manage liability risk

How to Manage Liability and Risk as a Small Business Owner

By Mark Thompson

Many small business owners often wonder just how limited liability protection differs from liability insurance. The point of buying liability insurance from an insurance company is to have coverage for claims against your business. When businesses are structured as corporations or limited liability companies (LLCs), this provides a degree of protection by preventing a creditor from seizing the personal assets of the owner.

Frequently, small business owners do not understand the fundamental difference between limited liability protection and liability insurance. The fact is they serve two entirely different purposes. Still, both of these protections help you to reduce the risk of serious financial loss in a lawsuit. It’s been reported that roughly 30% of small businesses will either be threatened with a lawsuit or actually sued at some point. This makes it extremely important to properly plan out effective liability protection.

Detailed Differences between Limited Liability Protection and Liability Insurance

Establishing a business as a limited liability entity will protect the owner’s assets, while liability insurance can help protect the business’s assets. You buy liability insurance from an insurance company in order to protect the assets of your business, including real estate, equipment, investments, surplus funds and so on). Should you be faced with a lawsuit or a claim, you will have this insurance as a shield for your business.

On the other hand, limited liability protections in detail when you have formed your business as a specific entity type that separates your personal assets (such as your home, savings, retirement accounts and vehicles) from those of the business. Many small business owners either incorporate or form an LLC for this purpose.

How Does Liability Insurance Work?

When you decide to purchase liability insurance from an insurance company to provide coverage against lawsuits or claims against your business, you’ll find that it comes in many different types. Common types of liability insurance you can purchase to protect your business against lawsuits include:

  • Product Liability Insurance – If your small business manufactures or sells products, it can sometimes be held responsible for the safety of its products. In this regard, some of the most common risks related to such products include the risk of that that product will cause personal injury.
  • General Liability Insurance – This broader type of insurance is referred to as an umbrella policy, since it provides a general protection against many of the legal issues small businesses encounter, including injuries, accidents and negligence claims.
  • Professional Liability Insurance – Sometimes referred to as E&O (errors and omissions) insurance, this type of insurance will protect a business against any mistakes that service providers make that in turn harm clients. This can include negligence and malpractice claims. Many professionals – such as doctors – are legally required to purchase liability insurance.

For any small business owner, liability insurance can be an important consideration. Even if your small business isn’t making massive profits, this relatively small amount for insurance can be money well spent – if only because it eliminates one thing you have to worry about. Check with your insurance company about the relative costs versus potential benefits of liability insurance.

Liability Insurance Drawbacks

It has to be acknowledged that there are certain drawbacks related to purchasing liability insurance, including the following.

1. Coverage Exclusions

There are several ways that the liability insurance policy might not cover a particular claim:

  • The nature and specific type of claim lies outside of the terms laid out the policy. Policies often list particular types of excluded claims. For example, a number of insurance companies will not provide professional liability coverage for those services they deem to be very high risk.
  • With certain types of coverage, an insurance company can argue that the claim occurred when the coverage was not enforced. For instance, policies will often not cover incidents that do not develop into a claim for months or years. Policies also may not provide coverage for claims that began to develop before the policy went into effect.
  • There’s also the chance that the insurer will find a technicality that can be used to deny coverage, such as arguing that the policyholder (you) did not follow the guidelines and procedures laid out by the company. This type of coverage denial can occur if a policyholder does not provide accurate and complete information on their initial insurance policy application.

2. Policy Limits

There are two types of policy limits, aggregate and per incident. The limits on a liability insurance policy are represented by two numbers, with the first representing the per incident limit and the second representing the aggregate limit (for example, $250,000/$750,000). Your business may be responsible for any claims that exceed this sum.

  • Per Incident Limits – The per incident limit represents the maximum sum that your policy will pay on a single claim. This means that if the limit is $300,000, while the claim is $500,000, your business may have to pay the difference of $200,000.
  • Aggregate Policy Limits – Aggregate limits represent the maximum your insurance company will pay a policy over a policy period. If the limits it set $1 million, once all of the claims during that period reach that amount you (as the policyholder) may be responsible for any claims beyond that.

In the event that your insurance policy does not fully cover the claim, creditors will often go after your business’s assets in order to cover the full amount of the claim. If it turns out that your business does not have assets of sufficient worth, these creditors can pursue your personal assets as well.

This is the inherent drawback to relying entirely on liability insurance policies for liability protection. While it is of course important to have such insurance coverage, it’s wise to put in place additional protections in case your insurance is insufficient. All small business owners should consider how such limited liability protection can minimize their risk of facing significant personal financial loss.

Limited Liability Protection

Forming a corporation or LLC can provide limited liability protection for small business owners. This accomplishes the goal of preventing creditors from coming after your personal assets, including your home, savings, cars and retirement funds. This legal business entity creates a “corporate veil” shielding you from any liability risk. Of course, this assumes that the entity has been properly set up and maintained.

As for how this works, let’s assume that your business makes some sort of mistake that harms a client. The client then chooses to file a lawsuit and wins an award of $200,000. Let’s assume that the insurance policy has a limit of $100,000 per incident. Clearly, the insurance would not cover the full amount of the claim. In this instance, the plaintiff could decide to pursue the remainder by other means.

And if your business does not have sufficient assets to cover this remainder, the plaintiff could then try to come directly after you and your assets. But if you are operating your business as a limited liability entity, it would be extremely difficult – if not impossible – for the plaintiff to recover any monies from you personally.

Limited Liability Protection Drawbacks

This kind of business entity helps the owner protect personal assets, but does nothing to help protect business assets. Creditors would still be able to come after the assets the business owns. This means they could use those assets to cover anything not covered by liability insurance.

Choosing the Right Liability Protections

Small business owners need to establish both limited liability protections and sufficient insurance coverage to protect themselves and their business. Having only one or the other will not provide you and your business with complete protection. Also keep in mind that you probably want to hire an experienced attorney to help you deal with the process of incorporating your business or setting up an LLC.

Photo credit: Liability concept with carabiner from Tashatuvango/Shutterstock

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Mark Thompson
Mark is and old-school entrepreneur that owns a woodworking business and has decades of experience running a traditional brick and mortar business. He is trying to adapt to the digital age by founding Tools Critic, a website where he shares his expertise and networks with like minded entrepreneurs.

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