For many business owners and CFOs, risk management is not an enjoyable topic. So, how can Enterprise Risk Management (ERM) surge wealth? After all, a complex nomenclature like “Enterprise Risk Management” sounds like code for “spend more money.” However, the opposite is the case. Developing and executing a more mature risk management approach – described as ERM – will almost always increase the total wealth of a business and its owners, while better managing risks.
Over the years, entrepreneurial thinking has created tremendous wealth in the United States, fueled upward mobility, expanded the middle class and provided a standard of living that would have been unimaginable to America’s founders. This same entrepreneurial spirit gave rise to captive insurance companies as enterprising businesses looked for a better approach to manage risk. In their early days, captives were primarily used to control insurance costs and ideally return a portion of premiums paid for insurance back to the parent company.
Beginning in the mid-80s, many businesses continued down an entrepreneurial path and shifted their mindset from risk management simply as a form of cost containment to risk management as a profit center. Indeed, a more mature approach to risk management can be quite creative and entrepreneurial. Making a paradigm shift from viewing risk management purely as a cost center to viewing risk management as a profit center and strategic pillar of the business can be very rewarding from a financial standpoint.
ERM is the paradigm shift that transforms risk management from a cost center to a profit center. Large corporations have employed ERM for some time, and this mature approach to risk management can also be adopted by small and mid-size companies. The chassis of an ERM approach is a captive insurance company (or companies). Captive insurance companies give business owners or CFOs the ability to take an active versus a passive approach to risk management. ERM increases depth of coverage and is a forward-looking approach to risk management. Furthermore, as a company’s ERM strategy matures, risk management can transition from being a cost center to serving as an entrepreneurial profit center.
Ownership of one or more captive insurance companies makes ERM possible, because a business is able to both:
- Increase depth of insurance coverage
- Increase the time horizon of its risk management approach
Increase Depth Of Insurance Coverage
When employing a mature ERM model, business owners can categorize risk as core risk, operational risk and strategic risk. Most businesses and individuals simply insure core risk and usually do so via third party commercial coverage. Utilizing an ERM approach, a captive insurance company, in its formative years, gives businesses depth of cover by addressing the second and third layers of risk management (operational risk and strategic risk). As the captive matures and amasses reserves, it can also play a role in addressing core risk. It’s worth noting that many non-core risks evolve into core risks. Examples include: cyber, supply-chain risk, extended warranties, administrative action, terrorism, receivables, key contracts, key employees and employment risk .
Increase The Time Horizon Of Risk Management
Another characteristic of a mature risk management approach is taking a forward looking stance. A short term approach to risk management typically buys insurance from year-to-year with the goal of keeping costs as low as possible. Each year, all premiums paid for third party commercial coverage are a “sunk cost.” At the end of the year, if there are no claims, the money is gone. Because a captive insurance company is owned by the business owner(s) or the parent company, premiums paid to the captive insurance company are retained after claims are paid. Wealth accumulates in the captive as insurance reserves and provides flexibility to the business in its risk management in future years. A captive facilitates an ERM strategy because it enables a multi-year approach to risk management.
Financial Impact Of ERM With A CIC
Adopting an ERM approach with a captive insurance company as the chassis can be a financial game changer for business owners. Because the business owner and/or company can reap additional profits from its captive insurance company, the organization will inevitably make risk management and risk mitigation a higher priority. Furthermore, as the CIC grows its reserves, it is in a position to help reduce total reliance on third party commercial cover for core risks. This can often be achieved by reinsuring deductibles and insuring additional potential losses not covered by commercial insurance (including losses above third party insurance policy limits). Finally, CIC ownership enables the business owner or owners to capitalize on the favorable tax treatment that insurance companies receive on their reserves set aside for future claims. A well-structured ERM strategy with a CIC can save a business owner up to $600,000 per year in taxes.
Because a captive insurance company is owned by the business owner(s) or the parent company, premiums paid to the captive insurance company are retained after claims are paid. Wealth accumulates in the captive as insurance reserves and provides flexibility to the business in its risk management in future years. A captive facilitates an ERM strategy because it enables a multi-year approach to risk management.
ERM with a captive insurance company is particularly powerful, because this approach enables a business or business owner to capitalize on insurance law. Fortune 500 companies and other large company CFOs have been capitalizing on insurance law and tax treatment since the 1950s. The exact same strategies are available to small and mid-size companies. As part of its ERM, a business can purchase insurance from its captive insurance company (ies). Premiums paid to the captive are a tax deductible expense to the parent company. The captive insurance company receives the premiums in a tax-favored manner as a large portion are set aside as reserves for future claims. Reserves are not taxed, hence the insurance company is able to invest and grow a large pool of money. Insurance companies amass wealth by investing large amounts of pre-tax reserves. It’s also worth noting that if the insurance company qualifies as a “small” insurance company (defined as receiving annual premiums of $1.2 million or less), it can make an 831 (b) tax election and be taxed at a 0% (zero percent) rate on its underwriting profits. Hence, a well-structured ERM strategy with a CIC can save a business owner up to $600,000 per year in taxes. This brings us full-circle to our headline, “Enterprise Risk Management Can Surge Wealth For Business Owners.”