It’s well understood that wars make or break countries. What’s not so well understood is that wars and conflicts can make or break businesses and business owners as well. Last week, we noted that “in increasingly uncertain times, most small and mid-size businesses are underinsured.” Our thesis was further hammered home by an article last week in Captive Insurance Times that emphasized that corporate risk managers expect increased uncertainty in the next 10 years. Not surprisingly, such uncertainty requires greater preparedness on the part of businesses and suggests a compelling need for successful small and mid-size businesses to own their own insurance company.
In a Captive Insurance Times article titled “International Conflict The Biggest Risk In 2015,” published January 15, 2015, author Stephen Durham wrote that the 10th Edition of the Global Risks Report cited “The biggest threat to the stability of the world in the next 10 years will come from the risk of international conflict.” The large-scale survey included input from over 900 risk managers.
Durham’s thoughtful summary of the Global Risk Report noted that,
“The report has found “interstate conflict with regional consequences” as the number one global risk in terms of likelihood, and the fourth most serious risk in terms of impact. In terms of likelihood, it exceeds extreme weather events, failure of national governance systems, state collapse or crisis, and high structural unemployment or underemployment. Other top and potentially impactful risks include the rapid and massive spread of infectious diseases, weapons of mass destruction, and the failure of climate change adaptation.”
To read the entire article in Captive Insurance times, CLICK HERE.
In today’s inter-connected and global business climate, conflicts, sanctions or embargos could have a serious impact on many small and mid-size businesses. Michael Chindamo of Fautores Family Offices in Orlando, Florida shared a report by Price Waterhouse Coopers on family owned businesses with us. The report noted that 60% of family owned businesses earned export revenue in 2014. 60% is a staggering number. If you would like a copy of the report, please let me know. The report did not address family owned business reliance on overseas suppliers, but the number is likely 60% or more as well.
Clearly, the prospect of international conflict in the next ten years is real and daunting. This reinforces our thesis that most small and mid-size businesses are underinsured. At a minimum, most could benefit from robust insurance policies addressing:
– Business Interruption
– Supply Chain Interruption
– Loss of Key Customers
– Kidnap and Hostage
– Indirect Losses Caused by Any of the Above
Pondering this Global Risk Report raises three key questions.
- Why don’t most small and mid-size businesses carry the robust insurance policies outlined above?
- Should most small and mid-size businesses carry the robust insurance policies outlined above?
- Is there a better alternative?
Let’s start with question 2. The answer is usually “yes.” All business owners must do a cost / benefits analysis when taking on business expenses and planning the future of the business. Decisions concerning risk management, risk management systems and insurance are no different.
Which brings us to question 1. In doing a cost / benefit analysis (even if it’s a simple mental exercise), there are numerous obstacles to placing a business in a heightened risk management posture, including the purchase of the robust insurance policies outlined above. As we have noted in prior Captivating Thinking articles, third party commercial insurance is a sunk cost. Yes, the business owner benefits from peace of mind, and, in many cases, compliance with laws requiring minimum insurance coverage. However, if the business doesn’t suffer losses and file claims, all money paid in premiums is gone forever.
It’s not difficult to imagine a scenario, where a healthy business would spend thousands of dollars to purchase millions of dollars of insurance coverage for supply chain, loss of key customers and business interruption. In an increasingly uncertain world, these types of coverage are expensive with costs likely to escalate in the future. After five years, the business owner drops coverage to increase investment in a capital project. As fate would have it, a regional war ensues and cuts of access to a key supplier, crippling the business. Five years of insurance premiums paid are down the drain and of no use as the business owner struggles to survive, possibly laying off talent, losing key customers, or even choosing to close the business.
In addition to third party commercial insurance coverage being a sunk cost, it’s important to note that most insurance policies are riddled with exclusions. In the example above, imagine if the business owner had supply chain insurance, but the U.S. government declared the regional conflict an act of terrorism – not war. If the supply chain interruption policy excluded terrorism, the insurance policy purchased is worthless.
This brings us full circle to question 3. Congress provided small and mid-size business owners a far better alternative when it passed the Tax Reform Act of 1986. This legislation was passed by a Democrat controlled Congress and signed by a Republican President (a true piece of bi-partisan cooperation) and paved the way for “small” captive insurance companies. This legislation was a real game changer for small and mid-size businesses, because it made it feasible and affordable for small and mid-size businesses to own their own insurance company – specifically, a captive insurance company. Large corporations had owned captive insurance companies for decades, but until 1986, they were effectively out of reach for smaller businesses, which are the real backbone of the U.S. labor market.
Importantly, it didn’t stop there. Congress wanted to encourage small and mid-size businesses to significantly improve their risk management and survivability posture, so it built in a tax incentive known as the 831(b) tax election. Commercial insurers and large captive insurance companies already received tax advantaged treatment, because they operated under insurance law. The 831(b) tax election simplified accounting and operations for “small” captives.
Captives overcome the trade-offs outlined above. Businesses can improve risk management, buy the robust insurance policies desperately needed in uncertain times and be covered by insurance policies with few or no exclusions. Most importantly, captives overcome the sunk cost dilemma outlined above because the business owner or owners own the insurance company. The genesis of “small” captives is one of the crowning jewels in the Ronald Reagan and Tip O’Neill era.