Over the last four weeks, we have developed the thesis that most small and mid-size businesses are under-insured and that for many, the best remedy is to own their own captive insurance company. Owning a captive insurance company enables small and mid-size business owners to blend third party commercial coverage with coverage by their captive. This blended approach results in far more robust coverage, helps overcome the “sunk costs” trade-off of purchasing insurance, and can even turn risk management into a profit center.
A veritable stockpile of support for this thesis can be found at the U.S. Department of Homeland Security’s web-site Ready.Gov. It’s worth noting that this is a very thoughtful and well laid out web-site.
A quick perusal of this site is sobering. Ready.Gov notes that “40% of businesses affected by a natural or human-caused disaster never reopen.” Clearly, helping small businesses survive such disasters is important to the government and to our economy because, per the Small Business Administration’s statistics cited on the Ready.Gov website, such businesses “represent 99.7% of all employers, employ about half of all private sector employees, have generated 65% of all net new jobs over the last 17 years, and made up 97.5% of all identified exporters.”
The government site recognizes that low-frequency and high-impact risks are the ones that pose the greatest threats to small and mid-size businesses. Addressing small business disaster preparedness, Ready.Gov notes that:
• “Businesses can do much to prepare for the impact of the many hazards they face…including natural hazards like floods, hurricanes, tornadoes, earthquakes, and widespread serious illness such as the H1N1 flu virus pandemic.
• Human-caused hazards include accidents, acts of violence by people and acts of terrorism.
• Examples of technology-related hazards are the failure or malfunction of systems, equipment or software.”
Consider “Human-caused hazards [like] terrorism.” Ready.Gov makes it clear that any business, large or small, in the U.S. could be impacted by terrorism. Businesses should have business interruption insurance for lost revenue caused by terrorism including chemical, biological or nuclear attack. Businesses should also be insured for business interruption caused by failure of the power grid (due to natural disaster, terror attack or a solar storm). Also, businesses should have robust business interruption insurance to cover lost revenue in the event of a pandemic disease in the U.S. It is not inconceivable that the government would confine all non-essential workers to their homes for 30, 60 or 90 days to stem a national emergency.
The above mentioned risks are real and can have significant impact as Ready.Gov makes clear. In fact, the terrorism risk in particular is so real that Congress had to pass the Terrorism Risk Insurance Act (TRIA) in order to induce the insurance industry to issue certain types of terrorism policies at all. And, even then, these policies still usually only cover property damage (not loss of revenue), and they exclude the most extensive risks (like chemical, biological, nuclear or radiological attack) completely.
Furthermore, commercial insurance policies for all the risks outlined above including corresponding business interruption coverage can either not be purchased or is prohibitively expensive for many small and mid-size businesses. For many of these risks outlined on Ready.Gov, the best risk management approach is to blend third-party commercial insurance coverage with additional insurance coverage provided by a captive insurance company owned by the business or its owners. Captive policies are more flexible than commercial policies, have few or no exclusions and avoid the “sunk cost” trade-off of commercial insurance.
Ready.Gov advises small businesses to purchase insurance as a means of mitigating the financial impact of such risks. However, purchasing commercial, mainline insurance to protect against all or most such existential risks is cost-prohibitive to the typical small business, amounting to ten percent or more of off the businesses gross revenue in some instances. What small business can afford to devote more than ten percent of its gross revenue to the “sunk cost” of purchasing third-party commercial insurance, especially when that insurance is notoriously riddled with exclusions and limitations?
This is why small businesses are increasingly using small captive insurance companies instead. Not surprisingly, Congress explicitly incentivizes small businesses to do so by providing the 831(b) tax “benefit”.
An 831(b) tax election permits a Captive Insurance Company (usually owned by the business or the business owner) to retain underwriting profits in the event that none of the existential threats discussed on Ready.Gov materialize. These profits may eventually be plowed back into the business. Profits from insuring unrelated third parties (via participation in risk distribution pools) further reduce overall insurance costs to the business, and the pools themselves serve to diversify the business’ risks. Insurance policies obtained via the associated captive insurance company and risk pool typically have far fewer exclusions, better positioning the business for long term survival.