Entrepreneurial thinking and enterprises have 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 “grown up” 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.
CIC Services recently attended the 2014 Captive Insurance Companies Association (CICA) conference in Scottsdale, Arizona to stay abreast of legislative and regulatory changes that impact the captive insurance industry. The CICA conference also addresses new alternative risk concepts, emerging trends and best practices in the industry. We attended a presentation at the conference titled “Enterprise Risk Management For Captives And Their Parent Organizations.” This session was presented by Robert Walling, FCAS, MAAA, CERA, Principal and Consulting Actuary at Pinnacle Actuarial Resources and Barry Franklin, SVP & Chief Risk Officer, Zurich North America.
Enterprise Risk Management (ERM) requires a paradigm shift in thinking about risk, but this paradigm shift is financially rewarding. Large corporations have employed ERM for some time, and this mature approach to risk management can also be adopted by mid-size and smaller companies. The backbone of an enterprise risk management approach is a captive insurance company (or companies). Mr. Walling noted that a captive insurance company “offers the opportunity to engage in ERM because it enables the business (or business owner or CFO) 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.
Last week, we discussed ERM as presented at the CICA Conference and its multi-tiered approach to risk management, including addressing core risk, insurable risk and business risk. This article will discuss ERM (“grown up” risk management) as a profit center.
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 and ERM strategy because it enables a multi-year approach to risk management.
At the CICA conference, Robert Walling gave examples of companies implementing ERM that matured their risk management strategy into a profit center. He noted that numerous trucking companies with well-run, profitable captives have decided to extend insurance coverage to owner/operators. The trucking companies have been able to provide auto liability and cargo liability coverage to owner/operators while simultaneously enabling owner/operators to buy insurance at a lower cost. This has been a competitive advantage to the trucking company in securing owner/operators and also a profit center as the insurance company has returned profits to the parent company. Robert noted that some trucking companies have been so successful in their insurance operations that they even insure their competitors. International Harvester, a large equipment manufacturer, is another example of an entrepreneurial business that utilizes its captive insurance company to insure competitors.
Mr. Walling also provided the example of Firestone roofing materials. Firestone utilized its captive insurance company to provide insurance coverage to contractors who installed their roofing products. In doing so, Firestone was able to provide lower cost insurance to contractors while insuring that contractors installed their product correctly. Providing insurance put Firestone in a position of control over the installation process. This insurance program through its captive was also profitable and impacted Firestone’s bottom line.
The most interesting example of the expansion of risk management to create a profit center was an example Mr. Walling provided about a company that manufactures crop duster airplanes. This manufacturer turned its captive insurance company into a profit center by providing overspray liability insurance provided to businesses that buy their planes.
In addition to the creative examples outlined above, employing ERM with a captive insurance company 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.