It is not uncommon to come across successful and profitable businesses that generate little meaningful wealth for their owners. For starters, businesses often face an array of expenses in addition to operating costs that sap revenue including administrative costs, leases and insurance. What profits remain are typically ravaged by taxes, weakening the business and hampering wealth accumulation by the owners.
Advanced strategies to outrun these challenges often include starting or acquiring a second business that serves their primary business. This is often described as vertical integration, and it is often effective because a supplier or service provider is already making a profit serving the parent company.
Consider a successful business owner that chooses to stop leasing a facility in favor of purchasing a facility inside a new company owned by the business owner. In this situation, the business owner can now earn a profit on two companies and can depreciate the real estate asset in the second business to reduce taxable income as well. This strategy enables the business owner to build meaningful wealth in real estate and equipment.
Or, consider a manufacturer that purchases or starts a business in its supply chain. This manufacturer is now able to earn profits on both businesses and gain better control of risk…specifically, the risk of a key supplier folding or choosing to sell to a competitor.
As Advanced As It Gets
For many successful businesses, there is a highly advanced strategy to form a second, profitable business that can facilitate significant wealth creation for its owners. The advanced strategy is to start its own insurance company, known as a captive insurance company.
What Is A Captive Insurance Company?
A captive is a unique insurance company. It includes its own corporation, insurance license, reserves, policies, policyholders, and claims. It is a sophisticated way to self-insure and is generally formed to insure the risks of its owners and related or affiliated third parties.
A captive insurance company can serve as the backbone of an Enterprise Risk Management strategy (ERM). ERM is a more sophisticated approach to risk management that holistically expands its risk management approach in 2 dimensions – time and space. In the time dimension, a company implementing ERM shifts from managing risk year-to-year to managing risk over a 10 to 50 year horizon. This is possible because an ERM strategy with one or more captive insurance companies in place will usually accumulate loss reserves, providing increased risk management flexibility in the future. In the space dimension, an ERM approach results in a wider risk management and insurance umbrella. This occurs because the business conducts a broad risk assessment of all threats the business faces. An ERM strategy is developed and includes broader (or more) lines of insurance coverage. Typically, this larger insurance umbrella includes a blend of third party commercial insurance coverage and insurance coverage provided by the captive insurance company.
How Does This Advanced Strategy Protect & Grow Wealth?
First, the parent company is now able to insure risks that were previously uninsured. The added insurance protection provided by the captive plugs gaps in commercial coverage and addresses operational and existential threats that can threaten the very survival of the business.
Second, Enterprise Risk Management with a captive can create wealth by reducing third party insurance costs. As the captive matures and builds up loss reserves, it can help lower commercial insurance costs by taking over a portion of the core risks faced by the business. One approach is to increase deductibles on commercial policies and purchase deductible insurance from the captive. As the business and captive develop a reliable loss history and the captive builds loss reserves, the captive can also be in a position to provide “first dollar” coverage to the business for core risk. In these cases, the captive will likely purchase reinsurance.
Third, the overall (or aggregate) wealth of one or more companies with a captive insurance company is higher than the overall (or aggregate) wealth of one or more companies without a captive insurance company. This occurs for two primary reasons. First, the parent company takes an expense as it pays its insurance premium to its captive. This lowers the parent companies taxable income. And, the captive may make an 831(b) tax election if it qualifies as a “small” insurance company, so that its underwriting profits are taxed at a rate of 0%. A “small” insurance company is defined as an insurer that receives less than $1.2 million in premiums annually. Second, the captive is able to earn a return on its reserve pool (or assets). And, the captive’s asset pool has been amassed with pre-tax dollars, enabling asset growth on a larger starting base.
How Does a Captive Insurance Company Increase Total Wealth?
A captive provides many benefits to its parent company or business owner including risk mitigation, asset protection, security from creditors and increased profits. As such, a captive can form the backbone of a comprehensive ERM approach as outlined above. A captive primarily insures its parent company or related companies. Hence, the parent company is able to purchase insurance from its captive. In the early years of owning a captive, a business can insure risks that third party insurers will not insure or risks where the cost to insure with a third party is prohibitive.
These are risks that many businesses regularly face and informally self-insure. Which means that if an event occurs, the business “bites the bullet,” often taking a loss, laying off workers and possibly facing partial or total closure. With ERM and a captive insurance company in place, businesses can formally insure risks not normally insured by third party insurers.
Premiums are paid from the parent company to the captive with pre-tax dollars (up to $1.2 million annually if the captive makes an 831 (b) tax election). Captive reserves can be translated into virtually any other type of asset (some domiciles have restrictions). Hence premiums paid to the captive are in effect a “transfer of wealth” and are protected from the parent company’s creditors and lawsuits. For this reason (tax savings and reserve accumulation), a captive insurance company is an advanced strategy that helps successful businesses transition into successful wealth engines.
The Window For Successful Businesses To Implement The Advanced Strategy Of Forming A Captive And Paying Premiums In 2015 Is Closing
It takes 60 to 90 days to form a captive insurance company. Call us to discuss whether or not a captive insurance company or additional captive insurance company is the right move for your business.