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 food and agribusiness 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.