How Captive Insurance Can Offset Risks and Mitigate the Impacts of Legal Disputes in Economic Downturns
Legal disputes pose a significant financial risk for businesses, and the costs associated with them have been steadily increasing over the past few decades. Clients often face uncertainties and numerous questions regarding legal fees and potential financial liabilities if they are found responsible for these legal conflicts. Moreover, economic downturns tend to exacerbate the frequency of legal disputes as individuals and businesses seek remedies for financial losses.
In a May report, LendingClub Bank highlighted that in 2022, 64 percent of Americans lived paycheck-to-paycheck. This financial hardship prompts individuals to explore alternative financing options, including seeking legal funding, especially when traditional sources of financing are unavailable. One common form of legal funding is non-recourse, which means that if the case does not result in a favorable outcome, the party seeking funding is not obligated to repay the funder. Consequently, during times of economic difficulty, financially strained individuals are more inclined to pursue legal actions to alleviate their financial burdens.
Captive insurance provides a viable solution for business owners, particularly those operating in industries prone to legal disputes, such as construction and healthcare. By utilizing captive insurance, companies can protect themselves against potential financial and operational losses stemming from legal conflicts. Captive insurance offers more comprehensive coverage than traditional commercial insurance, enabling businesses to effectively mitigate risks.
The costs associated with legal disputes are substantial for both large and small companies. According to a study by the US Chamber Institute for Legal Reform (ILR), liability costs for businesses increased by 14 percent between 2016 and 2018. Small businesses, earning $1 million or less annually, bore the brunt of these costs, accounting for 39 percent of expenses related to legal disputes. Even larger businesses with revenues exceeding $50 million were responsible for an average of 37 percent of these costs. In 2018 alone, legal dispute-related costs for small businesses amounted to a staggering $343 billion.
The ILR study featured the story of Chuck Jones, owner of Jones Coffee Roasters, who endured a protracted legal conflict that drained hundreds of thousands of dollars from his business. The significant legal expenses incurred throughout the case deprived him and his family business of funds that could have been invested in hiring, expansion, or product development. This example highlights the potential financial ramifications that legal disputes can impose on ordinary small businesses.
Traditional commercial insurance often fails to adequately address the evolving risks that businesses face daily. This is where captive insurance steps in to fill the gaps. A captive insurance company, which is a wholly-owned subsidiary of the insured business, acts as a reservoir of capital in times of crisis. It can quickly adapt and provide the necessary coverage to meet the changing risk management needs of the business. In the current economic climate and amidst uncertainties, captive insurance can make the difference between weathering a crisis or succumbing to it.
Captive insurance also offers the benefit of deferring taxes on loss reserves, enabling businesses to accumulate larger funds for investment. Additionally, incoming premiums that are not utilized for claims or administrative costs contribute to the growth of loss reserves or become underwriting profits. Over time, captive insurance can evolve into a profit-generating entity.
Ultimately, the primary objective of captive insurance is to assist businesses in managing risks and minimizing potential losses stemming from legal conflicts. It serves as a valuable financial tool for CEOs and CFOs seeking to reduce business risks and maximize profits, particularly during economic downturns.