Insurance is vitally important to a small business owner who wants to be protected from day-to-day liability risks. But, one must have the correct types and amounts of insurance to be protected.
There are two basic types of insurance:
- liability insurance and
- property insurance.
Each basic type of insurance is subdivided into specific types of policies, designed to cover specific types of risks. It is important to understand the differences between the purposes each type of insurance serves, so that you can purchase the right amount of insurance for your business.
Most small business owners should have a comprehensive liability and property insurance policy. Many small business should also carry specialized forms of liability and property coverage (such as "fidelity insurance) that cover the risks inherent in the specific business.
When making insurance purchase decisions, bear in mind that over-insuring will siphon valuable dollars out of the business to pay unnecessary premiums. On the other hand, under-insuring can end up costing you your business. The more you understand the ends and outs of insurance, the wiser--and more cost-effective--your insurance choices will be.
Liability insurance covers damages you cause
Liability insurance covers damages that you (the insured) cause to others, both personal injuries and property damage. Thus, a liability insurance policy will have separate provisions, including separate limits, for personal injury and property damage caused to other persons.
Every small business owner hopes that he or she is never on the receiving end of a liability judgment. However, it is wise to prepare for the "worst-case scenario." The asset protection strategies advocated throughout this small business guide are based on these principles.
Ideally, you have structured your business to limit liability and you are executing strategies to avoid day-to-day liability risks. As a result, if claims occur, it is hoped that the claimants will be unable to satisfy their claims from your personal or business assets. However, some of these claims may penetrate the multiple layers of protection you have created. If this occurs, you should have one final layer of protection—liability insurance.
Property insurance covers damage to you caused by others
In contrast to liability insurance, which is a last resort for asset protection, property insurance is your first line of defense when your property is damaged. Property Insurance covers damages to the insured's own property. Property coverage is addressed separately in an insurance policy. Thus, property coverage should not be confused with liability coverage for property damage that the insured causes to another person's property.
In most cases, you will have multiple insurance policies. Accordingly, if a claim is not covered (or not fully covered) under one policy, you must not overlook the possibility it is covered by other policies.
However, be aware that if there is overlapping coverage, the extent of each insurance company's duty to contribute toward the loss is one of the most frequently litigated issues in business insurance claims. In this litigation, insurance companies are pitted against each other, with you (the insured) as an adversary of each company. And, don't expect any insurance company to voluntarily admit that it has a duty to contribute or even that the claim is covered under its policy.
This is why it is critical to know the scope of coverage of each policy, how to make timely claims under each policy and how to demand enforcement of the policy provisions.
In some instances, liability coverage is mandatory. Common examples are auto insurance or, in some states, professional liability insurance for certain professions. Even if insurance is mandatory, coverage at the minimum policy limits required by state law may be insufficient. You want to realistic evaluate your risk and insure accordingly--even if this amount is greater than the statutory minimum.
However, in most cases, insurance is optional. This raises the issue as to whether or not to obtain insurance coverage. In certain cases, the small business owner may wish to forego insurance and instead rely on other asset protection strategies because premiums are cost-prohibitive (see, e.g., malpractice insurance). This can be a risky strategy in many cases. In a close case, choosing insurance will be the better decision. Indeed, you may want to consider purchasing an umbrella policy, which provides coverage after primary insurance is exhausted.
But in order to make sound decisions regarding the types and levels of liability and property insurance needed for your particular business situation, you'll need an understanding of the basics of insurance coverage and terminology.
Insurance companies want to deny and delay claims
Although you faithfully pay premiums on your policies, you and the insurance policy have very different goals when a claim is made. You want compensation under the terms of the policy: the insurance company wants to ensure its profit flow continues.
Insurance companies earn a profit in two ways:
- through the spread (the difference between insurance premiums charged and the payments made to insured parties for claims)
- thorough investment income (interest derived from investing the premiums received)
If an insurance company can deny a claim, the spread and, therefore, its profits will be higher. Similarly, the longer an insurance company can delay paying a claim, the longer the premiums will continue to earn income. This form of income cannot be overlooked because, in practice, it represents a significant source of profits since insurance companies collect billions of dollars in premiums.
As a result, the business owner should expect the insurance company to deny the claim or to delay paying the claim because the insurance company has a strong financial incentive to do both.
Understanding insurance coverage ground rules
Most people don't realize is that denial of a claim begins well before a claim is made. It begins with the carefully selected wording in an insurance policy. The actual language in the policy, subject to court interpretation, will delineate the scope of the coverage and exclusions from coverage.
Certain issues are common to each and every insurance policy. The small business owner should follow these general guidelines with respect to any type of insurance coverage:
- Compare premiums and policies beforehand.
- Retain insurance policies indefinitely.
- Give prompt verbal and written notice of a claim.
- Enforce the duty to defend clause.
- Use the threat of a bad-faith claim.
- Rely on another party's insurance.
- Seek indemnification by other parties.
- Make sure to factor liability insurance into solvency tests.
- Understand the court's interpretation of coverage and exclusions.
Compare policy terms and premiums before purchasing insurance
Insurance policies are form contracts. (Form contracts are often referred to as adhesion contracts because of the disparity in negotiating power between the two sides.) Therefore, don't expect the insurance company to negotiate the language of various clauses.
The insurance company is making a "take it or leave it" offer for coverage. However, this doesn't mean you are completely at an insurance company's mercy. It is well known that premiums for exactly the same coverage can vary significantly among insurance companies. However, what is less known is the fact that policy provisions (i.e., coverage and exclusions) can also very widely from company to company. Even if you have to ultimately accept one company's contract exactly as written, you can "shop around" before you buy any policy.
Comparison shopping is important. Don't limit this to a comparison of premiums. And, don't accept the insurance company's (or an agent's) word as to the policy's coverage and exclusions. Instead, obtain an unexecuted copy of a policy for the coverage you want from several different companies.
Read each policy thoroughly and compare the policies, in terms of coverage and exclusions, as well as premiums. If the coverage is too narrow or the exclusions too wide--dismiss that company from the pool of contenders.
All insurance policies contain language that can be ambiguous in certain situations. The ambiguities may relate to the scope of coverage or to specific exclusions from coverage and can give rise to denial of claims. However, you should be aware that the courts almost uniformly have held that coverage is to be liberally construed, while exclusions from coverage are to be narrowly construed.
Don't expect the insurance company to tell you this or even to assume you know this, but where coverage is an issue, generally there is a strong presumption in favor of coverage. However, remember, if there are no ambiguities concerning a lack of coverage or a specific exclusion from coverage, the presumption in favor of coverage will not apply and the insurance will not cover the situation.
Retain insurance policies indefinitely
Most policies insure against any covered loss that occurred during the policy period. Thus, even though a policy expires, claims can still be made that will be covered under the policy. But you can't expect the insurance company to willingly provide you with a copy of a policy in effect for an earlier period in which a covered event occurred, or even admit that you were covered during that period.
Be prepared to prove that you were insured during the period in which the claim arose and be able to produce a copy of the policy in effect for that period. Remember that policies are amended from time to time. A current policy may not be identical to the policy that was in effect when the claim arose.
Generally, insurance policies should be retained indefinitely. This is especially true with respect to liability policies. At the very least, liability policies should be retained until all of the statutes of limitations for all possible causes of action have expired.
Generally, tort actions must be filed within two or three years of the event that gave rise to the damages. However, laws vary from state to state, and in certain instances (e.g., personal injuries due to exposure to asbestos), states have significantly lengthened the statute of limitations. The best practice is to retain insurance policies indefinitely.
The actual policy should be kept in a secure location, such as a bank safety deposit box. A copy should be kept in a separate location, in a fireproof box, with a note attached to it that indicates the location of the original policy. This in fact is a sound practice with respect to all important legal documents.
Act immediately when claims arise
All insurance policies have a clause that requires the insured to give prompt notice of a claim. In fact, policies may contain very specific requirements for giving notice. For example, if a summons and complaint were received, the insured will usually be required to forward a copy to the insurance company. Failure to follow these exact requirements may result in the notice being deemed defective.
Unless the policy clearly specifies otherwise, you should immediately give notice by telephoning the insurance company. This verbal notification should always be followed by written notice in the form of a letter.
You should keep a record of both the telephone call and letter. This record should include the date, time and name of the other party should be recorded when any verbal communication occurs.
Defective notice may result in claim denial
Where notice is not given, or is defective, the insurance company may deny the claim, if it can prove it was prejudiced by the failure to give adequate notice of the claim. Why take chances? Giving prompt verbal and written notice eliminates these issues.
Most failures to give adequate notice are harmless because the insurance company won't be able to prove it was harmed and, therefore, can't deny coverage. However, the District of Columbia, New York and Illinois follow an older rule that allows the insurance company to automatically deny coverage when adequate notice was not given, even though the insurance company was not prejudiced in any way.
Enforce the duty to defend clause
A standard clause found in various types of liability insurance policies requires your insurance company to supply an attorney, at its cost, to defend against a lawsuit filed against you. The duty to defend clause covers all costs involved in defending you, such as the cost of expert testimony and depositions.
You should determine if the proposed policy has a duty to defend clause. If it doesn't contain this clause, or the clause contains too many exclusions, the business owner may want to consider a different policy.
Clearly this additional coverage can be a significant benefit to you and give you an advantage over the individual suing you. In many cases, hiring an attorney at a rate of $150 to $300 per hour may preclude the defendant from obtaining representation or induce him to settle a case on unfavorable terms.
However, there is a down side. Where litigation costs will be extensive, the small business owner should realize the insurance company will have an extra financial incentive to deny coverage. Where the claim is not covered, the duty to defend, of course, does not apply.
Duty to defend in the case of multiple causes of action. When a lawsuit is filed, the plaintiff alleges a certain cause of action (e.g., negligence) in his complaint. Multiple causes of action may be alleged and each is identified in the complaint as a "count." Where multiple causes of action are alleged, but one of the causes of action is excluded from coverage, insurance companies sometimes attempt to deny coverage or deny their duty to defend against the action. This is improper. The courts have ruled that if one cause of action is covered, the claim is covered and the duty to defend applies.
Consider obtaining your own lawyer. Even if your policy has a defend clause, you can hire separate legal counsel. This private attorney can ensure that the insurance company provides adequate representation, assist in developing strategies, and document any evidence that may be the basis of a bad-faith claim against the insurance company. Because the insurance company will provide, at its expense, the lead counsel on the case, the cost of hiring private legal counsel should be less expensive.
Don't hesitate to threaten a bad-faith claim
Many times, the mere mention of "bad faith" causes an insurance company to change its position. Thus, you believes the insurance company is guilty of bad faith, the best strategy is to send the company a carefully worded letter that subtly mentions the possibility of a bad-faith claim. This letter ought to be drafted by an attorney. The insurance company will understand the implications of the letter.
Refusal to settle can be basis for bad faith action
A common form of bad faith involves an insurance company's refusal to settle a case for the policy limits, which is based on a reasonable offer from the injured party. Insurance companies have a financial incentive to behave in this way. For example, assume the policy limit on an automobile insurance policy is $100,000. Assume the plaintiff, who has damages that equal or exceed $100,000, offers to settle the case for the policy limit. The worst-case scenario, ,for the insurance company, is paying the policy limit. Its liability, of course, cannot exceed this limit, so the insurance company may conclude that it has nothing to lose by refusing to settle these case and going to trial. If, after a trial, the judgment is $400,000, the insurance company still only pays $100,000, the policy limit.
Thus, by refusing to settle the case and going to trial, the insurance company is gambling that the jury might award less than the policy limit, thus producing savings for the insurance company. In engaging in this gambling, however, the insurance company is taking no risk at all. Instead, all the risk is on the insured. Essentially, the insurance company is gambling with the insured's money. In this case, for example, the additional $300,000 in damages would have to be paid entirely by the insured.
If it can be shown that the injured party's offer to settle the case, at the policy limit, was reasonable, but the insurance company refused the offer and went to trial, the insurance company may be held liable on a bad-faith tort claim brought by the insured. The result of a successful bad-faith claim in this case will be that the insurance company will be ordered to pay the entire judgment. In other words, the insurance company's liability will not be limited to the policy limit. In this case, continuing our example, a successful bad-faith claim would mean that the insurance company would be required to pay the entire $400,000 of damages.
Reporting company to state insurance department can provide leverage
The threat of a bad-faith claim also can be coupled with another effective strategy: reporting the situation to the state department of insurance. Every state has an insurance department and involving the government in a lawsuit or dispute can be very effective in inducing a favorable settlement. The government has immense resources and, in certain cases (e.g., disputes with insurance companies), the power to levy civil fines. Involving the government is the equivalent of hiring a large law firm free of cost.
Even the threat of a complaint to the insurance department can, many times, force an insurance company to act reasonably. However, as is true with any threat, if the threat does not produce results, it should be followed by the actual filing of a complaint.
Take advantage of other people's insurance
You may be able to have other people pay for the insurance on your property as a term of using the property. This is the strategy a mortgage company uses when they require you to carry homeowner's insurance that actually protects the their collateral. Under certain circumstances, you can do the same thing and rely on another person's insurance coverage.
You should always obtain a copy of the policy, rather than rely on word from the other party that the coverage has been secured. In fact, if you are named as an insured party, the insurance company will provide you with a copy of the policy, as well as copies of notices, including cancellation notices, related to the policy.
Mortgages, leases of property and joint ventures can carry insurance requirements. The business owner who lends money, by way of a mortgage, or in any other case where collateral supports the loan, can require that the other party obtain liability and property coverage, which specifically names the business owner as an insured party, in the same way that a bank requires this coverage. In the case of a mortgage or other collateral loan, do not limit yourself to property coverage. Liability for environmental pollution, for example, has sometimes been extended by the courts to banks holding a mortgage on the affected property.
The small business owner can also rely on another party's insurance when he leases property to, or engages in a joint venture with, another party. Here, again, care should generally be taken to ensure that the other party obtains adequate property and liability coverage.
Other party must be active participant. Reliance on other person's insurance is usually limited to situations where the other party will be carrying out all, or nearly all, of the activities. A mortgagee and lessee, for example, will have exclusive possession and use of the property. Thus, it is reasonable in both cases to require these parties to secure insurance coverage (this also has implications when structuring and funding a business using operating and holding companies).
Similarly, in the case of the joint venture, where the small business owner's role is only secondary to the venture (e.g., limited to putting up capital or devising a business plan, it would be reasonable to require that the primary party (i.e., the other party) obtain and pay for insurance coverage.
Require indemnification when relying on another's insurance
If you are relying on another party's insurance, you should consider a requirement that the other party indemnify you in the event of loss or other harm. This indemnification, or "hold harmless" provision as it is frequently called, requires that the other party reimburse the small business owner for any loss he suffers in the transaction or relationship. In this way, the small business owner adds an extra layer of protection.
An indemnification clause may seem to be superfluous given the insurance protection. However, insurance policies, of course, have many exclusions from coverage. The indemnification clause will apply when the insurance does not cover the liability.
Insurance may preclude finding of fraudulent transfer
Insurance can offer protection, not just by paying claims, but by helping you avoid challenges to transfers of assets because the value of the insurance policy may be considered under both the balance sheet and cash-flow definitions of insolvency if the creditor challenging the transfer as fraudulent could benefit from the policy.
The Uniform Fraudulent Transfers Act (UFTA) outlaws both constructive fraud and actual fraud. Constructive fraud automatically exists when a transfer is made for less than fair market value and the transferor is insolvent either before or after the transfer. "Insolvent" means either that the transferor's liabilities exceed his assets (the balance sheet test) or that he can't his debts as they come due (the cash flow test.) In actual fraud, the transfer's intent to defraud creditors is the key issue. However, insolvency is important because it is one factor evidencing on intent.
In addition, distributions from a limited liability company (LLC) or a corporation to an owner on account of his ownership interest are also subject to a constructive fraud test. Generally, these distributions are deemed fraudulent if they are made at a time that the business entity is insolvent.
So how do insurance liability limits relate to insolvency? The limits of a liability insurance policy can be deemed to be an "asset" under the balance sheet test and a future receipt of capital in the cash flow test if the creditor could benefit under the policy. This makes it less likely the transferor will be found to be insolvent.
Frank Burns, a surgeon operates his practice as a sole proprietor. Not surprisingly, a $100,000 malpractice judgment is entered against him. Frank, upon receiving notice of the lawsuit, transferred $800,000 to his children as a gift. This transfer leaves him with assets of $20,000 and liabilities (including the court judgment) of $400,000.
At first glance, it appears he is insolvent under the balance sheet test ($400,000 of liabilities exceeds $20,000 of assets). Thus, the transfer would be deemed fraudulent. However, Frank carries malpractice insurance with a policy limit of $800,000. Because the malpractice claimant is able to benefit from the policy, the policy is counted in determining insolvency. As a result, Frank is considered solvent before and after the transfer. Therefore, the transfer of $800,000 to the children is valid.
A different result would apply if he was found guilty of Medicare fraud and ordered to pay $400,000 in restitution. The policy would not be considered as a asset because the claimant could not benefit under it.
As you can see from the example above, insurance may in some cases preclude a finding of fraudulent transfer.