To Manage Risk, CRE Professionals Are Turning To Captive Insurance
Commercial real estate companies are acquiring a diverse set of assets, and they are beginning to consider insurance and risk management options.
More CRE professionals are turning to captive insurance companies as they evaluate their needs. This type of special-purpose insurance company aims to insure the risks of its owner and affiliated companies.
Workers’ compensation, general liability and auto liability are common captive targets. Flood, windstorm, hail, earthquake, environmental liability, mold remediation, loss of rents and reputational risk can also impact real estate owners. All of these risks can be funded into a captive. To determine whether captive insurance is a good fit for their operations, CRE professionals need to understand what benefit it offers.
While there are several formation types for captive insurance, companies in the middle market tend to focus on three options.
A pure captive is a wholly owned subsidiary of the parent company. It primarily insures the risks of the parent company and all subsidiary companies, but can also cover unaffiliated third parties. Pure captive structures offer the greatest level of flexibility for coverage and program design. But they typically require a minimum number of subsidiary companies, with each contributing roughly equivalent risk elements in size and scale.
Group captives are typically owned by multiple member companies and insure the risks of those owners. Coverage cannot be extended to third parties. Each owner is responsible for its own claims and expenses, as well as some risks shared among the other members. Group captives are often established to write specific risks, such as workers' compensation, general liability and auto liability. But some packages also offer auto physical damage and property coverage.
These options can benefit smaller companies that cannot establish a captive on their own. They can also be valuable to companies that need to participate in a risk pool or shared arrangement with unrelated entities in order to qualify for captive status.
Micro-captives or 831 (b) captives are single parent captives that operate as property or casualty insurance companies. They are established to provide coverage to their parent companies. These structures are often developed for smaller, middle-market companies that do not meet the diversification requirements of a pure captive. Micro-captives can be developed to write traditional coverage like workers’ compensation, general liability, product liability, auto liability and professional liability. Other captive managers have developed more of an “enterprise risk” management approach, offering several coverage options beyond traditional insurance products. These structures provide flexible program design, eligibility, lines of coverage and operating structures.
Commercial real estate companies have traditionally used captives to cover risks that can be forecast by qualified actuaries. They have also provided funding for risks that cannot be insured in the commercial marketplace or are too costly to insure commercially.
Captives can also be applied to enterprise risks. Exposures like administrative actions, computer system failure, deductible reimbursement, reputational risk, gaps in coverage from commercial policies, loss of intellectual property, judicial delay, uncovered legal expense, regulatory changes, supply chain risks, product recall, mergers and acquisition risk, and workplace violence can form the basis of a formalized risk management plan. This can protect the company’s balance sheet while creating additional benefits for the owners.
Pros and Cons
Captives can help CRE professionals with cash flow and budgeting. By funding deductibles, they can minimize unplanned balance sheet impact.
When used as a foundation for the client’s overall risk management plan, captives help sharpen organizational focus on core risk management principles. This provides an opportunity to reduce frictional insurance costs and return dollars back to the organization.
Captives are also regulated by a state. Captive owners incur additional audit expenses and other fees. In addition, 831 (b) captives are subject to increasing examination by the IRS.
As part of the PATH Act, which contains several changes to the tax law, the IRS increased premium investment in a captive from $1.2M to $2.2M. But with this increased funding flexibility came an additional disclosure requirement. In November of 2016, the IRS released Notice 2016-66, declaring 831 (b) captives “transactions of interest.” All 831 (b) captive owners are now required to submit Form 8886, Reportable Transaction Disclosure Statement. Companies need to ensure appropriate risk distribution and proper pricing of the insurance premiums.
Captives provide the advantages of tailored coverage, tax benefits and the opportunity to capture underwriting profit as capital to be deployed in other areas of a business. Commercial real estate companies should evaluate risks and determine whether a captive insurance company makes sense for their strategy.
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