Jeremy P. Colombik, of Management Services International (MSI) and Richard M. Colombik, of TLS Marketing and Management Services, LLC, discuss whether a captive is right for your business
Whether a business buys insurance or not the risk is still present. It is surprising how many business owners, advisers, CPA’s and lawyers we speak to, do not realise that risk is present, even if it is not insured. These people believe that there is only commercial insurance available for their risk needs and their only risk needs, frequently, are only the commercially available general coverage or coverage they need to run their business.
This includes doctors with a malpractice policy and other industries that require errors and omissions policies, as well as professional liability policies for professions such as CPA’s, lawyers and financial advisers. Almost everyone licensed profession, architects, engineers, etc. has personal liability for professional malpractice in most jurisdictions.
Most people generally view buying insurance as a one-sided transaction. What I mean by this is that their business buys commercial insurance policies that are deemed necessary to run their business(s) by regulatory bodies or for their perceived known risks. If the purchaser of the policy has low claims or no claims that year, they may get a reduction in their premiums payment for the following year, or they may just feel they wasted their money as it was not that “risky”, and maybe they should have self-insured if it was allowable.
Moreover, most people are not happy with the coverage(s) they have due to the perceived policy exclusions and/or gaps in their policy coverage. This type of frustration, particularly when a party files a claim and what they believed was covered is not causes many issues with insurance brokers and how professionals view general insurance coverage.
There is a solution to this dilemma, but the solution is multifaceted. (Yes, reading the policy thoroughly and asking questions is one method and an important one.) However, the first step in the solution is “Education”. Clients must be educated as to what they are insuring and what exclusions are present. This is where a well-trained adviser is paramount to work with the client to reach the proper level of understanding and coverage, costs and exclusions.
Additionally, a client and adviser should be aware that they may be a better way to define the coverage more broadly and the exclusions more narrowly. At times, there is a better way for clients to obtain this efficiency and beneficial policy language and exclusions. The solution may be for the client to be more efficient with their risk dollars and by placing such risk and potentially making it profitable through a captive insurance company.
Let me clarify and state that captives are not a good solution to all business(s), however you don’t need to be a fortune 500 company to participate and benefit through a more efficient system of risk management in a captive. A business owner could participate in a captive if their gross revenues are 1 million or more per year depending on their risk needs and the type of captive program.
It is of paramount importance to understand that just because a captive program allows you to participate, this does not mean you should. Is this a good business decision and an efficient way to manage your business’s insurable risks? Do the potential benefits of managing your risks exceed the cost?
If, by participating in a captive are you getting the coverage your business needs, with more favourable policy language, within your costs parameters, then you need to look into a captive further as a potential solution for your risk management
If you have determined the benefits of having more control over your policy language, coverage and exclusions exceed the costs of a captive, then, a captive could be a great solution for your business. The next logical inquiry is what are the captive benefits? First the captive may function as a profit centre, reducing commercial insurance premiums, (while narrowing commercial exclusions). Second you will have improved risk management. Third, you will increase your own risk awareness. Finally, you may also have ancillary income tax benefits.
A captive is an insurance company. As an insurance company, just like a commercial insurance carrier it will have claims. as with a commercial carrier, a captive will engage qualified actuary’s and underwriters to assist in coverage analysis and policy pricing, as well as projecting reasonable reserves to cover potential claims.
As a commercial insurance company, the company will price its policies, not only within market parameters, but will also try to make an annual profit. (Every business tries to be profitable, so no surprise)
Imagine taking a commercial insurance policy such as directors and officers liability, increasing the deductible from $1,000 to $250,000, which would lower your commercial insurance premium, and insure the first $250,000 of risk, with a $1,000 deductible into a captive you own.
Your commercial rate will go down and you may have deceased your total policy costs! Now if you have no claims in a year, then not only may you get a reduction of your commercial policy premium, but you would, as a company shareholder, participate in the captive insurance company profits. You may have just turned a former expense, with no ascertainable benefit to a profit centre, as you reduced your premium costs, obtained broader coverage and obtained a profit from your ownership in a captive!
Other benefits again focus on your risk management. You will most likely have less exclusions or policy gaps on your policies insured by your captive as you can with the assistance of your professional captive team tailor your policies, within commercial practices far more easily than you can negotiate these same issues with a commercial carrier. Further when your captive team does a risk assessment review on a client’s firm, this will also increase and educate a client as to their known and previously unknown risk awareness.
Many clients are surprised during this process to learn of unknown insurable risks. Further, even the risk was known, the client may not have been aware of the magnitude of such risk. This is extremely important as if one of these known but uninsured risks occurred, such as a regulatory investigation, this could put the client in financial duress due to the cost of defending such allegations.
The final potential benefit for captive owners is an income tax benefit. A captive which elects to be taxed under IRC Sec. 831(b) will be taxed as a small insurance company. This means that the insurance company can receive up to $2.2 million dollars per year of premium income, without paying income tax on the premium income received. A client to be more efficient can shift the risk from their commercial insurance policy to their captive, which does not pay federal income tax on the premium dollars received.
Combining a year when claims may be lower in a specific year, plus no taxation on the receipt of premium dollars a client may be able to create a profit centre, instead of only a cost centre with proper risk management and a ownership of a captive insurance company when the risk justifies the means.
Is a captive right for every company? NO! Yet, with the increase of technology and social media affected how business owners research and gather information, it will be easier to assess whether a captive solution is right for your business(s). More business(s) will realise that they don’t need to be a fortune 500 company to determine and participate in a captive as a solution to their risk management.
Captives, structured for the right purpose can be and are a valuable business solution they may also create a profit centre, reduce commercial insurance premium costs, improve risk management, increase risk awareness, and may have favourable federal income tax benefits. These benefits not only address known and unknown risks, but they can also determine if your risk management may be made profitable.