Risk management is a challenging business. In the twenty-first century, companies (particularly small and mid-sized ones) face innumerable existential threats. For instance, cyber risk is a growing and wildly unpredictable threat as evidenced by the havoc recently wreaked on Target by hackers. Terrorism is a real threat to businesses and their operations today (did you hear about the recent attack on a California electric company? How long could your business last without power?). Environmental disasters like the recent water contamination in West Virginia are more and more common (How long could your business last without clean water?).
Government regulators wield more power than in bygone days. Overzealous government regulators can "shoot first and ask questions later", as Gibson Guitar learned when their inventory of wood to make guitars was seized by the Environmental Protection Agency...Twice. Gibson was victimized by an unscrupulous supplier and settled the case, paying over $300,000 in fines. However, the total cost to the business far exceeded the fines paid. How many sales went to Fender or other competitors while Gibson was hamstrung?
Furthermore, litigation is an ever-increasing threat to business owners, and the dangers come from inside and outside of their businesses - 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.
In our twenty-first century complex, global and ever-changing business climate, is third party commercial insurance sufficient by itself?
In addition to property & casualty insurance, how much business interruption insurance is enough?
How much insurance would be required to offset the impact of lost trust and a sullied brand or tarnished reputation?
Is it possible to purchase insurance for everything that could go wrong?
And, even if a business owner could, what would it cost?
The Third Party Insurance Dilemma
It's a truism that the most needed types of insurance either are not available in the third-party insurance market or are often prohibitively expensive. For instance, it's nearly impossible to get third-party insurance at any price that would provide coverage in the event your business was harmed in a nuclear attack. Is that because the risk off loss is too remote? Hardly. It's because, regardless of how likely such an attack may be, it's impact on your business would be extraordinary.
Even when you can get reasonably priced third-party insurance to protect against a given risk, the drawbacks are significant:
1. Policy limits cap coverage
2. Policy exclusions limit coverage
3. Many policies are "cookie cutter" and based on a generic risk model that most businesses face rather than one customized for your business
4. Claims drive up the future cost of insurance
5. Marketing and distribution costs (commissions, commercials, etc.), as well as corporate overhead and profit margins, are built into 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 (and, we will speak to this point later - see "War Chest" below).
A Better Way - Blending Third Party Insurance With Formal Self-Insurance
For many, a far more powerful approach to risk management that overcomes the trade-offs just noted is to develop a layered or blended approach. 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.
Why Is Captive Ownership The Best Self-Insurance Money Can Buy?
Simply put, a captive insurance company is one of the most powerful risk management and wealth accumulation tools that a business can access. When properly employed, there is nothing else that can do what a captive insurance company does. 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. Captives can also insure third party insurance deductibles, enabling the parent company to raise its deductible and lower its third party insurance costs. Also, a business can enjoy more broad business interruption coverage from its captive when an adverse event occurs, particularly events where third party insurance doesn't cover all damages or peripheral damages.
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. Unique coverages can also be very expensive when covered by commercial insurers. This feature enables business owners and CFOs to say, "this has gone wrong in the past, let's insure against it in the future," or "other companies have experienced this adverse event, we can insure this via our captive." 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 (usually the business or business owners). One of the reasons that most businesses are underinsured is that purchasing insurance is a bit like purchasing a lottery ticket. If you don't win (or in the case of insurance, experience an adverse event resulting in a claim), your money is gone with nothing to show for it. With a captive, this simply isn't the case. Profits in the captive, defined as premiums collected less claims paid, belong to the captive owners.
Gain Access To A War Chest
Over time, businesses, owners and CFOs can build up a substantial war chest in a captive insurance company. This war chest is available to pay insurance claims the business may have. And, it can also be accessed should the owner or the business require funds. Assets accumulated in a captive almost always outpace retained earnings or a business' "rainy day fund." 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 for two main reasons.
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 0% (that's zero percent) on their underwriting profit. A small insurance company is defined as receiving premiums of $1.2 million or less per year.
Second, the captive is able to invest and grow 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 were not in place.