Large deductible policies differ from guaranteed cost in that they let employers retain a portion of their risk while lowering their overall cost of risk. Insurance carriers operating above the attachments point frequently offer excess coverage (state laws require variations on this approach, such as in monopolistic states requiring buybacks, but the general strategy is valid in all 50 states).
Large deductibles are deductibles or self-insured retentions of $100,000 or more. For most insureds, 80 percent of the workers' comp losses occur within the deductible layer. Losses are paid as they are incurred. Companies deduct these losses as they flow through the company. Most companies do not reserve anything for these losses, which sometimes creates cash flow crunches.
Using a captive to finance the large deductible allows the carrier to pay monthly premiums into a wholly-owned captive. These premiums are deducted from gross operating income in advance of claims. This creates a tax swing in favor of the insured. Claims within the deductible are paid out of the captive.
Assume a client's standard premium is $800,000. If the client elects to take a $250,000 self-insured retention or large deductible, then the client is likely to experience a 45 percent credit. This reduces the $800,000 premium by 45 percent to $440,000. The client's self-insured retention covers the majority of losses with the $440,000 financing an excess layer with an A-rated workers' comp carrier.
- Standard Premium: $800,000
- Deductible: $250,000
- Large Deductible Credit: 45%
- Excess Premium: $440,000
- 8% Commission: $35,200
The estimated premium savings to the insured with a large deductible program are significant. If we assume losses of $200,000 for the policy period, the insured may deduct $200,000 of claims against gross operating income to pay for losses as they arise. This results in a total expenditure of the large deductible program of $640,000. Assuming an
8 percent broker commission, the broker should enjoy an annual fee of about $35,000 for placing this risk with a carrier.
Unfortunately, most brokers stop their analysis at this point. The reality is that most clients that are a good fit for a large deductible workers' comp program are also a great fit for a captive to finance the self-insured layer. This strategy has significant financial advantages to the insured and increases the broker's commission. The following example illustrates how the financials work:
- Estimated Premium: $360,000
- Incurred Losses: $200,000
- Dividend: $160,000
- 8% Commission: $28,800
In this situation, the insured established a protected cell company to finance the workers' comp large deductible and pays $360,000 of premium into its own captive insurance company to finance the deductible. The $360,000 is deductible before losses are incurred. This minimizes the potential for cash crunches when large losses occur.
If the insured's actual losses amount to $200,000 over the policy period, then the captive will have an additional $160,000 of potential dividend to distribute to the captive owners. Because the captive writes less than $2.3 million in gross written premium, it qualifies for the 831(b) election, which excludes the $160,000 as taxable underwriting profit to the captive. The captive does not pay any taxes on the dividend. With the use of the captive, the insured created a $360,000 tax deduction with tax-free profits remaining in the captive. The owners can choose to distribute these dividends back to the owners or invest the profits.
The total spent under the captive program is $440,000 for excess coverage plus $360,000 for deductible layer premium minus $160,000 in the return of premium minus gross income taxes avoided. Assuming a 21 percent tax rate, the captive saved $25,200 in income taxes. This results in total costs of $614,800.
Losses in the workers' compensation line are generally paid out over a five-year period. This means that the balance of the $614,800 of assets will be invested in low-risk investments and accumulating interest until the losses are paid in settlements. Over 60 months, the captive removes hundreds of thousands of taxable income from the insured, invests it conservatively and distributes the dividends at a later date. This creates cash flow flexibility.
Meanwhile, the insured wrote an additional $360,000 of premium. Assuming an 8 percent commission fee to the workers' comp broker, this results in a $28,000 commission. This is a net commission increase of approximately 81 percent to the broker.
The captive-financed large deductible program provides a savings of $185,200 from the initial guaranteed cost program, which is about a 23 percent premium reduction to the insured. With the captive insurance company in place, the underwriting profit of $160,000 can be reinvested into the captive to expand reserves, invested into private equity opportunities or distributed to high-performing employees of the insured.
Queen serves as general counsel for Venture Captive Management.
About Matthew Queen
Queen is general counsel and chief compliance officer at Venture Captive Management LLC.