“We shape our tools, and thereafter our tools shape us.” -- Marshall McLuhan
There’s no reason to believe that Mr. McLuhan was ruminating on captive insurance, exactly, when he said those words. And yet, the thought is somehow apropos. In today’s insurance marketplace, the rapid proliferation of new areas of exposure have brought the captive insurance model into focus as a vital tool for independent agents, and one that can prove instrumental in shaping one’s future.
Once the preserve of Fortune 500 firms, captive insurance has increasingly become established as an important strategic tool for mid-sized companies as well. Recent history has provided plenty of instances to prove that the exposure to risk, including those of cyber attack or reputational damage, is not dictated by the size of the victim.
The conversation about captive insurance should include a broader range of both prospects and agents than is commonly understood. Different ways of covering risks continue to proliferate. More to the point, as risks and needs have become more sophisticated, alternative mechanisms for dealing with emerging risks have continued to evolve. As a result, today there are more than 6,000 captive insurance companies, many of which insure middle market companies, writing over $50 billion in annual premiums
And therein lies opportunity.
Like Nature, Captive Insurance Abhors A Vacuum.
Captives have achieved their popularity with independent agents in part because of the relative scarcity of products appropriate to or designed specifically for the new and emerging sources of risk. Significantly, in cases where standard products do exist, their usefulness is often limited by exclusions.
Emerging risks are underscored by the almost daily reports of cyber attack. Even though this category of risk has been around long enough to be disqualified as a newcomer, it continues to evolve in ways that make traditional approaches problematic. Other examples of risks which continue to evolve include reputational damage and various forms of supply chain interruption.
This gap between risks and available solutions underlines why the independent agent should have captives in their strategic toolkit. However, even in more traditional areas like workers’ compensation, the recent trend is toward some degree of self-insurance. By establishing a captive, which can provide coverage for deductible reimbursement, even mid-sized companies can enjoy the advantages, including tax advantages, that accrue from owning and operating a small insurance company.
This same logic applies to many categories of risk. It is in the best interest of the agent to help his client evaluate and quantify those risks, and establishing a captive may be the best option for transferring the risks identified.
This strategy assures that the funds are available to respond in the event that risk becomes reality, all while the company is able to deduct the premiums. In addition, the profit accrues tax-free or can be taken out in the form of dividends. The owners enjoy the dual advantages of being able to participate in the risk while turning risk to profit at the same time.
Enterprise Captives and the 831(b) Election
The main objective of a captive is to insure risks in categories for which demand has arisen but no carrier exists. Fortunately, today’s commercial insurance marketplace combines with unaddressed risks to make the option of setting up a captive attractive.
The rise of enterprise risk captives among mid-sized companies has come in no small part from taking advantage of a provision of the Internal Revenue Code, updated in 2004, known as the 831(b) election. This provision allows a captive to elect to be taxed on its investment income only, as long as the annual premiums collected do not exceed $1.2 million.
Let’s take, for example, a company that has elected a $250K deductible for its Workers’ Compensation policy. By setting up a captive to cover the deductible and take advantage of the 831(b) election, the carrier still handles the claims while the principals retain the advantages of captive ownership. These include retaining the underwriting profit, which remains in the captive tax-free until taken out in the form of dividends or capital gains.
A captive ownership structure can extend to key employees who may be rewarded for their importance to ongoing operations and contribution to an accident-free culture with a share in the underwriting profits.
Serving Niche Markets and Associations.
Often, an agent will target a specific line of business or vertical market, building special relationships with both clients and carriers over time. These situations are often ripe for setting up either a group or agency captive to cover the various risks associated with the niche market.
A small group captive offers the dual advantages of providing the owners of businesses with the benefits of captive ownership while helping the agent to solidify a specific book of business. On one hand, the agent may provide greater flexibility of coverage. On the other, the captive affords the owners the opportunity to reduce costs, participate in profits and have access to reinsurance.
Typically, a niche market may have a risk, or risks, for which coverage is difficult to obtain; or it may be difficult to obtain coverage at a competitive rate. Examples of niche markets may include businesses such as dealers in scrap metals or restaurants whose alcohol sales exceed a certain percentage, although the possibilities are virtually limitless. Often, independent agents utilize a single carrier who has developed special expertise in a niche market. In each of these cases, setting up a small group captive for the niche market may entail a relationship with a single carrier for the entire book of business. The agency, or agency principals, could own the captive and enjoy significant financial benefits beyond just collecting commission on the book; or, the agency and company owners in the niche market could set up a joint ownership structure for the captive. In either case, the benefits for the parties involved could be very attractive.
Associations also offer an outstanding opportunity for establishing captives. Typically, a trade or other association will encounter types of coverages that are particularly difficult or costly. Upon setting up the captive, the association members are able to buy coverage collectively from the captive and can participate as joint owners. As long as claims are managed well, owners are able to share in profits that accrue down the road.
In addition, association captives may be used for a particular enhancement of coverage. Usually, some combination of specific coverage and negotiated price make the captive an attractive option.
In short, captives are remarkably adaptive to a fast-changing economy. They are able to cover large deductible reimbursement programs, medical stop-loss programs, workers’ compensation and many other types of risk. Furthermore, various structures can be designed to accommodate the needs of various types of customers.
Independent agents should be cognizant of the opportunities captives offer, as well as the advantages they offer clients as well as themselves in navigating a constantly changing world of risks. Simply put, captives are another valuable tool in the agent kit for meeting both current and future challenges.