Private Equity Groups & Captive Insurance
Private equity groups are famously clever when it comes to creating valuable businesses. We know of a private equity group that was unhappy with its total maintenance, repair, and operations spend and it decided to form a new company designed to pool all of the companies in the portfolio into a group purchasing pool. The purchasing company became very profitable and ended up securing a number of third party clients. Now, the purchasing company is a multimillion dollar consulting firm. That’s creative.
Insurance is another pain point for private equity groups. New startups frequently face issues with insurance because new companies have limited history from which to generate premiums, or they may be operating in a new market unfamiliar to the underwriters. As a result, the premiums are little more than a shot in the dark and rarely match the actual risk associated with the ventures. This creates any number of problems ranging from overpaying for insurance to facing unanticipated exposures.
Paying too much for insurance is a pain. It really needs no explanation. Traditional carriers are generally not well equipped to price out appropriate premiums for ventures in new markets. If data is non-existent, then very sophisticated actuarial models should be employed in order to calculate the proper premium. Loss histories that don’t make traditional bell curves need customized calculations.
The larger problem of unanticipated exposures is a greater concern than a painful premium. These kinds of exposures can bankrupt a business before it gets out of the gate. Commercial General Liability policies have pages dedicated toward explaining what risks are not covered in their policies. Since these policies are written with very specific language, typically drafted by attorneys that are well-versed in the nuances of insurance coverage laws, these policies can be inscrutable. Thus, your new firm’s products may not be covered by the policy after all.
These issues open up a need for captive insurance. Private equity groups can create captive insurance companies designed to cover some or all of their businesses in their portfolio. There are any number of ways to organize the captive insurance structure. Every business can incorporate its own captive to underwrite specific risks, or the private equity group can incorporate a group captive to underwrite the risks of all of the companies. Either approach works.
However, there is particular value in creating a separate captive for each company in a portfolio. Any investor wants to know how to exit an investment. Paper profits aren’t very exciting. Captive insurance companies create an additional incentive for new investors to purchase private equity holdings from the portfolio. The key to utilizing captive insurance properly is through the understanding of how they add value to a portfolio.
Risk management is key when evaluating a potential investment. A private company with a captive insurance subsidiary is more likely to have fewer incidents, lower claims, and better overall profitability. This is because captive insurance uses the funds of the private company to create a wholly-owned subsidiary. Naturally, the owners of an insurance company will take more interest in risk management than those without a captive. After all, the captive’s underwriting profits only accumulate when there are no losses.
Thus, a smart strategy for an investor would be to use captive insurance in some capacity in order to give the business a marketable edge. The reality is that if a potential buyer is evaluating two separate private entities, and one of them has a lower overall risk profile, then the business with lower risk is likely to be the one which is purchased. Lower risk generally results in higher profits.
The middle market is adopting captive insurance at a fast rate. Increasingly, we are seeing middle market entrepreneurs using captives as a part of a broader marketing strategy to sell off their companies. As more investors realize the risk management value of captives, companies without captives will face negative valuation pressure as their risk premium exceeds comparables. In other words, captive insurance improves the value of companies by reducing their overall risk.
However, do not forget that captive insurance companies are insurance companies. Since the only reason to create a company is to make money, this means that these middle market companies with captives also have a second stream of income attached to them. Thus, the investors who are interested in purchasing a company’s IP, stock, and team will also purchase an independent stream of revenue. Properly managed captives generally produce a 10% return on investment (and frequently up to 50% if the needs for reinsurance are minimal).
In short, private equity groups should always evaluate captive insurance as part of a broader value-add strategy for their portfolio. Captives are unique financial vehicles that not only bring down the expenses of the organization, but also create new sources of income.