As a small to mid-market company or business owner, it can often feel like you are trapped in a relationship that is extremely one-sided. You consistently pay premiums on a monthly, quarterly, or annual basis to cover risks that you hope never manifest, and then when something does occur, the insurance company significantly undervalues the expense of making the situation whole again, leaving you and your company to pay the 30-40%, on average, that is still needed to cover the costs of the claim that the insurance company refuses to pay.
If you really want to make the insurance company pay what they agreed to pay in the policy (a.k.a., the insurance contract), then you must retain a lawyer, wait the 18 -36 months, on average, it takes to get to court, hope the decision is in your favor, and then give up 30-40% that the attorney will charge if the case is taken on a contingent basis.
But, there is a way to change this dynamic – own your own insurance company – often referred to asstarting a captive or alternative risk transfer. You may have been presented with the idea of starting a captive as it relates to health insurance, benefits, or worker’s comp, which are all great reasons to start a captive, but a captive can also cover property and other business risks that could significantly impact the daily operations of your business and its long-term financial health.
One of the benefits of captive ownership is the first of the five Cs: controllingCost. COSTS go beyond the expense of the premium. Costincludes making up any shortfall the insurance company refuses to pay as part of a claim. It involves the expense of extra time being set aside to deal with the insurance company as you fight through the claims process, advocating for every dollar you are owed that the insurance company does not want to pay.
And, there is the potential Cost of retaining an attorney to sue the insurance company because the delta of what they are willing to pay and the money needed to make a situation whole is so large that it makes more financial sense to take your chance in court rather than bearing the full burden of the claims expense.
In addition to these real expenses, conservatively, 15–20% of every premium dollar is used for business expenses and profit for the insurance company. This is 15-20% that could benefit your company and its long-term financial health.
Let’s look at how the premium amount is determined. Insurance companies can access a mountain of information/data about almost every kind of risk.
Given all of this data the insurance company can determine the amount of premium that should be charged to cover a particular risk, for a specific industry, in a specific geographic location. Using the Law of Large Numbers, actuaries can accurately determine the number of occurrences (claims) and the approximate Cost of these occurrences (amount paid out in claims) that will occur for any given risk.
Your specific traditional insurance company may give you a small discount if you keep your claim volume and claim amount low or if you have an established risk management program that helps to mitigate risks. However, suppose you are in an unfortunate situation where your company has had several claims over the last few years. In that case, you will experience a significant increase in the premium you will be required to pay.
Traditional insurance premiums are based on industry averages and take into account the worst possible scenarios. Captive insurance that you or your company owns is based solely on your company’s actions and its claims history over the last 3 -5 years. As your risk management and mitigation improve, so will the premiums you pay to your own captive insurance company. Ultimately, the actuarial study conducted exclusively on your company will determine the premium needed, but you have control over theCOST of the premium.
Traditional insurance companies usually operate on one-year premium cycles, meaning it is likely that your premiums will increase on an annual basis. Captives are not subject to the same types of market forces as traditional insurance companies, so premiums going into a captive can stay relatively flat over time. Premiums paid to the captive are considered a business expense, unlike self-insurance, where capital is trapped in an account earmarked for a specific occurrence (claim).
Captive insurance companies also have the opportunity to invest premium reserves. The capital currently being sent to the traditional insurance company are dollars your company has lost in terms of investment or redeployment opportunities. Investing premium reserves is a recognized practice amongst captive insurance companies.
A captive insurance company is allowed to retain its underwriting profits. That’s right; all the profits earned by traditional insurance companies can now be used by your company.
Below is a short illustration that even AI understands:
Creating a captive insurance company allows you to retain both underwriting and investment profits, offering significant financial benefits compared to traditional insurance. Here’s a simple illustration to demonstrate this:
Traditional Insurance
Premium Payment: You pay $1,000,000 in premiums to a traditional insurance company.
Claims and Expenses: The insurance company pays out $600,000 in claims and incurs $200,000 in administrative expenses.
Underwriting Profit: The insurance company keeps the remaining $200,000 as underwriting profit.
Investment Income: The insurance company invests the $1,000,000 in premiums and earns $50,000 in investment income.
Total Profit for Traditional Insurance Company: $250,000
Captive Insurance
Premium Payment: You pay $1,000,000 in premiums to your own captive insurance company.
Claims and Expenses: The captive insurance company pays out $600,000 in claims and incurs $200,000 in administrative expenses.
Underwriting Profit: Your captive keeps the remaining $200,000 as underwriting profit.
Investment Income: Your captive invests the $1,000,000 in premiums and earns $50,000 in investment income.
Total Profit for Captive Insurance Company: $250,000
Comparison
Traditional Insurance: You pay $1,000,000 in premiums and receive $600,000 in claims, while the insurance company keeps $250,000 in profit.
Captive Insurance: You pay $1,000,000 in premiums to your own company, receive $600,000 in claims, and your captive retains $250,000 in profit.
Benefits of Captive Insurance
Retained Profit: Instead of the insurance company keeping the underwriting and investment profits, these profits remain within your captive.
Investment Control: You have control over how the premiums are invested, potentially leading to higher returns based on your investment strategy.
Tailored Coverage: A captive can provide customized insurance coverage tailored to your specific risks, potentially reducing claims and administrative costs.
Risk Management: You gain better insights into your own risks and can implement more effective risk management strategies.
By creating a captive insurance company, you essentially internalize the profits and investment income that would otherwise go to a traditional insurance company, enhancing your overall financial position.
There are other cost savings related to a captive insurance program, including potential tax savings, but I think you may be starting to understand how creating your own captive insurance company can benefit your organization’s long-term financial health.
We would love to talk to you if you have questions about captives or would like to understand more about how a captive works and whether it could benefit your company.
In Part 3 of this series, we will explore how a captive insurance program can improve:Coverage.
