Why is this Topic Important to Financial Professionals? All businesses, as well as individuals face some risk, and that form can vary greatly.  Knowledge and identification of certain risks can help position clients in better risk management positions as apposed to ignoring them.

Risks can generally be divided into two sub-classifications; traditional and non-traditional.  Traditional risks are those typically covered by traditional insurance companies such as life insurance or forms of casualty insurance.  However, non-traditional risks are those which are conventionally uninsurable or prohibitively expensive to cover through traditional means.

What are some of the elements that are attributable to traditional insurance?

• Common underwriting standards (for example actuarial tables can accurately predict the insurance expense over time in relation to a large group of individuals).
• Common risk factors in market segment (everyone is faced with death, so the market to solicit this form of insurance is much more prevalent than say insuring an allowance for bad debt account).
• Standard contract terms are assigned (generally terms are not negotiable except premium and some investment risk).

What are some examples of non-traditional risk underwriting?

• Self-Insurance, this is when the business retains the risk by not shifting it to a third party and/or other insurance arrangement.
• Insurance on an actor’s ability to continue acting, or likewise, a sports star who has insured his body caused by physical injury during the season or career.
• Insuring business operations from financial loss caused by, say, a terrorism event or natural disaster.

Why would a business or individual consider alternative risk transfer?

Take for example the actor, who, lets say, is expected to star in a big film.  The production company may purchase a life-insurance policy, which may or may not contain traditional terms, to cover the risk of loss from the death of the actor before the movie is completed.  If the production company does not purchase a life-insurance policy, or similar product, the production company will be said to have self-insured the risk of loss caused by the death of the actor, if it were to occur before the completion of the production of the movie.

On the other hand, assuming the production company did purchase some life policy on the actor, insuring his life for a short period of time, until the completion of the movie, the production company has shifted that risk to a third party insurance company who bears the risk of loss — the stated benefit minus premiums paid, generally.

Assume the actor lives throughout the entire production; however the actor, for artistic reasons (which may or may not be allowed in the contract negotiated between the parties) does not want to continue and/or complete the acting portion of the film after working with a few of the co-stars for a couple of days.  Not only has the production company incurred significant costs associated with pre-production and whatever filming time has accrued, but the production company will most likely want to find a new actor to take the part, an additional expense causing delay costs to increase.

The production company, is similarly, self-insuring the risk that the actor will complete the film without walking off the set.  Self-insurance is generally defined as: “insuring [risk] by setting aside money to cover possible losses rather than by purchasing an insurance policy.” [1]

Here the risk has been identified as the financial loss from the actor walking off the set.  The production company will pay, out-of-pocket, the cost associated with the film until production continues with a new actor.

The example above is just one risk the production company could be exposed to during production of the film.  A complete risk analysis will identify and discuss most known risks and have some financial plan regarding the occurrence of those risks.

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[1] “Self-Insurance”. Princeton University.  WordNet 3.0 http://wordnetweb.princeton.edu/perl/webwn?s=self-insurance.  Last Accessed  8/25/2010.

Why is this Topic Important to Financial Professionals? Accounting is like a road map of the company’s financial operations.  It is essential to understand the accounting basics and how they relate to small businesses and insurance. 

Accrual or Cash Accounting Methods

Now that the business has been incorporated and is operating, what is required to keep the business accounted for?  The first determination a company must make is determining if the business will account using an accrual or cash system.  An accrual accounting method recognizes revenues and expenses in the period in which they occur whereas a cash accounting method recognizes transactions as they occur.

For example, an accrual taxpayer that performs services will account for income earned when the service is actually provided and not when the actual cash or payment is received.  A cash method of accounting is concerned only when cash is paid out and when paid in.  Expenses follow the same logic.  For example, if a service company that uses the accrual method incurs 500 dollars of phone expenses in December 2010 and the payment is not due until January 2011, the company will still account for the phone expense on its books in 2010 for December’s usage.

Accounting System

Once the business has determined its accounting method, it is ready to keep track of the transactions.  Every accounting system should provide a basic financial statement, income statement, cash flow statement, balance sheet, and statement of owner equity.  Each statement provides a view through a different window into the financial operation of the business.

The income statement is easy to understand.  The top item is revenues and beneath that line expense are deducted to determine the net income.

The cash flow statement is essentially a variation of the income statement.  However the cash flow statement will show the ability of the business to operate on a periodic basis given the ins and outs of cash payments.

The balance sheet will tell the financial planner what the business is comprised of.  Most accountants refer to the balance sheet as a snapshot of the business at any particular moment of time.  From it we can see what assets the business holds and how much money it owes others.

Lastly, the statement of owner’s equity shows how the business is owned and financed.

Financial Statements and Insurance

Properly kept financial statement can help ensure easier access to capital as well as give a truer understanding of the business’ financial position.  The financial statements are commonly used in the risk management processes including when insurance is purchased on a key man.  Small businesses are especially sensitive to this risk and keeping accurate books can help insurance agents and underwriters determine among other factors the insurance needs of the operation.

Key man insurance and buy-sell agreements are generally based on some total dollar amount that represents the value of the business.  This figure is usually based on some number that is related to the financial statements and accounting of the business.  Whether it’s the total assets, a factor of revenue or income, or some other determination, the need for a basic knowledge of financial accounting for small business is essential.

For a detailed analysis on business valuation and how it relates to buy sell agreements see AUS Main Libraries, Section 11 F—Insurance Needs Revealed In Financial Statements.

Tomorrow’s blogticle will address employees, independent contactors, 1099s and new legislation that your clients should know about.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.