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Captive Insurance: Protection and Profit

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What would happen to you, your family and your employees if you lost your franchise? What would be the impact on your business of a devastating hurricane or other major event? Depending on your location, hurricane insurance might be too expensive. And no commercial insurance carrier will underwrite protection against losing a franchise.

Still, those are real risks. And you need protection against such potentially tragic occurrences. There is a way. It’s called "captive" insurance.

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Captive insurance is commonly employed by large U.S. corporations, typically to cover risks that are low in frequency but high in severity. They establish their own captive insurance companies to manage risk where commercial insurance is unavailable or too expensive. A captive can provide any type of insurance allowed by the jurisdiction in which it is registered: property, inventory, business interruption, director and officer liability, errors and omissions, workers’ compensation, workplace violence, embezzlement, pollution, reputation risk, employment practices, general liability, garage liability, legal costs – and some you can’t get from a commercial insurer, like costs associated with losing a franchise or a supplier relationship.

Dealerships establish captive insurance companies to provide stable and cost-effective insurance. Their captives protect them from risks against which they are underinsured or for which they cannot get coverage from a commercial insurer – and to control costs, protecting against unpredictable, wild premium swings.

The most likely candidates to set up their own captive insurance companies are typically multi-entity dealers, those with half a million dollars or more in sustainable profit. Their businesses have uninsured or underinsured risks, and they are concerned with wealth accumulation and asset protection. Smaller dealership operations typically maintain commercial policies to cover catastrophic losses, or use the reinsurance market to get better rates, then use their captive to assume liability relative to more manageable risks.

There are several types of captive insurance firms. Large dealerships often can afford the premiums to create their own captive firm, a "pure" captive, or collaborate with other dealers in a multi-member pure captive. The amount of initial capitalization depends on the risks to be transferred; you must have a capital position sufficient to cover claims. However, dealers ordinarily don’t have to be concerned about coming up with significant cash for this initially because most captives are established with letters of credit from financial institutions. Capital requirements are also set by the location where the captive is to be domiciled. With regard to this requirement many states are captive friendly, such as Delaware, Vermont, Nevada and South Carolina; and some captives opt to domicile off shore. (It is important to note that although the captive may be domiciled in an off-shore jurisdiction, all of the captive’s funds are maintained in the U.S.)

Dealership associations have been known to set up captive firms for the benefit of their members. Alternatively, some insurance agencies set up captives and sell participation to dealers. And other captives often market theirs to dealers as "rent-a-captives." In all cases, the concept is much the same.

A properly structured and managed captive insurance company can provide a variety of benefits:

▶ Insuring business risks not addressed by commercially available insurance

▶ Having lower overall premiums

▶ Covering undisclosed self-insurance risks; that is, filling in the gaps in commercial coverage

▶ Allowing reserves to be set aside in a tax-advantaged manner

▶ Providing significant income tax savings

▶ Providing underwriting and investment profits

▶ Permitting use as an estate planning tool, or in succession planning to retain key employees

Most important to setting up your captive properly is working with an experienced captive management firm. Forming a captive can be a lengthy process involving feasibility studies, financial projections, domicile studies, license applications, risk transfer determinations, and actuarial computations. Be sure to ask anyone pitching a captive what structure they recommend and why. Too often, an insurance seller eyeing the potential profits for himself in the form of commissions lacks knowledge of important aspects of the proper captive structure. You need a qualified individual quarterbacking the process to capitalize on the full range of captive benefits.

Your captive is truly a separate business, so you’ll need to operate it as a company independent of your dealership. An experienced captive management advisor will ensure that shareholder and board meetings are scheduled, that actuarial reviews and tax returns are completed. They will address key formation issues including identifying the risks to be insured, analyzing risks and related premiums, and comparing costs to coverage in the commercial market.

Captive insurance companies are not a new phenomenon. They are used broadly by large companies to protect against risk, lower insurance costs and reduce taxable income. But small, closely held dealers can also enjoy the tax, cash flow and risk management benefits.

In Part II of "Captive Insurance: Protection and Profit," we’ll address the financial benefits and the tax advantages of captive insurance companies.

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