A “sunk cost” is typically defined as money that once spent is never recovered. In many ways, commercial insurance is a “sunk cost.” Aside from providing peace of mind (which is a real benefit) and possibly meeting contract requirements (EG the state requires worker’s comp insurance and the bank requires property insurance), insurance premiums are never recovered unless the business has a loss and a claim. But… businesses don’t want to have a loss and a claim, because it results in higher insurance costs in the future.
In today’s challenging economic climate, business owners, CFOs and advisors including CPAs and attorneys owe it to themselves to be vigilant in pursuing strategies that will safeguard the viability and wealth of the business and its owners. The sort of vigilance in view often requires rethinking business paradigms to look for ways to avoid sunk costs. This can also include identifying “both – and” versus “either – or” solutions. “Both – and” thinking seeks to avoid trade-offs (and sunk costs), equivalent to “having your cake and eating it too.”
For example, an old paradigm in the automobile market was the assumption that large, heavier cars were inherently safer. Hence, moves to improve fuel efficiency would likely come at the expense (or trade-off) of safety. The automobile industry has rejected “either-or” thinking and produced innovative vehicles that make great strides in both safety and fuel efficiency. The development of lower weight, energy absorbing auto bodies, aerodynamic designs, air bags, computer controlled engines and hybrid electric engines have combined to produce “both-and” results.
“Both-And” Thinking For Mid-Size And Small Businesses
For small and medium sized business owners in a challenging economy, a particular area where “both-and” thinking can address sunk costs is insurance. Insurance is often viewed through an “either-or” lens. A well- conceived risk management and insurance strategy is a necessity. However, insurance is almost always a sunk cost. It is certainly a necessity and often critical to the survival of a business, but it remains a sunk cost. Each year, precious dollars spent on insurance premiums are gone. It is a mere cost of doing business. And, while most businesses would benefit from purchasing a broader range of insurance coverages, many don’t, because more insurance coverage means less money in the business and less wealth at the disposal of the business owner or CFO.
The paradigm shift required to overcome this “either-or” scenario is for business owners to make the choice to own their own insurance company. Specifically, a business can set-up and operate what is known as a captive insurance company. Large corporations have been utilizing captive insurance companies for decades, and recent laws favoring “small” captives and competition among domiciles have made captive ownership a powerful and accessible risk management tool and financial vehicle for a growing number of small and mid-size businesses. Such a decision propels a business from “either-or” to “both-and” thinking because a business that owns its own insurance company can benefit from both more insurance coverage and more wealth at its disposal simultaneously. This approach turns sunk costs into sunk profits.
“Both-And” (Sunk Cost Avoidance) Benefit: More Insurance Coverage
Most businesses are under-insured. If a business owner, CFO or risk manager were to take an hour or so and write down every threat to the business, it is likely the list would fill up several pages. And in most cases, businesses purchase third party commercial insurance for a fraction of the risks they face. The reality is that it’s not practical or remotely affordable to purchase third party insurance for many of the threats a business faces. However, by choosing to formally self-insure many of the risks facing a business through a captive insurance company, a business owner is able to provide a much broader umbrella of insurance coverage. This improved risk management approach does not require the business to replace existing third party commercial insurance policies, although a captive can be used to replace third party coverage if it is prudent and expedient to do so. For small and mid-size businesses, the best risk management approach is usually achieved by blending third party commercial insurance with broad lines of insurance coverage afforded by one or more captive insurance companies.
Captive insurance companies have the unique ability to write customizable insurance coverage. So, they can write policies that are specifically tailored for the specific needs and challenges faced by the parent company. It is often difficult and inefficient for third party commercial insurers to write customized policies. This reality often renders customizable coverage unaffordable or impossible to acquire. Another benefit of providing insurance coverage via a captive arrangement is that captive policies do not have to include the exclusions that characterize most commercial insurance policies. In this sense, policies issued by a captive can be “wide open,” which is particularly important when a business has a loss and needs the money. Also, claims approval and processing for captive claims are simpler, faster and more certain. For these reasons, a captive insurance company is a powerful vehicle to:
– Replace commercial insurance
– Insure Enterprise Risks
– Provide blended insurance coverage with existing third party insurance coverage
– Fill gaps in existing third party insurance policies including covering exclusions
– Insure risks that were previously uninsured
– Insure warranties
– Accomplish any combination of the above
“Both-And” (Sunk Cost Avoidance) Benefit: More Wealth
By choosing to own a captive insurance company, a business owner or CFO is also choosing to enjoy some of the benefits of insurance law and taxation. It’s no secret that most insurance companies are very profitable. The skylines of most major cities in America are dominated by stadiums, banks, and… you guessed it, insurance buildings. Large commercial insurance companies receive millions of dollars in premiums, and in return, issue policies promising to pay in the event an insured adverse event occurs. Large insurers use actuarial calculations to reserve a large portion of premiums collected for future obligations or claims. It is important to note that these reserves are not taxed. Insurance companies are taxed on their profits, essentially computed as premiums received plus investment income less reserves for future losses, less expenses. Expenses essentially include operational, administrative, marketing and sales costs of doing business. At their core, large insurers are a lot like banks. They have a large pool of untaxed assets to invest and grow.
Small captive insurance companies are quite similar to large insurance companies as described above. However, small captive insurance companies can benefit from an addition to the tax code that was added in 1986 by Congress and signed into law by President Reagan. Small captive insurance companies can make an 831 (b) tax election if they receive $2.2 million or less in annual premiums. When a small captive insurance company makes an 831(b) election, it is taxed at a rate of zero percent (0%) on its underwriting profits. Hence, premiums received less claims paid, less expenses result in underwriting profit which is taxed at zero percent. Similar to large insurance companies, small captives will almost always have a large pool of assets to invest and grow.
The parent company or companies deduct insurance premiums paid to the captive insurance company as a business expense. This lowers operating profit and reduces taxes paid by the parent company or business owner. Also, a captive insurance company may be owned by the business, the business owner, related parties or key employees. By complying with insurance law, a captive enables a business owner to achieve the “both-and” benefit of retaining and controlling more wealth.
Paradigm Shift: From Sunk Costs To Sunk Profits
“Both-and” thinking can transform a business’ total insurance portfolio from a “sunk cost” to a “sunk profit.” As an example, consider a profitable business that spends $300,000 per year on commercial insurance policies covering general liability, property and auto. In a year with no claims, the $300,000 spent on insurance premiums is a “sunk cost.” Now consider the same company with an improved risk management strategy and a captive insurance company in place. The business still pays $300,000 on commercial policies for general liability, property and auto. However, the business also pays $1,000,000 in premiums to its captive insurance company to acquire a wide range of additional coverages including reputational risk, administrative actions, legal expenses, cyber breach and data loss, loss of key employee, loss of key account, supply chain, directors and officers, employment practices, terrorism and a large umbrella policy. Assuming a year with no claims, the business owner or business ends the year with $1,000,000 in his or her captive insurance company. The parent company deducted $1,000,000 in insurance premiums and reduced taxes paid by the owner by $500,000 assuming 50% combined state and federal income taxes. The $500,000 in tax savings less $300,000 in third party commercial insurance premiums nets $200,000 in additional wealth retained and controlled by the owner in the total insurance portfolio strategy for the business. By choosing to own a captive insurance company and applying “both-and” thinking, a business owner can turn risk management into a profit center, transforming sunk costs of third party insurance into overall sunk profits in a captive owned and controlled by the business owner.