The following is Part I of a six-part series of blog postings regarding whether a captive insurance subsidiary or one owned by the owners or affiliates of a company may represent an effective risk management tool that also provides economic benefits. Although there are various types of captive insurance, this posting and the five to follow will focus primarily on single parent/pure captives and how they might provide economic benefits for you or your company.
Effective enterprise risk management (ERM) is an essential component of any successful business that in almost all circumstances imposes costs and expenses and represents a drag on a company’s profits. Wouldn’t owners of such businesses and their managements be interested in learning about a risk management tool that provides insurance but may also result in the potential for increased earnings as well as tax savings and benefits? Captive insurance might be that tool for your company.
PART I: INTRODUCTION AND BACKGROUND
Although enterprise risk management has many definitions, it is generally recognized as “the process of planning, organizing, leading, and controlling the activities of an organization in order to minimize the effects of risk on an organization’s capital and earnings.” A well-run company recognizes that operating profitably necessarily involves taking risks. It views the implementation and operation of effective ERM tools as a cost of doing business so that the company may take the necessary business risks to operate profitably while avoiding or minimizing the potential for far greater losses.
Some companies choose to self-insure all or a portion of their liability risk. In its simplest form, self-insurance is actually no insurance. The company that self-insures simply covers its own losses or the liability it incurs for damages out of its own pocket from its profits or retained earnings. Such losses can adversely impact the self-insured company’s profits and in the case of a catastrophic loss or liability can drive the self-insured company into bankruptcy and liquidation.
Most companies purchase insurance against a wide range of potential losses. Insurance coverage provided to a company by a commercial third party insurer is an ERM tool. However, as many readers will have experienced, depending on the types of coverages sought, such insurance may be expensive. The policies may have sizeable deductibles or significant exclusions. The premium costs may become even more significant if the company never makes a significant claim as thousands or even hundreds of thousands of dollars are spent by the company that could otherwise have been used to pay dividends, make capital expenditures or acquisitions or for other corporate purposes. Further, given the industry in which the company operates or the particular risks it faces, commercial insurance may even be unavailable or management may become concerned that commercial insurers will eliminate such coverages in the future.
Other issues related to total reliance on third party insurance include:
- Commercial insurance providers often rely on industry loss statistics in setting rates rather than focusing on the loss experience of the individual company whose loss experience may be well below the industry average due to the company’s safety and other loss reduction programs;
- The constraints on a company to work with its insurer to fashion insurance policies and risk coverages with terms and conditions tailored to the company’s particular risk profile; and
- Inefficiencies and issues in processing claims through a third party insurer.
In view of the above, many companies have considered incorporating or organizing captive insurance subsidiaries as a means to address the legitimate business and economic issues that may arise from reliance on third party commercial insurance or self-insurance. Captive insurance is simply a type of risk management tool that is an alternative to self-insurance and traditional third party insurance. The business and economic aspects of insurance should be the driver in undertaking the analysis of whether the company can benefit from forming a captive in light of the considerable costs of implementing and operating a captive insurance company.
This six-part series of blog postings will address the first form only – the single member or “pure” captive which many companies have formed. This works well with holding companies with a number of subsidiaries. It also works well with a company with many operating divisions that can be incorporated or organized as separate limited liability companies and reorganized into a holding company structure. In the upcoming posts, the subsidiaries will be referred to as “brother-sister affiliates”.
A captive insurance company does not have to be owned by the parent holding company for the brother-sister affiliates to take advantage of the benefits a captive insurance company can provide. Another of the many ownership structures of captive insurance companies is one in which the shareholders or members of the parent organize a corporation or a limited liability company to qualify as a captive insurance company to provide the insurance to the parent and the brother-sister affiliates of the parent. This is often selected for wealth transfer and estate planning reasons and is the subject of Part II of this six-part series of blog postings.