the business.
Liability for sole proprietorships and partnerships
Generally speaking, if you run a business as a sole proprietorship or partnership, you will be personally liable for any debts or legal judgments that your business owes. The amount that you can be required to pay is not limited to the income you make from the business, or its value.
Example: Gail Gorgeous operates a a business that formulates and distributes hypo-allergenic make-up. The business, which is not incorporated, generates a yearly income of $70,000 and is worth about $200,000. Due to an error in the ingredients used for a lot of eye liners, a group of customers suffered allergic reactions, some severe enough to require hospital visits. Assuming that the customers' claims will total a quarter of a million dollars, Ms. Gorgeous will be liable for the full $250,000.
If you run the business as a corporation (including a corporation that is classified as an S corporation) or as a limited liability company (LLC), you will generally have what the law calls "limited liability." In theory, this means that your legal liability for the debts of your business normally will be limited to the amount of your investment in the company. In other words, you might lose your business, but you won't lose non-business assets such as your house or your car.
However, there are exceptions to this limited liability rule. Your may lose your limited liability as a corporation if:
- You fail to respect the corporate structure by actions such as treating corporate property or money as your own personal property.
- Your corporation is under capitalized. That is, the corporation does not have anything near the amount of assets that it may need to meet liabilities.
- You voluntarily waive limited liability (such as by agreeing to guarantee, as an individual, the debts of your corporation).
And when a significant amount of money is at stake in a lawsuit, attorneys will work hard to exploit those exceptions so that they can collect legal judgments against you personally.
The impact of personal losses on your business
An uninsured personal loss suffered by a small business owner can have a crippling effect on the business. How can personal losses affect a business? A solely owned, unincorporated business has no legal existence apart from its owner. Consequently, a large uninsured loss suffered by the owner can devastate the business. A business owner may be forced to sell business assets — or the business itself — to extinguish his or her debt.
However, although different liability rules apply to businesses that are run as partnerships, corporations (including S corporations), and limited liability companies (LLCs), you may be surprised to learn that a severe uncompensated loss to the business owner can still cause injury to these types of businesses.
Impact of personal losses on sole proprietors
If you are like many people who run a small business, you do so by way of the "single pocketbook," that is, as a sole proprietorship. Even though, hopefully, you keep separate records related to the business, as far as the law goes you and your business are one being. If an auto accident, an accident at home, or another unforeseen event causes a big economic loss to you personally (rather than to your business), your ability to profitably run your business may be in doubt, even if the cause of the loss had nothing to do with the business itself.
Example: A guest in your home trips over a dog toy in your kitchen, which is not part of your business work area. The guest falls and her injuries require medical treatment that costs $20,000. If she sues you for this amount and wins, and you can't come up with it otherwise, there may be nothing to stop her from making you sell business assets to raise the $20,000 you owe her. Although the state that you live in may place some limitations on the ability of others to force you to sell your business property to pay off legal judgments, you shouldn't depend on these rules — they may not shield all of the equipment and inventory needed to run your business.
Personal losses and corporations or LLCs
Even if you have taken steps to make your business a separate "person" in the eyes of the law, by creating a corporation or LLC, your personal economic losses may be detrimental to your business.
Example: You're backing your car out of your driveway and you accidentally hit a passing cyclist. The bike rider's Italian racing bike, worth $2,000, was destroyed and the rider incurred medical bills totaling $7,000. He sues, and gets a legal judgment against you for $9,000. You are unable to pay off the debt.
In this example, there are legal and practical reasons why the injured driver probably won't be able to force you to sell off, or transfer to her, the corporate assets of your business. But this doesn't mean that you would be home free: you might find it hard for your corporation to obtain credit in the future.
Usually banks will not lend money to a small corporation unless the shareholder/operators agree to be personally liable for repayment of the money borrowed. If you have a large judgment outstanding against you, a bank may see your guarantee as having limited value.
It's clear that insurance coverage for personal losses is essential as insurance is a key way to protect yourself and your business against the problems that may be caused by a personal loss. Remember, though, that insurance is only as good as the maximum of your policy's coverage limits. Remember also that certain losses may be excluded from coverage.