By Garrett B. Gunderson. His company, Wealth Factory, helps entrepreneurs navigate personal finances and investing.
Sometimes small businesses are small because they think small.
For example, there’s a “War Chest” strategy that most of America’s largest companies use. It generates billions in profits while providing extra risk protection. And even though this strategy is available to many small and mid-sized businesses, few take advantage.
But if more small and mid-sized businesses change their mindset and start “thinking big,” they can start to reap the rewards of this “War Chest” strategy, too, even if on a smaller scale.
Inside the “War Chest” Strategy
Did you know that some of the largest companies in the world– like Apple and Microsoft–are in the insurance business? It’s true. But you won’t see them advertising auto or property insurance on TV next to a gecko. These companies aren’t offering insurance to the public at all. Instead, they’re creating a special kind of private insurance company called a “captive” to insure their own risks.advertising auto or property insurance on TV next to a gecko. These companies aren’t offering insurance to the public at all. Instead, they’re creating a special kind of private insurance company called a “captive” to insure their own risks.
“The vast majority of these large companies utilize captives. These captives serve a critical role in protecting these companies from catastrophic events. Billions in profits are generated through these captive structures in the form of unrealized losses,” says Bo L. Brower, an expert on captive insurance and President of Corprotect.
But captives are not just for the giants of business. As Brower notes, “The little guy or gal that owns a business can do the same on a smaller scale. They too can put money away for a rainy day through implementing a small captive or an Enterprise Risk Captive.”
What is a captive insurance company?
A captive is an insurance company that issues policies, collects premiums and pays claims just like any other insurance company. But instead of issuing policies to the general public, a captive only issues policies to one business–the business that created the captive.
Businesses have a number of risks that traditional insurance companies don’t cover or will not cover cost efficiently. So it can make sense for a business to create a captive insurance company to set money aside for these risks.
In fact, it may even be more beneficial for small and mid-size businesses to start a captive because, unlike large corporations, they don’t have shareholders to fall back upon.
“Privately-held businesses have a lot of risk. These businesses are fragile and any number of catastrophic events can take them down,” says Brower.
There are dozens of risks that captives can legally insure against: data breaches, loss of key employees or customers, product warranties, recalls, copyright infringement, equipment breakdowns, regulatory changes, lawsuits–even cyber risk.
When you self-insure against these risks through a captive, you’re creating a “war chest” of cash to fight your way out of tough situations. For example, lawsuits can ruin a company. But if you have a captive insurance company as your “war chest,” you can design it to pay your legal costs if a lawsuit arises–possibly saving your company from disaster.
So captive insurance companies are a great way to strengthen the risk management of your business. But there are many additional benefits, too, like recapturing your investment income.
Recapture investment income, gain asset protection and more
Normally when you pay premiums to an insurance company, those premiums are invested in bonds and other vehicles considered conservative. Most of the time, you’ll never see this money–the insurance company keeps these profits.
But when it’s your insurance company, you get to invest the money according to regulatory guidelines and your captive gets to keep the profits. This is money that would have been lost had you used a 3rd-party insurance company.
Your captive insurance company also provides asset protection. Because your captive is a separate entity from your business, any premium that gets sent to a captive is separate from your business. If your business gets sued, your captive insurance company’s assets should not be at risk (consult an attorney for more details).
There can be tax benefits as well. With most small captives, the premiums you pay are a business expense just as if your were paying a third-party insurance company. That means they’re tax deductible as long as you stay under the IRS’s cap of $1.2 million in annual premiums. (See 831b in the tax code, and always consult a professional.)
“But what if risks never materialize–will I ever see my money again?”
At some point, after paying premiums for years, your captive may accumulate cash well above the insured risk needs of your business. This is referred to as excess reserves.
So then what? Where does the money go? It’s simple. If risks don’t materialize, you get to keep the money. This is how America’s largest companies end up generating billions. Instead of letting third-party insurance companies keep the money, they get to keep it when risks don’t materialize. If there are excess reserves, you can withdraw the money from your captive by taking a distribution, which would be subject to long-term capital gains taxes.
Is a captive insurance company right for your business?
A captive insurance company isn’t right for every business. First, there must be real risks to insure. For a small captive or Enterprise Risk Captive, your business needs to be privately held.
Your business should also meet one or more of these criteria: 10 or more employees, $5 million-plus in gross revenue, or pre-tax profits of $1 million.
If that describes your business, then a captive may be a smart decision (but always consult a professional).
Bo L. Brower explains it this way: “One of the questions we’ll ask is, “Have you ever paid an insurance premium and not put in a claim?” And the answer is almost always “Yes,” because we’re constantly paying premiums. Auto insurance, health insurance, business insurance. And very rarely are we submitting claims.”
“And in those instances, who is it that is making the money?” Bo continues, “The big insurance companies. They build skyscrapers and sponsor sports teams and race teams. They pay executives big bonuses. Insurance is big business.”
He’s right. Insurance is big business. So why not keep that money for yourself while building a large war chest to fend off disasters? And if at the end of the day things don’t go wrong, you get to keep the money.
That’s the power of a billion-dollar strategy applied to your business.