As a business grows, businesses owners may choose to start or acquire an additional business that serves their core business. 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, a manufacturer may choose to purchases or start a business in its own supply chain. This gives the manufacturer greater control of its supply chain. It also enables the manufacturer to earn profits on both businesses and gain better control of risk including the risk of a key supplier folding or choosing to sell to a competitor.
This situation, however, is not without risk. In some cases, the manufacturer may be ill-prepared to run another company. Their supplier may have expertise or sourcing advantages that the manufacturer is unable to replicate. And, choosing to compete with a supplier may embolden them to “pull out all stops” to support a business’ competitor.
Is There A Low Risk AND Low Effort Way To Set Up Another Profitable Business?
Actually, there is. A successful business can elect to set-up and own its own insurance company, specifically, a captive insurance company. This can be a low risk endeavor because the business can choose to keep existing third party insurance coverage intact and utilize the captive to cover gaps in its existing risk profile. Also, by using an experienced and proven captive manager, a business does not need expertise in operating its own insurance company. The captive manager does almost all of the work.
What Is A Captive Insurance Company?
Simply put, a captive insurance company is an insurance company. It is a C corporation and is licensed and domiciled like any large insurance company. Captives also have their own reserves, policies, policyholders, and claims. Owning a captive insurance company is a sophisticated way to self-insure, and captives are generally formed to insure the risks of a business, group of businesses and related or affiliated third parties.
What Are The Benefits Of Owning A Captive Insurance Company?
First, the parent company is able to benefit from a more robust risk management approach. Specifically, the parent company or companies can now formally insure risks that may have previously been uninsured.
Second, the overall (or aggregate) wealth of one or more companies with a captive insurance company is almost always higher – significantly higher – than the overall wealth of 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 companies taxable income. And, the captive does not pay taxes on the premium it collects (up to $1.2 million annually). Second, the captive is able to earn a return on its reserve pool (or assets). And, the captives asset pool has been amassed with pre-tax dollars, enabling asset growth on a larger starting base.
How Can Starting Another Company Significantly Boost Wealth?
A captive provides many benefits to its parent company or business owner including risk mitigation, asset protection, security from creditors and increased profits. 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 an 831 (b) captive in place, businesses can formally insure risks not normally insured by third party insurers.
Adverse events are going to occur whether or not a business has a captive insurance company in place. Businesses with a captive in place have a much larger pool of funds to address adverse events (typically 80% to 100% more) because captive assets are comprised of pre-tax dollars. Hence, the captive effectively acts as a legal tax shelter for the premiums received from its insured.
Premiums are paid from the parent company to the captive with pre-tax dollars, and accumulate tax-free as reserves of the captive (up to $1.2 million annually). 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 (tax savings and reserve accumulation), a captive insurance company is quite often a successful and profitable “second business.” Over time, a well- structured captive can often double a business owner’s wealth.