One approach for a business owner to increase profit and further protect the business is the buy-up or stand-up all of the vertical businesses that support the core business. Think of starting or acquiring additional businesses as an approach to build and protect a wealth engine. This is often described as vertical integration, and it is often effective because a supplier or service provider is already making a profit serving the parent company.
For example, consider a successful business owner that chooses to stop leasing a facility in favor of purchasing a facility inside a new company owned by the business owner. In this situation, the business owner can now earn a profit on two companies and can depreciate the real estate asset in the second business to reduce taxable income as well. As another example, consider a manufacturer that purchases or starts a business in its supply chain. This manufacturer is now able to earn profits on both businesses and gain better control of risk…specifically, the risk of a key supplier folding or choosing to sell to a competitor.
For many profitable businesses, there is a simple, well-proven path to form a second, profitable business. Simply put, businesses can choose to OWN THEIR OWN INSURANCE COMPANY, known as a captive insurance company. In so many ways, a captive insurance company is the perfect second business (or third, or fourth…).
What is a Captive Insurance?
A captive is a unique insurance company. It includes its own corporation, insurance license, reserves, policies, policyholders, and claims. It is a sophisticated way to self-insure and is generally formed to insure the risks of its owners and related or affiliated third parties.
A captive insurance company can serve as the backbone of an Enterprise Risk Management strategy (ERM). ERM is a more sophisticated approach to risk management that holistically expands its risk management approach in 2 dimensions – time and space. In the time dimension, a company implementing ERM shifts from managing risk year-to-year to managing risk over a 10 to 50 year horizon.
This is possible because an ERM strategy with one or more captive insurance companies in place will usually accumulate loss reserves, providing increased risk management flexibility in the future. In the space dimension, an ERM approach results in a wider risk management and insurance umbrella. This occurs because the business conducts a broad risk assessment of all threats the business faces. An ERM strategy is developed and includes broader (or more) lines of insurance coverage. Typically, this larger insurance umbrella includes a blend of third party commercial insurance coverage and insurance coverage provided by the captive insurance company.
How Does A Second Company Create A Proven Profit Center?
First, the parent company is now able to insure risks that were previously uninsured.
Second, the overall (or aggregate) profit / wealth of one or more companies with a captive insurance company is usually higher than the overall (or aggregate) profit / wealth of one or more companies without a captive insurance company. This occurs for two primary reasons. First, the parent company takes an expense as it pays its insurance premium to its captive. This lowers the parent company’s taxable income. And, the captive may be taxed as an insurance company. Insurance companies receive favorable tax treatment. Second, the captive is able to earn a return on its reserve pool (or assets). And, the captive’s asset pool has been amassed under insurance company taxation, enabling asset growth on a larger starting base.
How Does a Captive Insurance Company Create A Profit Center And Increase Total Wealth?
A captive provides many benefits to its parent company or business owner including risk mitigation, asset protection, security from creditors and increased profits. As such, a captive can form the backbone of a comprehensive ERM approach as outlined above. A captive primarily insures its parent company or related companies. Hence, the parent company is able to purchase insurance from its captive. In the early years of owning a captive, a business can insure risks that third party insurers will not insure or risks where the cost to insure with a third party is prohibitive.
These are risks that many businesses regularly face and informally self-insure. Which means that if an event occurs, the business “bites the bullet,” often taking a loss, laying off workers and possibly facing partial or total closure. With ERM and a captive insurance company in place, businesses can formally insure risks not normally insured by third party insurers.
Premiums are paid from the parent company to the captive. Captive reserves can be translated into virtually any other type of asset (some domiciles have restrictions). Hence, premiums paid to the captive are in effect a “transfer of wealth” and are protected from the parent company’s creditors and lawsuits.
For this reason (additional insurance protection, insurance company taxation and reserve accumulation), a captive insurance company is quite often a successful and profitable “second business.”
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