One of the greatest challenges that small and mid-market businesses face is building up sufficient liquid reserves. It has often been said that, “Cash Is King,” and liquid assets are key to the long term health and survival of an enterprise. Being in a strong cash position is particularly important if an unforeseen calamity strikes. Also, liquidity enables businesses to quickly adapt or pivot to address changes in the marketplace.
I recently talked with an insurance agent in the Mid-West who explained why many farmers were land and equipment rich but cash poor. During good years, many farms are quite profitable, creating strong cash flow. However, to avoid high taxes many farmers purchase brand new equipment, even if their current equipment is fairly new and in good working order.
Our experience in business has revealed two time-proven destroyers of liquid reserves:
Destroyer #1 – Uninsured Losses
Destroyer #2 – Taxes and/or Tax Incentives
As an example, consider taxes on “excess” retained earnings, known as the Accumulated Earnings Tax. This tax is deliberately designed to discourage business wealth and liquidity. The Accumulated Earnings Tax (AET) is a penalty tax, imposed on C corporations perceived as trying to avoid or defer shareholder income tax through an “unnecessary” accumulation of earnings. The AET threat is intended to encourage corporations to make timely payments of dividends, thus triggering the double taxation of C corporation earnings. There is no bright-line test to define when a C Corporation is purposely avoiding income tax or what is an impermissible accumulation of earnings. Once an IRS agent asserts that there is an excess accumulation of earnings, the burden of proof shifts to the taxpayer to substantiate that the accumulations were for anticipated needs and were reasonable in nature.
Can Liquidity Destroyers 1 & 2 Be Meaningfully Addressed?
The great news for business owners is that Destroyers 1 and 2 outlined above can be addressed by one game-changing, risk management and financial strategy – Enterprise Risk Management (ERM) with a Captive Insurance Company (CIC). The chart below that visually depicts the powerful benefits of implementing an ERM approach with one or more CICs. Indeed, we know of no other risk management and financial vehicle that affords its owners the array and magnitude of benefits that captive insurance companies do. By choosing to own their own insurance company, a business owner or CFO is able to simultaneously have more insurance protection and more money.
The chart below compares the status quo on the left with ERM implementation and captive ownership on the right. This illustration covers a 10 year period and assumes a 4% rate of investment return for both scenarios. Both businesses have third party insurance coverage in place to insure core risks. The business on the right which implemented ERM with a captive insurance company has more insurance coverage and more money. In fact, over a ten year period, the business on the right has almost 80% more wealth (or liquid reserves) than the business on the left.
Understanding Liquidity Destroyer 1
Today, small and mid-size business owners face far greater challenges than their predecessors faced. In fact, they are far more likely to face existential threats that can drain their limited cash reserves or completely wipe out their operations. For instance, cyber risk is a growing and wildly unpredictable threat. Terrorism and impact from international conflicts are very real threats to businesses and their operations (Even if a business isn’t directly targeted, how long can cash reserves last without power…without infrastructure…without key suppliers…without key customers?).
Spending a little time on Ready.Gov, the U.S. Department of Homeland Security’s business preparedness web-site, puts the threats listed above into perspective. The threats are real and their impact can be catastrophic. Ready.Gov notes that “40% of businesses affected by a natural or human-caused disaster never reopen.”
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, largely because they can wipe out liquidity. 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.
In addition to the existential threats covered above which can quickly empty business coffers, small and mid-size business owners face risks posed by their own governments – local, state and federal. Government regulators wield more power than in bygone days. Overzealous government regulators often “shoot first and ask questions later.” They often have the power to shut down a business until a dispute can be resolved by the courts.
Finally, litigation is an ever-increasing threat to business owners and liquidity, and the dangers come from inside and outside of their businesses. Business owners and their staffs must navigate a complex maze of employment laws, healthcare laws, worker’s compensation laws, environmental laws, tax laws and many other laws that can result in costly lawsuits. Also, many commercial insurance liability policies will cover damages, but do not cover punitive damages awarded in a lawsuit. In many cases, punitive damages awarded to plaintiffs are 3 to 10 times higher than compensatory damages.
ERM with a CIC can address the liquidity threats outlined above by supplementing commercial insurance coverage with insurance coverage provided by the CIC.
Addressing Destroyer 1 – Enterprise Risk Management – Blending Third Party Insurance With Formal Self-Insurance
For many, a far more powerful approach to risk management is Enterprise Risk Management that results in a layered or blended approach. By combining third party insurance with a captive insurance company, a business owner can establish a far more comprehensive and thorough risk management approach. ERM is also a better forward looking approach, because the captive insurance company will accumulate additional reserves in years with low claims. These ERM reserves can provide more robust insurance coverage in the future and, when necessary, can be accessed by the owner (or CFO) as a war chest to address contingencies or unanticipated risks.
What Is A Captive Insurance Company?
Simply put, a captive insurance company is a closely-held insurance company that insures primarily thought not exclusively your business. 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. Insurance policies are issued by the captive to its parent or related companies and are actuarially priced. 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. A captive (or captives) form the chassis of a small / mid-size business ERM strategy.
Why Is ERM With A CIC A Powerful Approach To Address Destroyer 1
A CIC is one of the most powerful risk management and wealth accumulation tools that a business can access. When properly employed, there is nothing else that can do what a captive insurance company does. By operating their own insurance company as part of ERM, business owners and CFOs can:
Fill Third Party Gaps
A captive insurance company can issue insurance policies that address gaps not covered by third party insurers. Captives can also insure third party insurance deductibles, enabling the parent company to raise its deductible and lower its third party insurance costs. Also, a business can enjoy more broad business interruption coverage with ERM and a CIC when an adverse event occurs, particularly events where third party insurance doesn’t cover all damages or peripheral damages.
Utilize Customizable Coverage
Captive insurance companies can write customizable coverage for the businesses they insure. Many businesses face unique risks that may not be addressed by commercial insurers. Unique coverages can also be very expensive when covered by commercial insurers. This feature enables business owners and CFOs to say, “this has gone wrong in the past, let’s insure against it in the future,” or “other companies have experienced this adverse event, we can insure this via our captive.” The flexibility afforded by a ERM with a captive is extremely beneficial in a complex world.
Benefit From Few Or No Policy Exclusions
Captives can provide broad coverage without the exclusions that riddle typical commercial insurance policies. Insurance coverage is worthless if an exclusion prevents the insured from receiving a claims payment when it needs it most.
Avoid Sunk Cost Of Third Party Insurance
Premiums paid to a captive insurance company remain the property of the captive owners (usually the business or business owners). One of the reasons that most businesses are underinsured is that purchasing insurance is a bit like purchasing a lottery ticket. If you don’t win (or in the case of insurance, experience an adverse event resulting in a claim), your money is gone with nothing to show for it. With a captive, this simply isn’t the case. Profits in the captive, defined as premiums collected less claims paid, belong to the captive owners.
Addressing Liquidity Destroyer 2 – Taxes
Over time, businesses, owners and CFOs can build up a substantial war chest with ERM and a captive insurance company. This war chest is available to pay insurance claims the business may have. And, it can also be accessed should the owner or the business require liquid funds. Assets accumulated in a captive almost always outpace retained earnings or a business’ “rainy day fund.” Because the captive is a formal form of self-insurance, it benefits from insurance law and favorable tax treatment. Hence, it is able to accelerate asset accumulation for two main reasons.
First, premiums paid to the captive receive favorable tax treatment. Premiums paid to the captive are an expense to the parent company. This lowers the parent company’s taxable income. As, the captive takes in premiums, it is taxed as an insurance company on its underwriting profits (typically defined as premiums less reserves to pay future claims). For large insurance companies, underwriting profit is actuarially determined. However, small insurance companies can make an 831 (b) tax election, resulting in a tax rate of 0% (that’s zero percent) on their underwriting profit. A small insurance company is defined as receiving premiums of $1.2 million or less per year.
Second, the captive is able to invest and grow larger pool of assets. Large commercial insurers have entire staffs whose sole purpose is to invest reserves (that have not been taxed).
For these reasons, ERM with a well-run captive insurance company will typically double liquid capital. And, the same claims that would be paid by the captive would have to be covered out of retained earnings anyway if the captive weren’t in place.
The Long Term Benefit Of Defeating Destroyers 1 & 2
When business owners are ready to sell their business or retire, they keep the war chest. A successful captive amasses wealth for its owners that can be accessed and enjoyed in the future. This unique ability to improve risk management and simultaneously stockpile wealth makes ERM with a CIC The Most Efficient Approach For Businesses To Build Liquid Reserves.