In our last “Captivating Thinking” article, we noted that most small and medium size businesses are under-insured. The 21st century economic, technological, political, regulatory, social and legal climate is very different than the climate businesses faced in the recent past. Simply put, businesses face far greater risks both in the spectrum of possible threats to a business and the magnitude or potential loss those threats pose. Most businesses insure common risks like theft, fire and general liability. However, there are a host of other risks that businesses face that are either specific to their industry or thrust upon them in the rapidly changing business climate.
Lawsuits are far more common in the current business climate, and lawsuits can come from both outside or inside a company. Businesses face more and more regulations, and it’s not uncommon to read a news article about a business crippled or closed down by regulators. Many businesses today also face cyber risks and threats to data security and IT systems. As if that is not enough, terrorism in the U.S. now poses a legitimate threat to businesses. And, many of these “new” risks are not covered by typical third party insurance policies. These types of coverage often require additional policies that are often very expensive.
Should Businesses Simply Buy More Third Party Insurance to Address the Myriad of Risks Facing Their Business?
In some cases, the answer may be “yes.” But, in most cases the answer is “no.” In our last article we noted that insurance premiums paid to a third party commercial insurer are a SUNK COST. After a year or two or three or ten or twenty with no claims, a business is left at the end of the term with nothing to show for it. It’s that simple, there is nothing to show for all those insurance premiums paid. This forces businesses to be particularly selective about the insurance coverages they purchase.
Is a “Rainy Day Fund” a Good Solution?
A “rainy day fund” is certainly preferable to having no “rainy day fund.” These funds would usually be set aside as retained earnings in the business or as savings by the owner or owners. In either case (retained earnings or savings) both are set aside using after-tax dollars. A “rainy day fund” can be reserved to cover risks or threats to the business. This approach to risk management can also be described as informally self-insuring risk. In essence, informally self-insuring risk is choosing to take the risk and risk “taking the hit” should a loss or adverse situation occur.
How Does Informal Self Insurance Via a “Rainy Day Fund” Compare to Additional Third Party Commercial Insurance Coverage?
The positives of a “rainy day fund” are that it provides some risk management, gives a business financial flexibility and avoids the “sunk cost” of purchasing additional third party commercial insurance. The negatives of a “rainy day fund” as both a risk management and financial tool are that it is funded with after-tax dollars and provides reduced dollars for loss mitigation in the event of an adverse event.
The positives of purchasing additional third party commercial insurance are that it provides far more financial recompense should a loss occur and it is funded with pre-tax dollars. The greatest negative of purchasing additional third party coverage is that premiums paid are a sunk cost. Also, many standard insurance policies contain provisions, caveats and policy limits that can result in a loss being only partially covered or not covered at all.
Is There a Solution that Eliminates the Trade-Offs Outlined Above?
The formation of a captive insurance company can help business owners avoid being under-insured without the “sunk cost” of paying insurance premiums to a third party insurer and having nothing to show for it. The business or business owner or related parties own the captive insurance company. Hence, the premiums paid to the captive to insure risks faced by the business are not “sunk costs.” They are insurance reserves and profits owned by the captive owner.
Furthermore, captive insurance companies allow owners to customize their insurance coverage. Said another way, policies can be written to perfectly address the businesses identified risks as well as gaps. And, policies can be written without the various exclusions and caveats that are contained in most third party commercial insurance policies.
Also, captive insurance companies are real insurance companies, and they operate like real insurance companies. As such, their reserves set aside to pay claims are not taxed. Small insurance companies, defined as receiving annual premiums of $1.2 million or less, may make an 831 (b) tax election and are not taxed on their reserves for claims or their underwriting profits. Hence a business or business owner is able to formally insure risk via a captive insurance company, pay $1.2 million in premiums annually to the captive insurance company, and the $1.2 million paid to the captive is not taxable.
Assuming a combined tax rate of 50% (federal and state), a business or business owner can essentially double the funds set aside in a captive insurance company versus the funds set aside in a “rainy day fund” to pay for losses incurred by the business.
What Is A Captive Insurance Company?
A captive is a unique insurance company. It includes its own corporation, insurance license, reserves, policies, policyholders, and claims. It is a formal way for business owners to self-insure risk, and captives are generally formed to insure primarily though not exclusively the risks of one or more businesses owned by the same or related parties.
How Does a Captive Insurance Company Work?
A captive primarily insures its parent company or related companies. Hence, the parent company is able to purchase insurance from its captive, and it can insure risks that third party insurers will not insure or risks where third party insurance cost is unaffordable.
Premiums are paid from the parent company to the captive with pre-tax dollars. The captive can invest its assets mostly as its owners choose (some domiciles have restrictions).
Call us to discuss whether or not a captive insurance company or additional captive insurance company is the right move for your business