Doug Houser: From Rea and Associates Studio, this is unsuitable, a management and financial services podcast for entrepreneurs, tenured business leaders, and others. We're ready to look beyond the suit and tie culture for meaningful measurable results. I'm Doug Houser.
As the cost associated with owning and operating business continues to rise, owners are always on the lookout for ways to keep more of their money in the business. One popular place to look is insurance, and while there are a variety of insurance options available, on this episode of unsuitable, we're going to talk about captives, specifically what captives are and how micro-captives and group captives can benefit business owners. Brad Stammler, vice president of commercial property and casualty with Leavitt Group is here to explain what these options are, how they can help, and when this option might make sense for your business. Welcome to unsuitable, Brad.
Brad Stammler: Thank you. Glad to be here.
Doug: Great to have you. And I think this is a wonderful topic for our business owners out there because there's a lot of, I would say, misinformation about captives, as well, and certainly a lot that they can learn. So, from a high level, talk a little bit about what a micro-captive is and what that can do for a business owner.
Brad: A micro-captive is a single parent captive, which means one person or several individuals may own that captive versus multi companies. And it allows that business owner to transfer either uncovered risk or under-insured risk into their own insurance company. It's a C corporation, and so that business owners, typically going to be the owner of the captive, and so those risks that are not covered by your traditional insurance programs can be transferred into the captive so that they are pre-funding on a pretax basis for those risks.
Doug: Okay. And again, we're talking about insurance coverage here, and where they work well are for risks that may be difficult to ensure otherwise or is that kind of a misnomer?
Brad: That's one of the areas. Traditional insurance policies will have exclusions. And there's a saying, "What the big print giveth, the small print taketh away."
Doug: Very true.
Brad: And so, as we look at these types of captives and do our risk analysis, one of the areas we look at is what current policies do they have in place and the exclusions that are in those policies. And we can literally issue a policy that will cover all the exclusions. So, for example, every business is going to have a property policy. Every business can have a general liability policy. And the exclusions are there for a couple of reasons. One, because it's covered better in another policy, or two, it's against public policy to ensure against that type of thing. So, we will, we will issue a policy that says, "Okay, in the property we're going to cover all the exclusions that are in that form." So, now they really truly have an all-risk policy, where before it was kind of an all-risk subject to your exclusions. And you can do the same thing with general liability.
Doug: Okay. So, give us some examples of some things that might be, then, included in this better type of policy, let's say.
Brad: Yeah. So, we can cover things like flood. A lot of times that's a pretty standard exclusion, and you can buy it in the open market a lot of times. But if you get into coastal properties or where there's earthquake risk, you can either totally fund it that way or you can go into the traditional insurance market and there may be a carrier, but maybe the carrier is only going to provide coverage in excess of half a million dollar deductible. So, now we can issue a policy that covers that first half-million dollars. So, instead of having that claim and that half a million coming right out of cash flow and working capital, they can now pre-fund it on a pretax basis and have invested it at the same time. And if it ever happens, now they have a choice. They can either pay for it out of their working capital or they can say, "All right, I'm going to go ahead and turn a claim in on this particular type of loss."
Doug: Right. Now, you and I have worked with and continue to work with several mutual clients in the construction segment, and that's an industry, I think, that lends itself quite well to some policies in the captive world because there are certain risks within the construction industry that aren't easily covered elsewhere.
Brad: Absolutely. Yeah. One of my favorite stories or examples is we have a client that builds military runways throughout the US and is a successful contractor. And as I was talking to him, and this was probably eight or nine years ago, when I do the risk analysis, my last question to anybody after I go through my questionnaires and you're listening for answers and thinking about what the next question might be, my last question is always what keeps you up at night? And he looked at me and he said, "A bad pour." I said, "A bad pour. Tell me what you're thinking there?" He said, "Well, we're going to pour a runway, and if we don't have the texture correct, if we don't have the mixture correct, if the government doesn't like it, then that's back on us and we got to pay for to rip it out and we've got to pay for the new concrete and we've got to pay for the labor to put that concrete in. And that's a four to $500,000 check I'm writing Brad." And he said, "That's what keeps me up at night."
Brad: And we chuckled a little bit, but after talking to him and talking about, "Okay, what's your last five years’ experience been in that? How often have you been called back?" Whether it's warranty work or a major repair, we're able to take that information, and as long as we can identify the risk, measure the risk, get an idea on its loss experience, we can then go to our actuaries and develop a premium for that. And they'll definitely actuarially develop the loss triangles, the curves, all the analytics associated with it, and then they will develop a premium for us as to what he will pay over 12 months in a case that risk occurs.
Doug: Which is great. This is a mutual client I know you're speaking of now, and he's otherwise generally a very conservative operator, operates within a very narrow scope of work with what they do. So, for him to be able to cover that is wonderful.
Brad: Absolutely. It protects the company against just a bad year. And again, if something happens, he then has that choice to make whether he wants to pay for it out of working capital or whether he wants to go ahead and file a claim.
Doug: Now, a micro-captive, a so-called 831(b) captive, there are some limitations. Premiums that are paying to that have to be under a certain threshold. Is that correct?
Brad: Right. Right. I think for 2020, it's in the 2.3, 2.4 area-
Doug: Million?
Brad: Million. Excuse me. Thank you. And it originally, back in the day, the max was 1.2 million, and it went through some legislative changes in, I think, it was '16. And there was a compromise, said, "Okay." It had never been changed, so inflation was eating away at that amount. So, they took it up to 2.2 million and put a three or 4% inflationary guide on it. So, it's in the 2.3, 2.4 million right now.
Doug: Gotcha. And obviously, I know there's been some press around some so-called bad actors in that sector. Like anything, there are bad actors out there who try to take advantage of the way things are written. Now, the problem with those, and maybe you can expound on this a little bit, are folks that aren't using that to underwrite real risk, and there aren't real claims involved, they're sort of, for lack of a better term, making up stuff to put in there. Is that fair to say?
Brad: Yeah, no. We were happy to see the IRS kind of investigate this. They kind of came out with what they referred to as a Dirty Dozen List, and it was listed as a transaction of interest. And because of what they were finding is there were captive promoters out there that were literally setting up captives without any risk management approach or concept to it, and they're using strictly as a tax play, and they got caught.
Doug: A tax dodge, in other words.
Brad: Exactly.
Doug: It wasn't-
Brad: It minimizes the tax, don't pay the tax. Because as with any new business that you set up, you're always considering what the tax ramifications are. It's just good business. So, if you set up an 831(8) correctly, there can be some tax advantages to it. You can put in up to 2.2 million, you're transferring risk from the corporation. So, again, now you're pre-funding on a pretax basis, and that captive that you've set up, and if you set it up correctly, there is no tax paid on the earned premium net income of the captive.
Doug: Solely paid on the investment gains.
Brad: Exactly.
Doug: Yeah.
Brad: Exactly. So, if you do it correctly, there's benefit from a risk transfer standpoint and a tax advantage, too.
Doug: Yeah. But the purpose of them, the problem that these folks, these bad actors ran into, they weren't trying to underwrite real risks. They weren't looking at it as an insurance product, which in essence it is. You're trying to manage and mitigate risk.
Brad: Absolutely. I mean, there's three or four cases that have been decided in the last three or four years, and as we read them, you could see that there were some very flagrant actions being taken. For example, there was a case, I think it was out in Arizona, and the capital was put together by an attorney in Georgia. And oh gee, the attorney had never been face-to-face with their client, and it was all done via telephone, email. You tell me how much you want to put away, and I'll get you there kind of thing. So, there was absolutely no risk analysis. Another one was the client was not happy with the captive manager for the renewal, his overall premium went down, and he sent an email saying that he was not happy, that his premiums went down for the year, which I've never gotten any emails like that in my career. So-
Doug: getting an email saying, "My fees are way down. I'm not happy."
Brad: I'm getting cheated here. I don't feel like I'm paying enough. Or another example was the captive premium was actually more than his traditional premium, and it was for a policy that was acting as an excess policy. So, again, how do you pay for the higher limits, pay more than what the lower limits were for? So, there are some pretty flagrant actions going on out there that, again, we were very pleased that the IRS stepped in because these captive promoters or just doing it for the wrong reasons, bad image, and they got caught. And if you do it right, it works well, and it certainly, there's no reason to do it any other way than the way they tell you to do it because it works right and you're getting rid of risk and you're able to pre-fund for it.
Doug: Do it honestly and for the right reasons and have a true professional involved in helping you set it up and structure it and all of those things.
Brad: And that's key, too, because again, we'll spend a lot of time upfront on the risk identification and make sure we understand it and the ownership of the captive and get all the financial information, do our analysis, and then we will send it to actuaries, that this is all they do is work with captives, different types of captives. And having been to their office several times, that's just a different world in and of itself. You think accountants are a little weird, you go to that actuary [crosstalk 00:14:38].
Doug: Come on now, Brad.
Brad: And that's a whole new ball game.
Doug: You're calling us out.
Brad: No, no. But they do a great job, and they are looking, again, at the loss experience, the loss triangles, and they'll do research into the insurance industry itself and say, "Okay, here's what we're seeing in the marketplace." And they're going to subscribe to different resources that help them, as well. So, when we get the report back, it's about three-quarters of an inch thick, and a good half of it is all of the statistical analytical stuff that we all studied or tried to study in college in our stat courses. And it tells you the basis of what they used and why they use particular factors. And it's there to legitimize what we're doing, because you may be audited, and that's what we have to protect ourselves against is that we did it the right way. It will stand up with the IRS.
Brad: The other thing, too, when we do those reports, you're going to have three to five different audiences sharing going to read that. Your CPAs are going to read it, your bankers are going to read it. Obviously, the client's going to read it. The IRS may read it. But the other thing, too, is typically these captives will be domiciled, whether it's in the US or what we call offshore. And when you send these reports in, they are going to look at these for how legitimate are they. Is this just a proposal off the shelf, change the names, and just to solidify that, "Okay, we can do this?" Or does it have some purpose to it and professionals visually analyze this thing? And so, that is really the majority part of the report that goes into the finance director or the captive director, wherever you might send it, for them to review it and say, "Okay, I'm comfortable with this. They did their homework. It's done the right way. We'll go ahead and certify and give them a permit."
Doug: So, there's true risk analysis obviously that's performed there and analyzed, and that's very critical to the process. So, interesting.
Brad: Yeah.
Doug: So, we've talked a little bit about the micro-captive and what that does. Talk a little bit about a group captive and how those work and how they might be a little bit different.
Brad: Okay. A group captive, as it sounds, it's typically more than one person. There's a group of companies, a group of individuals. One of the big distinctions besides that, and I'll cover that a little more, is the fact that most group captives are going to provide coverage for traditional coverage, where, again, the 831(b), it's not traditional, it's ancillary. It's the, again, uninsured, uninsured. It's never going to dabble in the general liability, auto, workers' comp, unless you're, again, ensuring the deductible. So, the group captive, depending upon the particular group captive you're looking at, will cover the general liability, the automobile, and workers' comp outside of Ohio.
Doug: Okay. So, more traditional type of things?
Brad: Absolutely traditional. And what you're doing is literally today, if an insured has a policy and it has limits of $1 million, they're getting the policy, it says $1 million on the general liability auto. What they don't know is that a particular insurance company is going out and buying re-insurance to back them up. So, let's say an example of the million-dollar limit, they may have what's called a treaty in place that says for every general liability policy that they issue, that has $1 million limit, some re-insurance company is going to charge them a particular premium so that they will take that upper half a million dollar risk.
Brad: And the reasons companies do that is to protect and manage your balance sheets. They don't want the large catastrophe, whatever it might be, to all of a sudden it's not just one insured we have, it's 20, and, "Oh my gosh, we got 20 million at risk here." Where with some re-insurance, you're not going to get down to 10. So, when you think about a group captive, what we're doing, it's the same structure, but wherein the traditional sense you have the fronting company, or who's issuing the policy, they're going to keep the first half a million. Then, again, that second half a million is re-insured.
Brad: In the group captive, what we're doing, we're going to have a fronting company. Let's pick a name, AIG, and AIG will issue the policy, then they will turn around and re-insure the first 350,000 to this group captive. And let's give it a name of Presidio. And so, Presidio is owned by individual members, shareholders, insureds, that are operating companies that the common denominator is their emphasis on safety and loss control, and they have fantastic loss experience. So, what we're doing is going out and kind of picking off the cream of the crop, if you will, from the traditional marketplace and saying, "Okay, if we can get the top, pick a number, 5% of the insureds of all the national branded insurance companies, we're going to be able to take that group," and again, their premiums are going to be developed off of their own experience, which is going to be better than the average experience within that national insurance company. So, my experience has been, when we do that, we are generally going to be able to save them 25 to 40% on their annual insurance premiums. So, that's the first place they're going to get benefits.
Doug: That's huge.
Brad: Yeah.
Doug: And again, these are best in class type from a safety perspective operators?
Brad: They are absolutely best in class. And they've been just screened and interviewed and inspected, and it takes a lot to get into these things. So, that's the first place you're going to see a savings. The second place is, again, we've got this layered approach where AIG's a fronting company. The first 350 goes to Presidio and 350 to a million will go to AIG re-insurance. And again, so they've taken the catastrophe type claim out of the captive because those are the hardest ones to predict. So, they've done that.
Brad: So, again, back to the first 350, again, we've looked at everything, and that's really, that where the most predictable losses are. So, the actuaries, again, can pick a number, and they're going to pick what's called a loss pick, so if you've got your general liability, your auto, and your workers' comp, they're going to say, "Okay, I think that contractor is going to have $300,000 in claims." They underwrite to a 60% loss ratio. So, if that 300,000 represents 60%, then that means my premium's going to be a half a million dollars, and that 200,000 bogey in there is for the operating costs of the captive. So, that's kind of how it works from that aspect. So, it's at $300,000 that will be kind of put into a bucket, if you will, for that particular client, and I won't go much deeper than that, but there's an A fund and there's a B fund. But that's there to pay your losses. So, again, we saved 25 to 40% on the premium. That's the first savings.
Brad: The second savings or income is as you pay your premiums in, those premiums are invested in your own name. So, versus the traditional market, those premiums go into the insurance company. They're the ones investing, they're the ones getting their returns, and they're getting the benefit.
Doug: It's a black box. You never see it or-
Brad: You never see it again.
Doug: Right.
Brad: So, again, that's the second place you're going to get is the interest income. Then the third piece is, again, I talked about that $300,000 or 60%. In the perfect world would say, if you don't have any losses, that 300,000's yours. Now, it will take some time to get it back because there's what's called a tail to these types of coverages. It takes time to mature and closeout. But you will eventually get that with the exception of any type of claim that will be shared within the group captive, and those are typically on bigger claims because the incentive of a group captive is, again, to have excellent companies join that do not have frequency issues with their claims, that the real world is the fact you're going to have a big claim every seven years.
Doug: Something's going to happen. You can't always do anything about [inaudible 00:24:56].
Brad: Right. So, you got to have some insurance there, and they call it the B fund, where the risk-sharing takes place, which will allow the premiums to be deducted then.
Doug: Yeah. Well, I think, this is awesome stuff and there's certainly a lot to learn and a lot of potential advantages. I think it goes back to you want to sit down with a real professional like yourself and make sure you have the conversation and understand what you can do, the advantages, the risks, and there's great potential assistance here for business owners certainly.
Brad: Right. Right. Yeah. They've got to be open-minded, that there are different options and alternatives out there besides just buying traditional insurance. And the key to it is, what are you currently spending? And typically, the group captive, they should be spending at least $150,000 in those three lines for it to work.
Doug: Makes sense.
Brad: Yeah.
Doug: And I know the experience we've had with mutual clients, some of the ones that I know that do it are some of the most conservative folks that I know, and you would think, "Wow, this sounds a little out of the box," but it's been a wonderful experience for them.
Brad: They do a great job protecting the mothership if you will, that being the captive, whether it's through letters of credits, whether it's through just underwriting, safety, loss control because again, you are with the best in class.
Doug: Yeah, absolutely. Well, this is great stuff, Brad, and really appreciate it. Very informative. And for our business owners, I'm certainly hoping they want to have a conversation and maybe think about something that's a little bit different maybe haven't explored in the past. So, good stuff.
Brad: Great.
Doug: If you want to hear more business tips and insight, or to hear previous episodes of unsuitable, visit our podcast page at https://www.reacpa.com/podcast. Thanks for listening to this week's show. You can subscribe to unsuitable on iTunes or wherever you like to get your podcasts, including YouTube. I'm Doug Houser. Join us next week for another unsuitable interview from an industry professional.
Disclaimer: The views expressed on unsuitable on Rea Radio are our own and do not necessarily reflect the views of Rea & Associates. The podcast is for informational and educational purposes only and is not intended to replace the professional advice you would receive elsewhere. Consult with a trusted advisor about your unique situation so they can expertly guide you to the best solution for your specific circumstance.
