More Powerful Then Retained Earnings – Think Like Fortune 1,000 CFOs Think
Why Fortune 1,000 CFOs Own Captive Insurance Companies and Why Small and Mid-Size Businesses Should As Well
Many mid-market CFOs and small business owners alike yearn for the day when their company can build a “war chest.” A “war chest” or stockpile of cash reserves can give the business flexibility to invest during times of opportunity or to protect the company’s strategic position or resources during uncertainty or an economic downturn. Corporate war chests are commonly built by stockpiling retained earnings, usually over many years. In many cases, amassing a war chest is difficult because taxes slash retained earnings and common tax avoidance strategies employed by corporations deplete reserves. A good friend of mine who worked for a Fortune 1,000 company explained that year-end bonuses, parties, tax favored capital expenditures, reward trips and off-site planning meetings were approved simply to “smooth earnings” and lower corporate taxes.
Retained earnings are a source of joy for CFOs and business owners, and there is a financial tool that should be considered as a component of any war chest strategy. This tool is a Captive Insurance Company (CIC) as part of an Enterprise Risk Management (ERM) strategy. Choosing to implement a Captive Strategy is essentially choosing to own your own insurance company. In fact, approximately 75% of Fortune 1,000 companies and 90% of Fortune 500 companies own one or more Captives.
Captives can:
- Replace all or a portion of commercial insurance
- Insure Enterprise Risks
- Insure warranties
- Issue performance bonds
- Any combination of the above
A captive insurance company and the reserves it holds have many strategic financial advantages when compared to corporate retained earnings alone (or taxable ordinary income or corporate profits passed through to business owners). This article will briefly discuss six reasons why Captive Insurance is more powerful than retained earnings.
First, a captive insurance company significantly improves the risk management posture of the business. The captive can provide a broad range of insurance coverages to the parent company, including property, casualty, worker’s comp and healthcare.
Second, a captive insurance company can formally insure risks not currently covered by third party insurance. There are many risks that businesses face which are too expensive or too difficult to insure. A Captive can provide a broad umbrella of insurance coverage with far fewer exclusions than commercial insurance policies.
Third, by owning its own insurance company, a business benefits from insurance taxation. In the case of small and mid-market businesses, many Captives can make an 831(b) tax election. The 831(b) election applies to insurance companies with annual premiums below $2.2 million. With the 831(b) election, Captive underwriting profits are taxed at a rate of zero percent (0%). And, retaining earnings pre-tax (as insurance reserves in the captive) results in a bigger base of assets that can grow through investments.
Fourth, reserves in the captive can lower future insurance costs. A company’s captive can insure its deductibles for third party insurance coverage. And, as reserves accumulate, a CFO may consider reducing third party insurance costs by increasing the deductible. The increased deductible can be insured by the reserves in the captive. Over time, the company’s captive insurance company will build up reserves that give the CFO greater flexibility to make strategic financial choices, including replacing some or all commercial insurance.
Fifth, the reserves of a captive insurance company can be taken as dividends to the owners of the captive insurance company at a future date. Often in business, timing is everything. A captive that builds strong reserves gives CFOs and business owners flexibility to take dividends at opportune times.
Sixth, when properly structured, the assets of the insurance company are secured from creditors.
A captive insurance company should be viewed and managed as part of a company’s overall financial strategy. With so many benefits to the CFO and business owner, it is easy to see why over 90% of Fortune 500 companies own captive insurance companies.
Small business CFOs and owners need a war chest as much as Fortune 500 CFOs. CIC Services, LLC has been helping small and mid-market businesses own their own insurance company and access strategies that are more powerful than retained earnings since 2005. It is very gratifying to help small and mid-size businesses strengthen their financial position.