Thinking Strategically: Consider the Benefits of Captive Insurance

The article appeared in the September/October 2017 issue of CFMA’s Building Profits.

A contractor’s strategic plan goes beyond day-to-day positioning and operations – it evaluates opportunities, contemplates unforeseen risks, and demands return on investment. However, in light of the prolonged economic recovery, many contractors remain cost-conscious when developing their strategic plans. Investment in property and equipment, additional labor force, and professional development is often delayed until the lack thereof becomes a critical constraint on operations.

So how can contractors seize strategic opportunities and proactively manage risks while watching the bottom line and containing costs? One such solution lies in captive insurance programs – specifically group captives. (Other types of captives are beyond the scope of this topic.)

A captive is a vehicle that provides required insurance products and other ancillary benefits to its members. Captives offer contractors transparency into insurance costs, greater control of future expense, and significant advantages beyond traditional insurance coverage – all while maintaining cost
control and keeping cash flow in check. This article will explore ways in which a captive can benefit a company in meeting its strategic goals.

How Does a Captive Work?

A captive offers similar insurance coverage to that of traditional commercial insurance companies to meet an insured’s risk management needs (e.g., general liability, professional liability, workers’ comp, property and business interruption, employee benefits, and automobile liability). It is owned and
managed by its members and can operate in similar or differing industries, known as homogeneous and heterogeneous captives, respectively. (Given specific risk factors in construction, homogeneous captives are popular among contractors to underwrite risk profiles common in the industry.)

Members have transparency into and influence over the captive’s operations through a seat on the board of directors. They determine eligibility requirements, which often results in membership with better loss history. Annual premiums are based solely on the members’ loss history instead of the combined impact of the members’ loss experience, the general loss experience of the particular industry, and insurance marketplace trends. Any losses sustained are funded by the member’s premium and potentially the premiums paid by other members. The captive is reinsured to protect members
in catastrophic loss situations.

Many types of captive insurance programs exist, and determining the structure that best fits a contractor’s needs is key. Since the right structure varies for each company, it’s important to understand the benefits of different programs.

Ancillary Benefits

Ideal captive candidates are well-capitalized, maintain good liquidity ratios, invest in safety programs, perform well in the field, and generally operate under a well-defined strategic plan. Membership in a captive insurance company can be cumbersome to unwind and financial obligations can remain
for a period of time after the contractor exits the captive. As such, contractors with recent significant insurance claims, a history of reportable incidents, weak cash flow, or poor financial performance may not qualify.

Cost of Membership
As an owner and insured member of a captive, a contractor is responsible for certain capitalization costs and funding annual premiums. Capitalization costs include the initial capital investment to purchase the common and preferred shares as well as funding a deposit account. Members can choose to provide a letter of credit or directly fund the deposit account, usually over a three-year period. The deposit account funds member to-member obligations provides working capital to the captive, and serves as collateral for catastrophic reinsurance.

As previously stated, annual premiums are based on the company’s loss history. However, group captives present an element of risk-sharing, as all members are required to pay for significant losses of another member. Although it is impossible to eliminate risk, proper management of the captive and strict compliance with safety and loss history requirements can help mitigate future losses. Additionally, requiring that all members meet specific risk profiles helps to reduce the likelihood of additional costs associated with risk-sharing.

Safety & Claims
The construction industry has put forth significant effort to improve workplace safety, including investing in a safety director or department, providing extensive safety training, investing in new technologies, and implementing companywide safety protocol and incentive programs. These significant investments usually have little effect on traditional insurance premiums as those fluctuations can result from general economic conditions.

Captive insurance programs, on the other hand, allow management teams to clearly connect recent claims and loss history to the premiums being assessed.
In addition, contractors that successfully improve their company’s safety culture (which is then reflected in current and future claims) can capture what is known as underwriting profit – that is, the excess of premiums collected over claims and administrative expenses paid by the insurance company. With traditional insurance, underwriting profit is retained by the carrier, often utilized to supplement other clients’ losses.

When evaluating whether or not to join a captive, it’s also important to weigh the opportunity costs of not participating. Given the continual popularity of these and other self-funded programs by Best in Class contractors, the traditional marketplace increasingly includes contractors with sub-par safety records, which increase premiums since traditional carriers would determine appropriate premiums based on loss experience, operational cost, and reasonable profit.

Cash Flow & Tax Implications
Captive insurance programs require an upfront investment in order to capitalize the company and provide it with adequate working capital. In addition to annual premiums, it’s important to consider the impact of capital investment and the deposit account on the company’s cash flow. Although captives can provide more predictable annual premiums, a captive’s initial years can put a strain on a company’s cash flow if not planned for properly.

Alternatively, the deposit requirement can be fulfilled by a letter of credit at a nominal fee; however, the member would forego investment earnings that accumulate on his or her deposit funds.

Keep in mind that the deposit requirement, and thus required letter of credit, can increase along with premiums over time. Premiums paid to the captive that are not used to pay claims or administrative costs remain in an account for the benefit of the member. This balance, combined with the funded balance of the deposit account, accumulates investment earnings within the captive.

A significant advantage of captive insurance programs over the traditional market is that excess premiums and investment income are returned to the member as a dividend. Dividends are usually not released for 5-7 years following the close of the insured period in order to capture all claims originating during the insured period. Dividends highlight the contractor’s ability to control insurance expenses over the long term and can significantly reduce the overall cost of the insurance program.

Similar to premiums paid to traditional market carriers, annual premiums paid to the captive insurance program are tax-deductible. Additionally, members may be able to defer tax implications on investment earnings that accumulate within the captive, depending on where it is domiciled and
other relevant factors.

Typically, the owner of the common and preferred shares of the captive insurance company will be required to include additional information in annual income tax reporting. It is important to consult a construction CPA to help eliminate adverse tax implications and cash flow surprises.

Ancillary Estate Planning Opportunities
While the common share must be owned by the contractor that purchases the insurance, the preferred share may be owned by the contractor, an individual, or other entity (such as a trust).

Dividends from the captive insurance company are paid to the holder of the preferred share. Since either the contractor or another entity can hold the preferred share, the captive arrangement allows for unique estate planning opportunities. Dividends help decrease premiums by returning some
portion of previously paid premiums or unused loss funds to the company. If the contractor is well-capitalized and the owner desires to build wealth outside of the company, then the preferred share and thus dividend can be transferred to an individual or another entity.

Keep in mind that an owner who holds the preferred share and receives dividend payments would need to consider capital gains when filing his or her personal tax return.

Another common method of achieving estate planning goals is to transfer the preferred share to an irrevocable trust to benefit the owner’s family. While estate planning and personal wealth accumulation should not be the primary reason for entering into a captive arrangement when planned properly, the ancillary benefits of a captive can add significant value to estate planning strategies and serve as a vehicle to help meet an owner’s financial goals and objectives.

Networking & Benchmarking
Captive insurance members typically meet annually to review financial performance, vote on key operational issues, and decide the captive’s future strategy. In addition, many captives maintain a committee structure that reports on such topics as membership, financial performance, loss prevention, and underwriting.

The captive format presents opportunities to strengthen professional networks; however, it is often an overlooked benefit of membership. Members can take advantage of interacting with like-minded construction professionals, especially in homogeneous captives. Contractors may find that other members are dealing with similar business issues and industry challenges. Attending these meetings is often required, so be prepared for additional travel time and cost as needed.

Additionally, benchmarking against industry averages can help contractors keep track of opportunities and potential weaknesses. Captive insurance companies accumulate significant financial data from member contractors in order to properly underwrite each member and determine annual premiums,
and often anonymously share this data with member companies to help them better understand the risk profile of others.

Conclusion

While not a fit for every contractor, captive insurance programs can offer significant competitive and strategic advantages while providing ancillary benefits to owners that allow them to meet long-term financial goals. Contractors can address construction-related risks while controlling costs, sharing in underwriting profit, and gaining better insight into potential future insurance premiums.

Since captives are a long-term investment, be sure to consider potential downsides, costs, and risks. Consulting with a team composed of an experienced captive company representative, a knowledgeable construction CPA, and a construction attorney can help a contractor enhance its strategic plan.