CHAPTER
10

Understanding Insurance

In This Chapter

• Managing risk with liability insurance
• Protecting your things with property insurance
• Health and life insurance for your employees
• Accounting for insurance expenses

Life is fraught with risk, and owning or managing a business often brings exposure to even more risks. Although you can’t guard against every risk in life, you can share the burden of risks you can anticipate by purchasing insurance.

As with many aspects of running a business, there’s an art to using insurance effectively. As you’ll see in this chapter, if you have employees, you need to purchase workers’ compensation insurance, at a minimum. You also could purchase other types of insurance to protect your business and your personal assets. You can offer insurance to your employees as a benefit as well.

In this chapter, we break down the various types of insurance you might consider purchasing to protect your business and employees, including those types of insurance you’re legally required to buy.

Liability Insurance

The purpose of liability insurance is to protect an insured party against unintentional acts or situations that cause some form of harm to others. Liability insurance takes many forms, and most are optional, but as you’ll see, at least two forms are government mandated.

Even the tiniest of home-based businesses can encounter situations in which an expensive legal defense is required, even if the business isn’t in any way at fault. If your business is sued, your liability insurance covers your legal defense fees. Further, if your company is found to be at fault, liability insurance covers any court-ordered monetary amounts up to your policy limits. This can protect your business from catastrophic financial payouts that could cripple or even bankrupt it.

Keep in mind that liability insurance does not offer any protection against criminal acts. Also, liability insurance policies are very tightly written, so you might need to purchase more than one type of coverage to protect your business from various risks.

Insurance companies continue to segment coverage into specialty protections that aren’t listed in the following sections, but we can offer a general overview of the types of coverage you should consider for your business.

BOTTOM LINE

Insurance is a means of sharing risk, and for most policies, you’re expected to provide some level of first dollar coverage. This means your policies likely have a deductible you need to pay in full before the insurance company pays any part of a claim. Deductibles also can be used as a financial tool. In some cases, your insurance premium amounts could drop if you’re willing to shoulder a larger deductible, which lessens the insurance company’s initial exposure should a claim against the policy arise.

Workers’ Compensation

The underpinnings of workers’ compensation date back as far as 2500 B.C.E., although in the United States, workers’ compensation coverage is a fairly recent development that originated in the early to mid-1900s. In a previous era, this type of insurance was known as workman’s compensation insurance.

The purpose of workers’ compensation insurance is to provide a safety net for workers who are injured on the job. This insurance provides automatic benefits to injured employees and also protects employers from legal action for negligence stemming from such injuries.

Workers’ compensation is not optional, although certain states allow employee-owners or officers of a business to opt out of workers’ compensation. That is, only owners and officers can choose to opt-out; all other employees must be covered.

DEFINITION

Workers’ compensation insurance provides a safety net for workers who are injured on the job. Employees in higher-level positions such as chief executive officer, president, vice president, secretary, treasurer, and so on are referred to as officers and are authorized to transact business and make decisions on behalf of the company.

Workers’ compensation provides injured employees the following:

• Coverage for medical expenses
• Income replacement during periods of temporary or permanent disability
• Funeral and dependent benefits resulting from a loss of life
• Vocational benefits to retrain workers unable to carry out their previous line of work.

Although the U.S. Department of Labor (DOL) provides oversight, workers’ compensation insurance is regulated by each of the 50 states, which means there are 50 different systems. We can at least provide a general overview of how workers’ compensation works in many states.

Employers purchase workers’ compensation insurance from a private company, or in the case of certain industries, a quasiprivate or public company designed to manage risks within certain industries. Certain large companies are permitted to self-insure, meaning they pay all worker benefits directly instead of paying premiums to an insurance company that would pay out the benefits.

The insurance premium is typically based on two primary criteria: the total payroll for each employee, and a risk factor assigned to each employee based on his or her job. For example, a clerical worker has a much lower risk factor than a deep-water oil rig worker.

At the beginning of a coverage period, employers pay an estimated premium based on the projected payroll and the associated risk factors for the period. The insurance company then performs an audit after the coverage period to calculate the exact premium due. Employers might have to pay for additional coverage if the initial estimate was too low, or they might receive a refund or premium credit if the coverage was too high. The audit typically provides copies of federal payroll tax returns to document the actual wages paid to each employee.

ACCOUNTING HACK

Workers’ compensation insurance is not optional. Although it might feel like a costly burden, the coverage protects your business from legal action and protects your employees. You or your business can be subject to severe penalties for not maintaining workers’ compensation insurance for your employees. However, you do not have to accept the first quote you get. Compare prices among multiple insurance carriers to stay compliant while also controlling costs.

An internet search with your state’s name and the words “workers compensation” should help you locate the government agency that has oversight over your state. You also can use the interactive map offered by the DOL at dol.gov/owcp/dfec/regs/compliance/wc.htm.

General Liability Insurance

This type of insurance provides a level of protection for business owners against civil litigation. For example, a customer could slip and fall in the lobby of your office and file a lawsuit. Business owners can purchase liability coverage in dollar amounts commensurate with the amount of perceived risk. As noted in Chapter 2, your choice of business structure might protect you personally from litigation, but litigation that consumes all the assets of your business could still be catastrophic to you personally.

Product Liability Insurance

This type of insurance protects businesses from financial losses when a product covered by the policy causes an injury or damage. For example, food recalls due to listeria, salmonella, and other bacterial agents can cause significant harm to customers. Just about any other product can spark unintended consequences, such as appliances with faulty wiring, baby cribs that cause injuries, or outdoor clothing with heating elements that cause burns.

Directors’ and Officers’ Liability Insurance

This type of coverage, often referred to as D&O coverage, protects directors and officers of corporations from legal defense costs for acts related to their role of running the company. Just as workers’ compensation only protects employees while working on the job, D&O coverage is limited to acts carried out on the job.

Professional Liability Insurance

Lawyers, accountants, architects, consultants, and many other professionals purchase insurance protection for improperly rendering services, or failing to live up to their professional responsibility. This type of coverage is sometimes referred to as errors and omissions (E&O) insurance. This insurance doesn’t protect against fraudulent acts, such as a tax adviser knowingly filing an improper income tax return, but the insurance can protect against negligent acts in the line of delivering professional services.

Medical professionals often have a special version of this type of insurance known as malpractice insurance.

Automobile Insurance

Any automobile you or your business owns must have a liability policy. The minimum amount of coverage varies by state, but often the minimum coverages are insufficient to fully protect your business. If you drive a vehicle without liability insurance, you run the risk of losing your driver’s license; incurring civil penalties; and being personally liable for any property, medical, and legal costs of any car accidents in which you are found at fault.

BOTTOM LINE

Automobile liability coverage does not protect the vehicle itself. It reimburses injured parties for harm and property damage caused by the insured vehicle.

Cyber Risk Insurance

It seems like every day the news reports yet another breach of computer systems at retailers, insurance companies, and even government databases. If you have even one device connected to the internet, you face the potential risk of your computer being hacked. Although you can purchase internet security software and firewall devices that lessen the risk, no system is completely infallible.

Your risk of exposure isn’t limited to someone electronically breaking into your computers. Confidential information can be inadvertently exposed through lost or stolen computers and devices, or disgruntled employees can misuse company data or computer privileges. It often can be difficult to quantify what’s involved in repairing the damage from data breaches of any sort.

A cyber risk policy might be available under a variety of names, including computer hacking, computer fraud, and data breach coverage.

Personal Umbrella Insurance

All the coverages we’ve discussed thus far are considered primary coverage, meaning the insurance company pays for covered events when warranted. However, in certain cases, litigation could result in judgments that exceed the policy limits of your primary coverage. For instance, if a customer successfully sues your business for $1,000,000 for a car accident caused by an employee but your liability insurance has a policy limit of $500,000, you or your business could be responsible for the remaining $500,000 beyond what your insurance pays.

It’s a good idea for every business owner, as well as high-net-worth individuals, to purchase personal umbrella insurance. This type of coverage is known as secondary coverage because it doesn’t take effect until the limits of one of your primary policies have been exceeded. Umbrella insurance is typically purchased in $1 million increments and is usually rather inexpensive, particularly when compared to primary coverage.

Umbrella insurance raises the limits of your primary liability coverage and helps protect your business or personal assets by providing a higher level of coverage than you might be able to afford. With that said, your umbrella policy might include a clause that requires you to increase your current liability coverage amounts to a higher level than you presently have. In the end though, you’ll have a much greater level of protection.

You’re probably familiar with homeowner’s or renter’s insurance that protects you personally should something happen to your home or your possessions within your home. Chances are, such policies exclude home-based businesses, so check your policies carefully.

Businesses located outside the home need similar property insurance that covers damage to the premises and its contents. Commercial property insurance policies can cover your premises, any outdoor signage, furniture and equipment, inventory, and even property belonging to others that’s stored in your building. However, a general-purpose property insurance policy might not be specific enough to cover some of the risks that your business might face.

Boiler and Machinery Insurance

This type of coverage, now often referred to as equipment breakdown coverage, protects against exposure from key pieces of equipment breaking down or causing damage. Any sort of machinery or equipment can be subject to malfunction. This type of policy doesn’t just cover the cost of repairs or replacement of almost any type of equipment you want to cover in your business. The policy also can replace lost business income as well as the value of damaged or spoiled products caused by the mechanical failure.

Despite the name, you can purchase coverage for small equipment, including computers, larger items such as kitchen equipment, and even production machinery.

Business Interruption Insurance

Earthquakes, tornadoes, flooding, hurricanes, and other natural disasters often strike without warning and wreak large swaths of havoc. Property insurance can reimburse you for losses of physical property, such as buildings, automobiles, and certain equipment. However, such coverage doesn’t provide any protection from situations in which you have a loss of income caused by property damage. Business interruption insurance can reimburse you for lost revenues attributed to a property loss. You typically must purchase this coverage as an addition to property insurance.

Inland Marine Insurance

Property insurance typically covers items within the premises of your business. This means it might not cover items you frequently use outside your premises, such as laptop computers, cameras, and other equipment that’s easily mobile.

Even though your business might not have anything to do with shipping goods on water, you might still need specialty coverage for portable equipment, known as an inland marine policy. The scope of this sort of policy has expanded over the years to cover modern technology equipment.

ACCOUNTING HACK

Insurance policies are available to cover just about every imaginable risk and exposure your business faces. However, insurance can be expensive. A knowledgeable insurance agent or broker can help you determine which risks you should insure against and can often help you identify multipolicy discounts.

Health Insurance

Most of the types of insurance we’ve covered so far are rather staid, and the rules and coverages don’t change very often. Health insurance is the exception to the rule, and lately, it seems like the requirements shift on an annual basis. (We’ll keep our discussion of health insurance here brief because the ground continues to shift on a regular basis.)

Depending on the size of your business, you might be subject to state or federal requirements that require you to provide health insurance for your employees.

Historically, health insurance has been optional and was primarily provided by employers to full-time employees. This left a large swath of part-time, unemployed, or individuals not in the workplace without coverage. The Affordable Care Act, signed into law in 2010, requires that every U.S. citizen have health-care coverage. As of January 1, 2015, employers with 50 or more full-time employees must provide affordable health care or incur a financial penalty.

The terms of this law are broad and complex, and some of the rules are coming into effect over a period of years. For instance, under the law, the definition of full-time employees includes part-time workers who work 30 or more hours per week, which differs from the traditional definition of full-time being those who put in a 40-hour workweek.

Businesses with fewer than 50 full-time employees are not required to provide health-care coverage at this time, but keep an eye on the regulations that are still being fine-tuned as the implementation of the law rolls out.

Even if you don’t provide health insurance for your employees, you do have to provide insurance coverage for yourself. In the past, individuals were often priced out of the health insurance market, particularly people with a preexisting health condition. The Affordable Care Act makes it much easier to purchase individual coverage from a health insurer at an affordable price, or you can use the health-care marketplace website at healthcare.gov. There’s even a section specifically for small businesses.

Usually you can get free advice and guidance from a health insurance broker, who is typically compensated by the health insurance companies directly. Businesses usually can secure group coverage for employees at a lower cost than what it would cost individuals to get health insurance coverage on their own.

The Internal Revenue Service (IRS) has been tasked with ensuring compliance with the Affordable Care Act, so you’ll want to get advice from a tax adviser as well to ensure you operate within the confines of the law.

RED FLAG

You might have difficulty securing individual health insurance if you miss the annual open enrollment period that runs from November 1 through January 31. The Affordable Care Act requires that all taxpayers provide proof of health coverage on their tax return or pay a penalty that can be as much as 2 percent or more of your taxable income.

Life Insurance

Life insurance pays out a designated amount of money if an insured person dies. Some businesses arrange for group-based life insurance as an employee benefit.

Recently, a major retailer was found to have secretly taken out life insurance policies on employees from which the company received the payout if the employee died while in their employment. Most states prohibit this type of secret coverage and also require what’s known as an insurable interest of the buyer.

Businesses that offer life insurance as a paid benefit typically provide no more than $50,000 coverage per employee. As you’ll see in the next section, the IRS considers employer-paid coverage in excess of this amount to be a taxable benefit.

It might be worthwhile for your business to consider a special type of coverage commonly referred to as key man or key person insurance. This type of policy protects a business against financial loss in the event of the death or disability of an important employee. Such coverage may be applicable for corporate officers, partners in a partnership, key salespeople, and other employees who significantly contribute to a business’s revenue. Key person insurance also can be used as a mechanism of succession planning.

DEFINITION

All businesses must plan for the eventual planned or unplanned departure of key employees or stakeholders. Succession planning involves grooming existing employees for future promotions to leadership and other key positions, as well as using insurance and other tools to minimize the financial ramifications of a change in succession.

Special tax rules apply to the deductibility of key man life insurance, so be sure to check with your tax preparer before purchasing.

All the types of insurance we’ve discussed in this chapter are tax-deductible expenses for your business. We cover personal and business tax returns in Chapter 19, but in short, a business can deduct what it pays for business-related insurance against its taxable income.

What’s more, certain types of insurance, such as health and life insurance for your employees, often can be provided as a tax-free benefit for them.

The IRS provides an exclusion for the premiums on group term-life insurance policies of up to $50,000 per employee. Policies that provide coverage in excess of $50,000 can trigger a taxable fringe benefit.

Health Insurance for the Self-Employed

Self-employed individuals who report their income on Schedule C or whose income is reported by a pass-through entity such as a partnership or an S corporation are subject to different rules when it comes to the deductibility of health insurance. The rules relate directly to the profitability of the business and your percent of ownership of that business.

If you’re self-employed and purchasing health insurance for yourself and your family, be sure to seek the advice of a tax professional to help you determine if, how, when, and where to deduct health insurance costs.

If you’re paying part or all of the cost of your and your family’s share of health insurance through your employer’s group plan, more than likely your employer is handling your payments through payroll withholding, and those payments are treated as “pretax payments.” This means the amount of your income withheld to pay for health insurance isn’t subject to income tax and isn’t allowed as an itemized deduction.

ACCOUNTING HACK

If your business is taxed as a S corporation, there’s an advantageous rule that permits you to deduct, dollar for dollar, every penny of health insurance premiums paid by you. It requires a proscribed treatment of the health insurance costs on your W-2. If this is applicable to you, be sure to check on it before your last check of the year.

As we discussed in Chapter 4, you need to establish a special type of account known as a prepaid expense account. This is an asset account that temporarily reflects the amounts of an expense, such as insurance, you’ve paid in advance for future months. So when you pay an insurance premium, your accounting transaction debits prepaid insurance, for instance, and credits cash. Each month, you’ll move a portion of the insurance premium to the Insurance Expense account, until the prepaid expense is exhausted. (You can automate this type of entry within your accounting software. See Chapter 17.)

Many small business owners tend to record the entire insurance premium payment as an expense in a single month, but doing so distorts your monthly operating expenses and can result in you taking an unwarranted income tax deduction. IRS Publication 535, Business Expenses, states “You generally cannot deduct expenses in advance, even if you pay them in advance. This rule applies to both the cash and accrual methods. It applies to prepaid interest, prepaid insurance premiums, and any other expense paid far enough in advance to, in effect, create an asset with a useful life extending substantially beyond the end of the current tax year.” Thus, booking insurance premiums to a prepaid account is not only a best practice with regard to your accounting, it’s also the law.

Insurance reimbursements represent cash received by your company, but this type of cash isn’t taxable revenue, per se. Presumably, you incurred some expense for which you’re being reimbursed in the form of repair of storm damage, repair to an automobile that was in an accident, etc. The insurance reimbursement you receive should offset the expense you incurred, so you record this amount as a credit to the expense account, reducing the amount of expense.

ACCOUNTING HACK

Sometimes you experience a delay between the time you pay for insurance repairs and the time you receive your insurance reimbursement. If this delay results in the expenses being paid in one year and the reimbursement being received in the next year, the IRS does not want you to take a tax deduction for the expenses the insurance will cover. Set up a current asset account called Anticipated Reimbursements or something similar. Reduce your expense by the amount you expect to receive in reimbursement, and debit the amount to the new asset account. Then, in the next year when you receive the reimbursement, you’ll clear—or zero out—the asset account.

The Least You Need to Know

• Liability insurance typically results in payments to others and protects your business from potentially devastating claims.
• If your company has employees, workers’ compensation insurance is a liability requirement.
• Property insurance protects you from incurring great costs if items you own are damaged.
• Health and life insurance represent key benefits you might offer your employees.
• The insurance benefits you offer your employees can be tax deductible for your company.
• There may be some nuances in how you record business insurance policy costs and any reimbursements your business receives.