Risk management for small business.

Author:Howard, Jack L.


Every organization is exposed to risks associated with employment practices and must develop strategies to avoid and/or minimize risks. Risk management is particularly crucial for a small business because a single poorly managed risk could threaten survival. In this paper, a framework that small business owner/managers could use to systematically analyze risks is described, and various options to manage risks are identified. Next, a risk transfer device is discussed in detail. This discussion focuses on protections, coverage, cost, and benefits of obtaining employment practices liability insurance (EPLI). Finally, risk reduction tools and techniques to complement EPLI are discussed.


Small businesses employ almost 58% of the workforce and represent 99 % of the organizations in United States (http://www.sba.gov/advo/stats/sbafaq.pdf). Every organization including small businesses is exposed to risks and must develop strategies to avoid and/or minimize risks and also to mitigate the effects of risks. In contrast to large organizations, small businesses do not have the resources to employ risk managers or risk management consultants to deal with risks. Yet, managing risks is, at least as much, if not more important, for smaller organizations than for larger organizations because a single poorly managed risk could drive a smaller organization to bankruptcy.

An organization engages in several operations or activities. Almost all of these activities, including technical activities (e.g., production, manufacture), commercial activities (e.g., buying supplies, selling products/services), financial activities (e.g., finding sources of capital, managing capital flows), accounting activities (e.g., recording and analyzing financial information), and human resource activities (e.g., hiring employees, disciplining employees) involve exposure to risks. The focus of this paper is on the risks posed to small businesses by human resource activities.

In large organizations human resource professionals and risk management specialists guide and help the organization manage the risks associated with human resources. In contrast, in small organizations, the owner or a manager directs all activities including those related to the management of human resources. The owner or manager must engage in several human resource/employee relations activities, such as hiring employees, promoting employees, resolving conflict among co-workers, disciplining employees, and terminating employees. Mistakes made in performing any of these activities will expose organizations to severe risks and consequences. For instance, disciplining employees in an inappropriate manner or terminating employees in an insensitive manner could lead to a discrimination lawsuit or charges of wrongful termination against the employer.

The primary purpose of this paper is to educate owners and/or managers of small businesses to better manage risks. First, an overview of the risk management process is presented to help managers/owners think about risk management issues in a systematic manner. Second, options available to managers/owners to manage risks are described. Third, a comprehensive discussion of EPLI is provided. Finally, tools and techniques that small businesses could use to complement EPLI are described.


Knowledge of the risk management process will help small business owners and managers to think about risk management in a systematic matter. The risk management process consists of the following 6 basic steps (Vaughan, 1997).

Determining objectives Identifying risks Evaluating the risks Considering alternatives and selecting the risk treatment device Implementing the decision Evaluating and reviewing the effectiveness of the decision A brief description of each step is presented. The focus as each step is described is on the risks associated with employment practices that organizations face in an everyday manner.

DETERMINATION OF OBJECTIVES. Employees in the United States receive numerous protections based on federal, state and local laws and statutes. As such, employment practices can come under the scrutiny of various enforcement agencies, as well as the court system. How employees are treated in an organization can lead to situations where employment practices can be questioned. An employer must decide which risks associated with employment practices he or she wants to address, as well as how to address these practices. As such, one or more objectives need to be set. One objective could be to protect the organization's financial position. Another objective could be to ensure that all employees are treated fairly. A third objective could be to prevent (if possible) or minimize the number of potential employment discrimination lawsuits, or the number of lawsuits associated with employment practices. Although the actual objectives may vary from one organization to the next, every organization must explicitly set objectives.

Setting objectives has two benefits. First, it forces the manager or owner to foresee potential risks. Second, it will serve as a control device to help ensure objectives are met. Setting objectives that are realistic is likely to be a challenging task for a small business because the owner and/or manager is forced to consider the large number of negative possibilities that could result from employment practices.

IDENTIFYING RISKS. The second step involves identifying the major actual or potential risks posed by employment practices of the small business. This is a daunting task. Small businesses that employ 15 or more employees must take this task seriously because organizations of this size have to comply with several federal and state laws and regulations. As such, identifying the pertinent laws to comply with at both the federal and state levels is a must for all small business owners and managers. It is important to have at least a basic understanding of these laws (Ledvinka & Scarpello, 1992; Sovereign, 1994).

The essence of most laws is to prohibit discrimination in all terms and conditions of employment on the basis of race, color, religion, sex, and national origin (Ledvinka & Scarpello, 1992; Sovereign, 1994). It is important to understand that every employment decision (e.g., recruiting, selecting/hiring, deciding who to promote, allocating pay increases) should be free from bias or prohibited discrimination. In essence, what this means is that any type of decision that deals with employees (e.g., hiring, promoting) can be legally challenged. The best way to ensure compliance is to always make decisions based on job-related qualifications (e.g., hiring the best applicant, promoting the best performer or the most senior employee). Additionally, employers are obligated to provide a harassment-free work environment. Employers including small business owners must take this seriously because sexual harassment lawsuits could significantly influence survival of an organization.

While the risks seem unending, a first step would be to become familiar with the various employment laws at both the national and state level (Ledvinka & Scarpello, 1992; Sovereign, 1994). The purpose is to identify employment practices that may not be in compliance (e.g., has been challenged in the past) or the practices that could be easily questioned. Practices that have led to litigation should be considered as known risks. Those that have not, but could, should also be considered as risks.

A second step is to examine the organization's written policies and procedures that shape employment practices. Certain policies may help one decide not so much whether a risk exists, but more precisely, how much of a risk exists (Gavin & Jawahar, 2002).

EVALUATING THE RISKS. Once a small business owner has identified the risks associated with specific employment practices, the next step is to evaluate those risks. The most effective approach for evaluating risks is to classify them into one of three categories (Vaughan, 1997).

"Critical risks: all exposures to loss in which possible losses are of a magnitude that will result in bankruptcy. Important risks: those exposures in which possible losses will not result in bankruptcy, but will require the firm to borrow in order to continue to operations. Unimportant risks: those exposures in which possible losses can be met out of the firm's existing assets or current income without imposing undue financial strain." The key to using these categories is to understand the potential costs of employment litigation, along with a complete awareness of the organization's assets. This will help the business owner to identify if they can financially withstand the potential $100,000 discrimination lawsuit. For a small business that is barely making ends meet and has no employment policy manual, this could be viewed as a critical risk. For a small business with an employment policy manual and some financial assets ($10,000-50,000), then this might be evaluated as an important risk. Each business must carefully and honestly evaluate...

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