Businesses are always looking for ways to increase profit—and protect it. Amazon serves as a prime example. In 2017, Amazon acquired Whole Foods and utilized the stores to sell its products and thus increase its customer base. And in addition to offering online shopping, it has its own distribution and product transportation facility. Through vertical integration, where a business integrates and extends its operations within its supply chain, it can gain profitability in a few ways. It reduces transportation costs, gains access to distribution channels, provides increased cost control, and creates economies of scale.
It’s important to note that it’s 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.
However, vertical integration isn’t without its disadvantages. The costs of purchasing a supplier, retailer, or distributor can be significant and it can create a mountain of increased debt. It can also be challenging and complex to manage. So, what is a business looking to capitalize on vertical integration to do?
For many profitable businesses, there is a simple, proven way to vertically integrate by the creation of a second, profitable business. A business can own its own insurance company, known as a captive insurance company.
A captive is a unique insurance company. It includes its own corporation, insurance license, reserves, policies, policyholders, and claims. It’s a sophisticated risk mitigation strategy to insure the risks of its owners and related 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 two 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 will usually accumulate loss reserves, and the corresponding assets that support the loss reserves, provide increased risk management flexibility in the future. In the space dimension, an ERM approach results in wider risk management and enhanced insurance protection. 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 coverage 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?
Through the captive insurance company, the parent company is now able to insure risks that were previously uninsured or underinsured. In addition, the aggregate profit and wealth of one or more companies with a captive insurance company are predominantly higher than without a captive insurance company. This occurs for two primary reasons. First, the parent company is able to deduct the premiums paid to its captive as an expense. This lowers the parent company’s taxable income. Also, since captives are insurance companies, they receive favorable tax treatment for instance where underwriting profit is not taxable. Additionally, the captive is able to earn investment income on the assets supporting its reserves.
How Does a Captive Insurance Company 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 can purchase insurance from its captive. In the early years of owning a captive, a business can insure risks that third-party insurers would 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. This means that if a loss event occurs, the business pays for the loss with out-of-pocket funds, which before such loss, were not tax-deductible. In comparison to premiums paid to a captive, the funds are deposited into the captive and are tax-deductible whether there is a loss or not. Also, 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 provides vertical integration and is most often a successful and profitable “second business”.
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About the Author
Christopher Gallo spent his career in risk management as a regulator with the Connecticut Insurance Department. He has taken the lessons learned from over three decades to apply them to improving risk mitigating strategies for businesses. Chris graduated from Central Connecticut State University with a Bachelor of Science degree in Administrative Science and obtained his Certified Financial Designation from the Society of Financial Examiners. After retiring from his regulatory career, he joined CIC Services in 2020 and consults directly with business owners, CEOs, and CFOs in the formation, and as a regulatory liaison, of captive insurance programs for their respective businesses. CIC Services, LLC manages over 100 captives.