By Randy Sadler, CIC Services
In today’s business environment, companies—particularly small and mid-sized ones—face innumerable threats. Cyber risk is a growing and wildly unpredictable threat, and there is terrorism, environmental disasters and political risk.
Litigation continues to pose significant threats to business owners, and the dangers come from inside and outside. There is employment law, age discrimination, sexual harassment, worker’s compensation, general liability, product liability, vehicle liability and innumerable other ways for a business to get sued. The #metoo movement has brought down high-profile politicians and big-name business owners, and small and mid-market businesses are definitely not immune.
In the 21st century, there is a complex, global and ever-changing business climate, and the question persists: Is third-party commercial insurance sufficient by itself? And, if commercial insurance costs rise, what other alternatives do businesses have to protect themselves?
It also raises another important question: In Our Twenty-First Century Complex, Global And Ever-Changing Business Climate, Is Third Party Commercial Insurance Sufficient By Itself? And, if commercial insurance costs rise, what other alternatives do businesses have to protect themselves.
The Third-Party Insurance Dilemma
Even when you can get reasonably priced third-party insurance to protect against a given risk, the drawbacks are significant. The policy limits cap coverage and policy exclusions limit coverage. Many policies are “cookie cutter” and based on a generic risk model that most businesses face rather one customized for their business. Claims drive up the future cost of insurance and there are also marketing and distribution costs as well as corporate overhead and profit margins that are built in to premiums.
Most importantly, the biggest drawback to third-party insurance is that premiums paid are a sunk cost. Unless claims are made, insurance payments are always lost money (with the exception of buying peace of mind). This lost money – lost paying insurance premiums today – reduces a business’ flexibility in the future.
A Better Way – Blending Third Party Insurance With Formal Self-Insurance
For many business owners, a far more powerful approach to risk management that overcomes the trade-offs is to develop a layered or blended approach. The key for business owners to insure their way to greater wealth is to own their own insurance company, known as a captive. A captive can form the backbone of an Enterprise Risk Management (ERM) plan, providing formal self-insurance. By combining third-party insurance with a captive insurance company, a business owner can establish a far more comprehensive and thorough risk management approach. This approach is also a better forward-looking approach, because the captive insurance company will accumulate additional reserves in years with low claims. These reserves can provide more robust insurance coverage in the future and, when necessary, can be accessed by the owner (or CFO) as a war chest to address contingencies or unanticipated risks.
What Is a Captive Insurance Company?
Simply put, a captive insurance company is a closely-held insurance company that insures primarily thought not exclusively your business. It is a C corporation and is licensed and domiciled like any large insurance company. Captives also have their own reserves, policies, policyholders and claims. Insurance policies are issued by the captive to its parent or related companies and are actuarially priced. Owning a captive insurance company is a sophisticated way to self-insure, and captives are generally formed to insure the risks of a business, group of businesses and related or affiliated third parties.
How Does Captive Ownership Enable You to Protect and Build Wealth
Simply put, a captive insurance company is a powerful risk management and wealth accumulation tool. By operating their own insurance company, business owners and CFOs can:
- Fill Third-Party Gaps: A captive insurance company can issue insurance policies that address gaps not covered by third-party insurers.
- Utilize Customizable Coverage: Captive insurance companies can write customizable coverage for the businesses they insure. Many businesses face unique risks that may not be addressed by commercial insurers. The flexibility afforded by a captive is extremely beneficial in a complex world.
- Benefit From Few or No Policy Exclusions: Captives can provide broad coverage without the exclusions that riddle typical commercial insurance policies. Insurance coverage is worthless if an exclusion prevents the insured from receiving a claims payment when it needs it most.
- Avoid Sunk Cost of Third-Party Insurance: Premiums paid to a captive insurance company remain the property of the captive owners and are retained as profit.
- Gain Access to a War Chest: Over time, assets are accumulated in a captive. Because the captive is a formal form of self-insurance, it benefits from insurance law and favorable tax treatment. Hence, it is able to accelerate asset accumulation.
How Wealth is Accumulated
First, premiums paid to the captive receive favorable tax treatment. Premiums paid to the captive are an expense to the parent company. This lowers the parent company’s taxable income. As the captive takes in premiums, it is taxed as an insurance company on its underwriting profits (typically defined as premiums less reserves to pay future claims). For large insurance companies, underwriting profit is actuarially determined. However, small insurance companies can make an 831(b) tax election, resulting in a tax rate of zero percent on their underwriting profit. A small insurance company is defined as receiving premiums of $2.3 million or less per year.
Second, the captive is able to invest and grow a larger pool of assets. Large commercial insurers have entire staffs whose sole purpose is to invest reserves (that have not been taxed).
For these reasons, a well-run captive insurance company will typically double retained earnings. And, the same claims that would be paid by the captive would have to be covered out of retained earnings anyway if the captive weren’t in place.
Enjoy The Ability To Reap Long Term Profits
When business owners are ready to sell their business or retire, they keep the war chest. A successful captive amasses wealth for its owners that can be accessed and enjoyed in the future. Captives have the unique ability to improve risk management and simultaneously stockpile wealth.
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Randy Sadler started his career in risk management as an officer in the U.S. Army, where he was responsible for the training and safety of hundreds of soldiers and over 150 wheeled and tracked vehicles. He graduated from the U.S. Military Academy at West Point with a Bachelor of Science degree in International and Strategic History with a focus on U.S. – Chinese Relations in the 20th century. He has been a Principal with CIC Services, LLC for 7 years and consults directly with business owners, CEOs and CFOs in the formation of captive insurance programs for their respective businesses. CIC Services, LLC manages over 100 captives.
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