Mind your Business - Insurance

Every business has to think about insurance in one form or another; it is one of the inescapable fixed costs that must be paid. Like domestic insurance, the principle is fairly simple but as a means of covering the potential liabilities of a business should something go wrong, it is vital.

Insurance is based on:

• The potential risks of something happening
• How much would be needed to cover that liability
• How many people are wiling to contribute premiums
• The ability of the fund managers who invest the premiums to get the returns necessary to cover potential outlays

The more risky the likelihood of the outcome, the more the premiums will need to be and the less willing insurance companies will be to cover the risk.

Imagine, then, the problems facing Sir Richard Branson as he tries to get his latest business venture off the ground - literally. Branson is working on developing Virgin Galactic. The plan is to extend the Virgin aviation business into space. Branson has plans to launch 100 initial flights lasting two and a half hours and including 15 minutes in space, with 5 minutes of weightlessness.

Branson is committing $240 million (£138 million) to the project. To date, 45,000 people have registered an interest in the tours - but these are not tours that you will find advertised in your local travel agent. The price for the tour is $200,000 (£115,000), paid in advance. 156 people have apparently paid a deposit to register their interest and a few have paid the whole fee.

Branson thinks the real competitive advantage will be in the way the aircraft is designed and that the sense of weightlessness is the thing most people are looking for. The cabin has been designed to allow people to be able to float around rather than remaining seated for this part of the flight.

Sir Richard scoffs at the sceptics who think that the idea will never 'take off' and sees the chance for ordinary people to be able to take part in space tours in his lifetime. He points to the fact that a flight between London and New York prior to 1939 would have cost the equivalent of $80,000 (£46,000)!

The major stumbling block to his plans, however, is not likely to be the technical challenges of the project but securing the necessary business insurance. The risk factor in space travel is high - 1 out of 64 missions have ended in disaster - and this is a risk factor that sends shudders down the spines of insurance brokers everywhere.

Experts believe that Sir Richard would have to get third party insurance cover for everyone living within four-and-a-half miles of the proposed spaceport in New Mexico - just in case debris falls from the sky and hits them. Whether those who actually travel on the craft are able to get insurance cover is highly debatable at the moment. Sir Richard has entered into negotiations with insurance brokers at Lloyds of London to discuss the issues.

The principle behind business insurance is simple but often misunderstood. The insured risk is that identified as being something that needs some form of cover. Let us take a simple example. A business has a warehouse with a stock of goods. It knows there is a risk that this building could catch fire and it would lose all its stock. The building therefore becomes the insured risk.

An insurance company will be approached to offer a quote on what it will cost to cover that risk. The insurance company will use the services of an actuary to assess the risk involved. The actuary will look at similar buildings, the area, incidents of fire damage and hosts of other data to assess the risk. The insurance company is then able to make a quote to the company based on this risk. The business concerned will then have to pay premiums to the insurance company for the lifetime of the policy. It could be that the business never has to make a claim for fire damage, in which case it will have paid large sums in premiums over the years and never get anything back.

On the other hand, it could be that the day after taking out the policy, the whole warehouse goes up in smoke and the company loses all its stock. The insurance company would have to then pay out, possibly millions of pounds, and has only received one premium! The insurance company therefore have to balance the risk of the event occurring with the number of people taking out policies and the expected payouts that they need to cover over a period of time.

In so doing, they will be looking at the amount of premiums they receive in relation to what they expect to have to pay out. The premiums should cover the expected payouts but the company cannot just aim to cover the anticipated payouts - statistics might give a useful indicator to chance, but reality tends to throw up events at any time. The insurance company therefore has to ensure that it has the funds available to cover all these eventualities and so uses the premiums it receives to invest in a range of financial instruments, including shares and bonds, to build up reserves of funds to cover their liabilities.

The diagram below highlights the basic principle.

Imagine that there are 10 businesses, A - J, each looking to secure insurance on their premises against fire. Each business values the buildings at £1 million. The actuaries have estimated that the risk of one of the buildings being completely damaged by fire and needing replacing is a 1:10 risk. The premiums are therefore set at £100,000 per year for each business. Each business pays the premium to the insurance company, which in turn uses the £1 million received to invest in various financial instruments. The returns from these investments plus the capital sum of £1million represents the fund that the insurance company have to pay out in case of a claim.

Let us assume that business J is unlucky enough to have that fire - the fund is used to pay business J £1 million to rebuild their premises. The fund managers will have to ensure that they have sufficient funds to meet this obligation. Of course, it could be that during the year, none of the businesses makes a claim, in which case the funds are kept in the pot to be built up. In another year, it is entirely possible that more than one firm could be unlucky enough to suffer a loss, in which case the insurance company has to make sure that they have sufficient reserves to cater for this eventuality. It is also possible that a firm makes a claim but that the claim will not be for the whole £1 million.

Insurance or Assurance?

These are two distinct terms in insurance circles and it is important to understand the difference between the two.

Insurance refers to something that might happen - your premises might get destroyed by fire, a customer might trip up in the store and break their nose on a shelf, one of your employees might have an accident at work and so on.

Assurance refers to something that will happen - you will die at some point in time. We therefore take out life assurance as opposed to life insurance.