Risk assessment is the vital first step of risk management.
"Until you know the scope of all of your possible losses, you won't be able to develop a realistic, cost-effective strategy for dealing with them," according to top family business expert
Schwerzler has been studying and advising family business entrepreneurs for more than 40 years and he is the founder of the
Family Business Institute.
Some are obvious like fire damage to the building and its contents, but risk assessment also considers:
- the damage or destruction that smoke or water from dozens of fire hoses can create
- damage to employees' property (coats, tools and personal belongings) and to property belonging to others (data-processing equipment you lease or customers' property left with you for inspection or repair, for example)
- whether your customers will wait for you to get back in business after a fire, flood, or natural disaster destroys your goods and facilities? Or, will they go elsewhere?
- whether your most experienced workers will seek outside employment after a severe operational setback? Will your temporary loss be your competitors' permanent gain?
1. "What could cause a loss"? And for each answer,
2. "How serious is that loss"? Focus on the possible severity of each exposure - the price tag, in dollars and cents. The purpose here is not to determine where the money will come from but how costly the loss could be.
A "risk analysis" questionnaire or survey, available from insurance agents, can be helpful in this first stage of risk assessment.
Our sample insurance checklist will help you.
Exposure to Six Kinds of Risk
Risk assessment generally considers exposure to 6 kinds of risks:
- 1. Property Losses
- Physical Damage
A risk assessment typically finds that most family businesses carry coverage against the losses arising from property damage caused by many common perils: fire, windstorm, lightning and vandalism. Even flood damage along our rivers and low coastal areas. But risk assessment also looks beyond damage to or destruction of the building itself.
Contents may be even more susceptible: manufacturers might lose both raw materials and finished goods that were ready to be shipped. Merchants may lose valuable inventories and fixtures. Any business might lose valuable accounting records (making it difficult to bill customers or collect from customers who owe money). Vital machinery or equipment may become inoperable because of fire and, if replacements can't be found and installed immediately, the business may even be forced into a temporary shutdown. Computer systems carry vital production as well as accounting information. The information itself might be protected by backup, but it needs replacement systems to be utilized. (Our next risk assessment section discusses business interruption losses in more detail.)
- Loss of Use
Your business could lose the use of property without suffering any physical damage. Government agencies like the EPA or OSHA can order closure for violating environmental or health and safety regulations. The local health department may close a restaurant because of unsanitary conditions. A gas-main break or downed utility lines from an ice storm may shut down an entire block for hours or days.
- Criminal Activity
Risk assessment looks for risks from crimes committed by others. Burglary and robbery, white-collar crime, employee theft, embezzlement or forgery. Merchants, in particular, may need protection against losses caused by acceptance of forged checks or unauthorized use of credit cards. Obviously, the property exposures a bank faces are different from those of a plumbing contractor, a restaurant or a grocery store. Each business has its own particular risk assessment focus.
- 2. Business Interruption Losses
We've seen how a direct loss from fire can shut down a business temporarily. Although property insurance provides money for repairing or rebuilding physical damage that is a direct result of a fire, most property policies do not cover indirect losses, such as the income that is lost while the business is interrupted for the repairs. Risk assessment will uncover these additional exposures.
A special kind of insurance will cover indirect losses that occur when a direct loss (that results from a covered peril, such as fire) forces a temporary interruption of business. For example:
- Weather damaged a retail store in September. It was repaired by late November and stocks replenished. But by then, it was too late in the Christmas selling season for the store to approach normal sales. Instead of earning the usual 50 percent of its annual volume in December, it earned only 15 percent. A 35 percent loss!
- If a private school that burns down in July reopens in December, the school may lose half, or even all, of a school year's tuition.
Risk assessment will indicate if you need business interruption insurance that would reimburse policyholders for the difference between normal income and the income that is earned during the enforced shutdown period.
During interruptions, besides your income being reduced or cut off completely , many business expenses continue. Things like: taxes, loan payments, interest, salaries to key employees, and utilities. Without income to pay for these expenses, the business is forced to dip into reserves. Risk assessment considers the impact of how much and for how long these expenses will continue.
Risk assessment also looks at the extra expenses triggered by an interruption. For example, a business may reopen with a skeleton staff (additional payroll) in temporary quarters (additional rent) using leased furniture and equipment (additional overhead). It might have to authorize overtime to shorten the interruption period. These extra expenses put an additional strain on finances at a time when little if any income is being produced.
A risk assessment will also consider if you need to protect against interruptions triggered by direct loss on someone else's property.
- If a key supplier is shut down by a fire and can't deliver critical raw materials to a manufacturer, the manufacturer's business may be interrupted just as effectively as if the supplier's factory has burned to the ground.
- Property damage at the key customer's business may have the same effect. If you depend upon the customer for most of your volume, and that firm's interruption causes them to suspend purchasing, you may be left holding the bag. Their interruption has caused you to lose income.
Every year hundreds of businesses that carry adequate insurance against direct property loss fail because they overlook the possibility of indirect loss. Risk assessment will help you to protect your business against loss of income and unusual expenses that may result if direct loss forces you to close temporarily.
- 3. Liability Losses
- Public Liability
A family business (any business for that matter) that is found legally liable for harming a third party will have to pay damages to compensate the injured party. The court may also award a fine in hopes of discouraging future violations in cases involving violation of a statute that protects the community as a whole. Whether or not you are successful in defending such a law suit, you lose valuable time to distraction from your business and could still incur legal and other costs. Risk assessment evaluates your business and its operations and industry to anticipate potential exposures.
You could become liable for bodily injury suffered by another person or persons, or for damage to or destruction of the property of others. Risk assessment keeps you alert to liabilities that might be the result of a court decision (as in a lawsuit charging negligence), statutory provisions (such as a workers' compensation law), or violation of contract provisions (a contract that makes one party responsible for certain kinds of losses). The injury or damage could arise from negligence or fault by the family business in general or its employees. Here are just a few examples of the kinds of situations that risk assessment has to look out for:
- A customer at your hardware store trips on a shipping carton left in the aisle during re-stocking.
- A defect in a product causes injury to its user.
- A workman who installs a ceiling fan a customer has purchased fails to secure it properly. The fan falls, injuring the customer.
- Your drive-in restaurant customer spills hot coffee in her lap.
- Your insurance agency rents space in an office building and signs a lease that holds the tenant (rather than the building owner) responsible for any third party claims for injury or property damage occurring in or on the rented space.
- A customer is in a traffic accident, causing much damage, on his way home from a celebration dinner at your restaurant.
- Liability to Employees
Every government jurisdiction has enacted legislation that protects the interest of employees who are injured or who contract a disease as a result of job-related activities. Workers' compensation laws require most employers to compensate employees for loss of income or medical expenses that are a result of work-related disease or injury (except for certain self-inflicted injuries). Should an employee die, as a result of a job-related accident or disease, the employee's family also collects a specified amount. So risk assessment will consider not only the types of injuries and death risks in the industry and business, but also what your business is doing to reduce risks.
In dealing with risk, some family businesses should consider having a scientific laboratory as strategic resource - check out the "world of small"
- 4. Key Person Losses
Risk assessment is needed to assess the impact on your business if a key person dies or is disabled: if an accident or illness made it impossible for you to work; if one of your partners or your sales manager were to die suddenly.
For a family business, or in the typical situation where the family is dependent upon the owner's stake in his or her business, the impact is even more critical. Consider a few of the questions risk assessment will help you to assess here.
- How will the business survive if the owner becomes seriously ill or disabled?
- What will the owner's source of income be? How will it be treated for tax purposes?
- Who would "take over" so that the business can continue? What if that person is not qualified or is a minor?
- If a will is not in place before the owner's death, what happens to the business? Does it close? Does someone inherit? Who?
- If the owner's life savings have been invested in the business, will the surviving family have to watch those savings go down the drain because no one knows what to do or how to do it?
- What will the surviving family's source of income be while the future of the business is being decided?
- If the business is to be sold, where will working capital come from for the transition period?
How is the fair market value of the business to be determined? Would the fair market value be apt to change because of the loss of a key person?
- If the business forms the bulk of the estate, what are the tax implications for the surviving spouse and heirs?
- Is there some pre-death strategy that could minimize that tax liability?
The risk assessment provides the foundation of information. Often a team of professionals with expertise in diverse matters such as estate planning, financial planning, current legal and tax codes works with you to develop a comprehensive plan.
Family Business Experts is well experienced with risk assessment
and works with accountants, insurance agents, attorneys and other professionals to ensure that you get the right solutions.
The legal form of your family business produces some specialized challenges in risk assessment.
Suppose the business is a partnership and one of the partners dies.
Unless the partners have prepared some other binding arrangement, that is already in place, their partnership is dissolved when one of them dies.
The duties of the surviving partner(s) are limited to winding up the affairs of the partnership. The surviving partner(s) will be personally liable for losses that the business's assets are insufficient to cover.
The partners may have to set up agreements that provide for the surviving partner's purchase of a deceased partner's interest at a prearranged valuation.
Business life insurance of each partner could provide the fund the survivors need to purchase the deceased partner's interest. Who should pay the premium? The business? Each partner? What are the pros and cons of these alternatives? What are the tax implications of each? How would each affect the firm's cash flow?
If the business is a corporation, risk assessment considers:
In most smaller incorporated businesses there are only a few stockholders, and most of them take an active part in running the business.
Death of a major stockholder often throws a spotlight on the survivors' differences. Conflict or major personality clashes can seriously threaten the survival of the firm. Dissension also damages employee morale, can lead to a loss of business and may even harm the firm's credit rating.
Unless otherwise provided for, the deceased major stockholder's shares will become part of an estate. While the estate is being settled, the estate administrator can vote (i.e., exercise the right to control) the stock. If a controlling interest in the firm is involved, that administrator could name a new board of directors and take over full control of the corporation.
What if the heirs decide to get involved in the business? If they decide to retain the stock, will it provide enough income for them to live on?
If the heirs decide to sell, would they be required to offer the other major stockholders first refusal? Could some plan be set up that would allow the surviving stockholders to finance a buy-out of the heirs' holdings? Without such a plan, would the remaining stockholders' search for buy-out funds have any impact upon the firm's credit?
Once again, planning is essential. Family Business Experts and your advisors rely on the risk assessment as the foundation to develop a strategy to prevent outsiders from unexpectedly coming into the business and to ensure an orderly "changing of the guard" should a major stockholder die.
Key Person Exposure
Risk assessment also looks at what would happen if you were to suddenly lose the services of a key person (who is not an owner, partner or major stockholder) because of illness, disability or death (e.g., a sales manager or the office manager / bookkeeper).
What impact would that person's absence have on sales volume? Costs? Productivity? Efficiency? The firm's credit?
How would you reassign duties to cover the missing person's functions?
What extra costs would you have to incur to recruit a replacement?
How long would it take before the replacement is trained and productive?5. Automobile Losses
While automobile losses are basic and very important to risk assessment, we do not cover them here since we feel there is ample information elsewhere in print and on the Internet.6. Family Brand and Reputation
With the rise of Google and social media that provides fast access to news stories, "brand and reputation risk” should be considered as part of the total risk analysis. As leading experts in family business dynamics, experience tells us that preeminently dealing with problems that could hurt the family's brand and reputation (divorce, alcohol and drug abuse, family feuds, etc)is a smarter strategy then letting the problems fester and hoping the problems will resolve themselves and the family will not have to deal with difficult situations.
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