One of the important things to consider when forming a captive insurance company is how the captive will deal with risk sharing that is required as a pre-condition for getting tax deductions for premium payments to the captive as an ordinary business expense. One of the safe harbors for achieving the pre-condition is to have at least thirteen organizations all participating in the sharing of the risk.
Many private business owners we talk with balk at the idea of risk sharing. They don’t know who they’re sharing the risk with and they always have the fear that they will be supporting someone else that has losses because of bad management on the part of the other owner. (It’s always the other owner who has the poor risk management.)
One of the ideas we’ve had is that when thinking about the formation of a captive it makes sense to put several companies together with cohorts of companies with similar interests.
For example, I do a lot of work in the vending industry. There are several groups that exist where there are fifteen member companies in a study or “mastermind” group. This group of companies would make a perfect group for putting together a captive insurance operation. In the case of the vending companies, they could agree to form a captive that insures the risk of vandalism with a $25,000 deductible. It’s rare that a vandalism event in a vending company exceeds that amount of money. At the same time, a risk such as this would generate significant actuarially derived insurance premiums.
If these vending companies decided to band together to form a captive insurance company or two, all would benefit from knowing each other and there is an excellent chance they would all receive significant benefits from the captive insurance program. In some cases, running a captive for ten years would provide more long-term value for the owners of these vending companies than the market value of the companies themselves.
As we go down the road of thinking about methods for captive insurance company formations, I believe these natural cohorts are an avenue we will be exploring in a more in depth manner. I’ll keep you informed as we learn more from any real world experience we get.
Josh Patrick
Filed under: Exit Strategies, For Business Advisors, For Business Owners, Risk Management, Value Creation | Tagged: Captive Insurance, cohort companies, Risk Management, risk sharing, study groups
Actually, the 13 organization rule only applies to having that many companies within the same economic family. Since most companies do not have lots of affiliates, most captives obtain third party risk via Revenue Ruling 2002-89, which requires that 51% of premium and risk come from third parties–even as few as one. This is typically done using a reinsurance pool also known as an insurance exchange. From and economic view, the more particpants in the pool, the more likely a loss, but each captive’s share of such loss is smaller. But the key is how the risks in the captives have been underwritten in the first place. Clients do balk at this risk sharing out of fear. We find that once you quantify the exposure, however, they see that (in a properly formed pool) thier exposure is usually less than the tax and other benefits of forming a captive that qualifies for special taxation under section 831(b) of the Code.
Jim, your comment is correct in all respects. I was pointing out in this entry that many business owners have a hard time putting together a risk sharing pool with people they don’t know. We find they are more likely to consider a captive strategy if they know the people they’re sharing risks with. Also, putting together a cohort captive will allow businesses that can’t afford $500,000+ in premiums per year to participate in a captive program that can add significant value to their company and eventual financial economic freedom.
Josh and Jim,
I think you are both right. A homogenous group does enable those with lower premiums into the captive space whilst solving (assuming enough members) the risk pooling conundrum. Of course, identifying such groups is not easy and, if you have to bring the members together, it may take a considerable time before they can become comfortable with sharing risk with those they have known for only a short time.
Jim’s approach to explaining the pros and cons of a pool is a good one. The risk has to be quantified. I would also suggest that the opportunity to purchase reasonably priced stop loss protection to reduce the potential downside is a significant help. In the end though, underwriting is key. What are the pool acceptance criteria? What is the pool’s historic loss ratio?
Unless there is a natural aggregation point for assembling group captive programs the exercise is much like herding cats. Josh, the fact that your firm has a connection with the vending industry makes you a viable aggregation point and you have already overcome the most significant hurdle to group captive formation. The next most significant hurdle is to structure the risk sharing components of the program in such a way that they are fair and equitable to all the members of the group and are simple enough for the average business person to understand. The advent of rent-a-captive programs worldwide provide a relatively inexpensive option to having to fund a group-owned captive insurance company. The captive insurance environment is ripe with these kinds of opportunities for firms that have access to groups of companies linked by a common industry need. Modern captive insurance arrangements are as much about meeting strategic goals and problem solving as they are about classic risk management.