There are few financial vehicles available to businesses, that when compared to a captive insurance company, provide greater opportunity to diversify revenue streams.
There are few financial vehicles available to businesses, that when compared to a captive insurance company, provide greater opportunity to diversify revenue streams. The ability to create a flexible and operationally efficient ‘subsidiary’ can be a powerful tool for a business that is not only seeking to maximise revenue but is focused on creating brand strength and customer loyalty.
For years, large companies, such as, Verizon, Wal-Mart and BestBuy, have been selling insurance, such as warranties and equipment protection, to their customer base, realising new profits. Historically, it was thought that only large companies could form a captive to provide warranties, guaranties and service contracts. However, small and medium-sized companies can now effectively manage risk and receive all of the financial benefits of an insurance transaction.
In addition, this development has the potential to provide a better spread of risk, source of revenue, and profit. This new niche of the captive marketplace known as a ‘profit centre captive’ focuses on risks that a business sells to its customers or premiums received from a controlled unaffiliated party.
To illustrate the potential benefit of a profit centre captive, Verizon Wireless offers its customers extended warranty protection on cell phones. The annual warranty cost is $60 per device. A $600 iPhone costs Apple approximately $200 to manufacture, while Verizon spends $300 to purchase from Apple. It is common for warranty programmes to have loss ratios in the 20 to 30 percent range, so each equipment plan sold may profit Verizon $42 to $48 annually. With millions of phones sold each year, the high margin warranty protection plans become as important as their core business service.
Note that some of the margin may be considered commission and not considered insurance. The breakdown between commission and insurance is determined via an independent actuary who calculates the premium and loss reserves.
These third-party or unrelated risks can be converted into new cash flows when the premiums are paid into a profit centre captive. The retained risk can now be addressed through the pre-tax fund, which will be almost twice the amount that would have been established without the use of a captive. This large loss-reserve nest egg will enhance solvency should adverse claims activity occur. In the event of favourable claims development, the captive will generate a new source of revenue to use for funding future risks, or as distributions at potential favorable tax rates.
Smaller profit centre captives may be able to make the Internal Revenue Code 831(b) election available to small property and casualty insurance companies writing annual premiums less than $1.2 million.
The underlying theme of a profit centre captive is that a third party pays the premium. The third party could be an independent contractor, tenant, supplier or customer.
If the risk covers a controlled unaffiliated party, then the captive owner must have contractual authority over the insured (for example, franchises, joint ventures and business partners) and the captive owner must be able to enforce loss control measures.
In addition to the inherent financial benefits mentioned above, there are intangible benefits to the captive owner. In an increasingly competitive environment this type of affinity programme can create good will, improve customer experience, fend off competition and overall cement the relationship with consumers.
Additionally, the risk management expertise required to form a captive will strengthen a company’s intellectual property and increase business valuation. The profit centre captive can even integrate sales and operations to give a customer an improved experience.
What product lines can form the basis of a profitable programme?
Traditionally, most profit centre captives insured warranty risk, but these captives have the flexibility to insure a host of other risks. The typical profit centre captive’s extended warranty provides a customer with protection against economic loss for the replacement or repair related to specific parts not covered by the manufacturer’s warranty for a specified duration.
The following represents an overview of a number of programme examples for profit centre captives.
Equipment distributor: extended warranties, providing cover for product replacement beyond the original equipment manufacturers embedded warranty period.
General contractors: sub-contractor default risk provides coverages to subs that may not be able to obtain bonding from the commercial marketplace. General contractors may offer only to preferred sub-contractors to avoid adverse selection.
Professional services: service contracts cover the repair or maintenance of a product that has been installed or sold to a customer (excluding product replacement). Common industries that provide service contracts include: HVAC installers; roofers; swimming pool contractors; home appliance sales and services; and electronics retailers.
Real estate: security deposit insurance is offered by residential property managers or owners to their tenants covering damage to property and reducing the cash requirement for new tenants and so increasing occupancy. Renters’ liability is offered by apartment property managers or owners to tenants and covers injuries suffered in an apartment unit for things such as slip and falls. In addition, it covers a tenant in the event they are sued and held liable by a landlord for damages to the apartment caused by a tenant’s negligence.
Deductible buy down may be offered by managers or owners of offices, industrial premises, strip malls and other commercial properties to tenants. Typical buy downs include property and general liability deductibles passed onto tenants via triple net leases. Contents insurance is offered by apartment owners or storage company owners to customers, which covers personal property and contents due to theft, water damage or fire, but generally excluding weather-related disasters.
Remediation: guarantee insurance, provides recourse for a business to cover pollution clean-up costs to contractually agreed levels.
Banks: have historically reinsured customer credit risk (unemployment, life) and force-placed homeowners insurance.
Rental: loss damage waiver (LDW) covers damage to a rented product. Specifically, an LDW releases the renter from liability for physical damage to the equipment in exchange for a fee, subject to the rental agreement or a state statute should one exist. LDWs are commonly sold in the car rental sector, but other businesses renting equipment may qualify.
Transportation: auto physical damage and bobtail liability (non-trucking liability) may be sold to drivers with independent contractor status. In addition, auto liability and cargo deductible costs can also be passed onto these drivers.
Vehicle service contracts and extended warranties: the auto-dealership market segment has been taking advantage of these types of arrangements for the past several decades. Several large warranty carriers in the mid-1980s set up captives to share extended warranty vehicle risk.
These warranty carriers’ efforts were very successful and this saw the formation of hundreds of low cost offshore captives. Most auto-dealers capable of setting up warranty captives have already done so.
Highly sophisticated software is needed to price each vehicle’s VIN number, which is beyond the capabilities of captive managers. Auto-dealers interested in forming an extended warranty captive should contact an auto warranty carrier. The auto-dealerships provide an example of an entire industry embracing the profit centre captive concept.
Product replacement: these programmes, commonly covering such things as cell phones and eye glasses or contact lenses, not only generate underwriting profit, they also ensure that the customer returns to your business for replacements rather than going to a competitor.
Regulatory environment
It is worth noting that some insurance products may be regulated by state insurance laws in the US whereby a profit centre captive cannot directly write this coverage. However, most profit centre risks are not regulated by state law, but can be considered insurance for federal law. It is recommended that when considering a programme of this nature an attorney is engaged to evaluate the laws of states where the business resides, including those states where the programme will be offered, to ensure that the profit centre captive programme satisfies local requirements.
As for domiciling profit centre captives, the majority of onshore domiciles have traditionally prohibited direct underwriting of unrelated risks, but this trend is changing, so long as the risk is not considered a personal lines coverage. Occasionally, onshore domiciles and US states where the risk is sold may require a ‘fronting’ arrangement whereby the profit centre captive assumes its risk from an admitted rated carrier. Offshore domiciles tend to be more flexible and permit the underwriting of unrelated risk, but remember the captive domicile does not give you authority to write a risk where it is sold.
Besides US state law, profit centre captives must be compliant with Internal Revenue Service (IRS) rules for the captive to be treated as an insurance company for tax purposes. To ensure premium deductibility and insurance tax treatment, 50 percent or more of the profit centre captive’s annual premium must come from unrelated risk.
In order for the risk to be deemed unrelated and for risk shifting to occur, then the third party should ideally pay the captive directly (ie, the captive does not indemnify the affiliated business).
The unrelated party must have the option to purchase coverage from the business and can also choose to purchase the coverage from a different company. Force placed insurance typically does not meet the IRS definition of third-party risk.
Businesses considering writing these types of third-party risks in their captive may, initially, have some reservations. After all, the traditional use for a captive, with which management will be most familiar, is the funding of some part of the business’s own risk and taking on third-party risk may appear hazardous.
However, it is usually in the nature of the risks under consideration that they are low severity risks, the cost of which are, to some extent at least, within the control of the captive owner and they tend also to be risks for which ample data is available.
For these reasons, an increasing number of businesses large and small are looking at profit centre captives as a means for turning risk to profit.
