2020 has been a brutal year for many businesses. First COVID-19 struck leaving many business leaders blindsided and their companies crippled. Some businesses have thrived, some have survived, some have eked by and others have folded. Paycheck Protection Program (PPP) loans have helped some businesses, but for many, the help was too little too late. Also, the nature of the pandemic has insulated most commercial insurance companies from paying business interruption (revenue replacement) claims to businesses. The majority of business interruption commercial insurance policies are tied to a property policy and only triggered if property is actually damaged.
And recently, a new threat has arrived: civil unrest. And, unlike many prior periods of civil unrest characterized by peaceful protests, strikes and “sit-ins,” this civil unrest has been characterized by violence, wonton property damage and looting.
A “one-two punch” from both COVID-19 and civil unrest will be even more difficult for many businesses to survive. According to the Insurance Information Institute, losses from the 1992 Rodney King driven civil disturbance in Los Angeles totaled $1.42 billion in today’s dollars and the current rioting could rival that figure.
Unlike COVID, civil unrest brings a whole new set of problems for businesses. Many businesses have had their properties damaged by rioters, and their commercial insurance policies can be expected to cover their property losses. However, some insurers are pushing back on paying business interruption (revenue replacement) losses for businesses impacted by civil unrest because business interruption could theoretically be caused by COVID and not by rioters. Also, businesses may have weathered COVID-19 and not experienced property damage by rioters, but civil unrest has still caused business interruption. And, because their property wasn’t actually damaged, their business interruption coverage isn’t triggered. The neighborhood near or around their business may be in shambles, but help won’t be on the way.
Finally, the rarely discussed impact of civil unrest on businesses is the pressing need to relocate and not rebuild. Many business owners will need enough money to move and start over, and the payment they receive from their commercial insurance may not be enough. Businesses that decide to stay may find it difficult or even impossible to obtain insurance. As the saying goes, “fool me once, shame on you, fool me twice, shame on me.” Commercial insurers don’t like “shame on me” moments, and communities where people will destroy their own neighborhood aren’t a good bet for providing coverage.
COVID? Civil unrest? 2020 is barely half over and 2021 may be worse – What is a Business Owner To Do?
So, for some business owners commercial insurance may be enough to ride out the impact of civil unrest, but for others, insurance may come up short. What’s a business owner to do?
Similar to 2001 and 2008, 2020 has demonstrated the need for middle-market companies to be prepared for the unexpected. And, the most straightforward to be prepared for the unexpected is to have more robust insurance coverage and more cash. For example, a business with more robust insurance coverage might have purchased business interruption policies that included triggers like:
- Pandemic disease
- Natural perils
- Loss of access to their location
- Supply chain interruption
- Government & regulatory actions
- Loss of key account
And, a business with more cash or access to more cash could more easily ride out a business slowdown or pay to move its operations in the face of civil unrest.
What is a middle-market business solution that provides both more robust insurance coverage and more cash?
For mid-market companies facing the rest of 2020 and unknown crises in the future, a solution that provides more robust insurance coverage and greater cash or liquidity is to own a captive insurance company. By combining commercial insurance with a captive insurance company, a business owner can establish a far more comprehensive and thorough risk management approach. This 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 business to address contingencies or unanticipated risks – extra cash.
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.
Captive insurance companies can:
Fill Commercial Insurance Party Gaps
A captive insurance company can issue insurance policies that address gaps not covered by commercial insurers. Captives can also insure deductibles, enabling the parent company to raise its deductible and lower its commercial insurance costs. Also, a business can enjoy more broad business interruption coverage with a captive when an adverse event occurs, particularly events where commercial 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 (EG only have business interruption insurance if property is damaged) 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 Cash
Over time, businesses can build up substantial cash with a captive insurance company. This cash 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 $2.3 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 weren’t in place.
Reap Long Term Insurance Profits
When business owners are ready to sell their business or retire, they keep the cash. A successful captive amasses wealth for its owners that can be accessed and enjoyed in the future. This unique ability to improve risk management and simultaneously stockpile cash makes owning a captive insurance company the clear choice in a post-COVID, post-riot world.
2020 has been a roller coaster year. We don’t know if we are heading into the Roaring ’20s, the Boring ’20s, The Goring ’20s or the Waring ’20s. We hope it’s either roaring or boring. Nevertheless, before another crisis strikes, now is the time for businesses to review their insurance policies and determine whether their insurance is truly enough to cover them when another storm comes. If the ’20s are goring or waring, businesses will want more robust insurance and more cash to meet the challenges ahead.
Learn More About Captive Insurance – CLICK HERE.