Fair Market Value, Exit Plans, and Captives
Exit plans are endemic to entrepreneurship. Everyone who founds a new company has a plan (realistic or not) of whom to market the company to when the time is right to sell. Marketing a business is tough work, especially given that there are literally millions of profitable businesses for investors to consider. One way of differentiating a business is to present the business as a lower risk investment than other similar businesses operating in the same space. One of the best ways to accomplish that is through the incorporation of a captive insurance company.
Risk Management and Loss Control
Captive insurance naturally lowers the overall risk of the company. Industry reports consistently show that companies utilizing captive insurance pay fewer claims and enjoy lower costs related to risks. This is a natural function of management taking back control over settlement, litigation, and an increased focus on the minimization of risk in general.
Risk management is a key factor keeping costs low in a business. This requires management to focus on preventing any problems from arising which would be presented to an insurance company. Examples of proper risk management include requiring employees to wear appropriate attire in order to reduce injuries, ensuring that employees properly document procedures for various regulators, and conducting routine audits of employees’ activities to ensure that policies and procedures are followed.
Companies using traditional insurance frequently overlook the value of risk management. Insurance creates a natural tendency to allow some activities to fall through the cracks. Small issues manifest into larger problems over time. A few small claims in one year often render the insured uninsurable a few years later. This is partially a function of training and employee expectations. Since captive insurance companies are funded with the employer’s own funds, the employer has a greater incentive to run a tighter operation. Naturally, this has a cost-lowering effect which increases the overall profitability of the company.
Litigation and Lawsuits
Litigation is an unavoidable feature of insurance. Claims occasionally do not settle and have to be fought in a court of law. Traditional insurance carriers wield virtually all of the power related to litigation. This includes the ability to settle claims and take them to trial. Business owners are often the targets of frivolous lawsuits. Insurance carriers settle many frivolous claims in lieu of fighting them as it is sometimes cheaper to do so in the short run. Unfortunately, a few large settlements put a target on the company’s back for plaintiffs’ firms and one lawsuit snowballs into a dozen.
If a company uses captive insurance then the owner has the final say with regard to settlement and litigation. If the claim is frivolous, it may make more sense to spend money on trial in order to send a message that lawsuits against the company will be hard fought and difficult. This creates a natural effect of lowering the total number of claims filed against the company. Traditional insurance carriers rarely engage in this line of thinking because it is more expensive to litigate claims in the short run and carriers do not place enough value on maintaining a client for an extended period of time. In other words, the interests of the business owner and the traditional insurance carrier are divergent. The interests of the business owner and its captive are aligned. Thus, there is more emphasis on using litigation as a means of curtailing future lawsuits and not just getting out of the current situation for the fewest number of dollars.
These elements of control, risk management and litigation administration, place more power in the hands of the business owner to run their company. This power adds value to the company. This additional value makes the parent company a more attractive financial investment for investors interested in acquiring a valuable asset.
In summary, captive insurance companies add value to the business owner’s investment offering. While captive insurance companies are not rare, they are not ubiquitous in the middle market. Thus, investors faced with two equivalent companies are likely to choose to invest in the company with a lower risk profile than the other without a captive. This value not only enhances the overall marketability of the company but also creates inflationary pressure on the asking price from the business owner.
In short, captives lower risk and increase value for a business. All entrepreneurs should consider captives when devising their exit plans from their investments.