Assessing Your Dealership’s Risk
Dealership owners face many risks in today’s world. Some of these risks can be covered through traditional commercial insurance policies, such as garage and general liability coverage. However, dealerships often face risks that go uninsured or are even specifically excluded in general insurance policies, leaving the dealer to manage these risks through their own cash flow and/or reserves.
“dealerships often face risks that go uninsured or are even specifically excluded in general insurance policies, leaving the dealer to manage these risks through their own cash flow and/or reserves.”
What’s a Captive Insurance Company?
One way to build reserves on a pre-tax basis against such future risks is for a dealership to form its own captive insurance company. Many dealers are familiar with captive insurance companies and may have already formed one to reinsure their Finance & Insurance (F&I) products. However, dealers may not be aware that captive insurance companies can be formed as enterprise risk captives to insure additional risks that are not typically covered by the dealer’s current insurance policies.
Some of the common risks typically insured by a captive insurance company for a dealership include but are not limited to commercial liability plus, commercial property plus, contingent liability, corporate disability income, crime or employee fraud, cyber risk, employment practices, inventory obsolescence, odometer tampering, professional liability and F&I, supply chain and product availability, transportation damages and many more.
So, how do you know if forming a captive insurance company is right for your dealership? By exploring the advantages, risks and required steps to setup a captive insurance company, this article will help you determine whether it’s a good option for your dealership and provide you with insight on how to get started.
“It is imperative that dealerships perform due diligence when choosing a captive manager.”
The advantages and risks of an enterprise risk captive
Under an enterprise risk captive, a dealership receives a tax deduction when it pays insurance premiums to the captive insurance company at the ordinary tax rates of approximately 50 percent (combined federal, state, and local taxes). During the life of the enterprise risk captive, it will pay dealership insurance claims and dividends at the capital gains tax rates of approximately 27 percent (combined federal, state, and Medicare taxes) to it owners. A dealership owner may also be able to borrow against the enterprise risk captive insurance company’s reserves to make real property dealership investments. Finally, when the enterprise captive is terminated, any remaining equity is paid to its owners at the approximate capital gains rate of 27 percent.
Because of the tax advantages that enterprise risk captives offer, many “bad actors” have entered this arena, so dealers should be cautious. It is imperative that dealerships perform due diligence when choosing a captive manager. The IRS is aware that problematic entities operate in this arena and have formed a “dirty dozen” hit list to investigate severe abuse of captive insurance structures. As recently as November 1, 2016, the IRS issued a tax notice making certain captive arrangements a reportable transaction. In short, the IRS knows abusive structures exist, and they want to gather information to study them. If the captive is structured and operated properly, you have no cause for concern.
Four steps to consider when setting up an enterprise risk captive
There are a few key steps that dealerships should take when looking into forming an enterprise risk captive. First, a feasibility study is an absolute must. This involves bringing in an independent risk manager, who visits your dealership and reviews your operations in its entirety. The risk manager also reviews all commercial policies to gain a thorough understanding of what is and is not covered to determine what coverages might be applicable to your specific operation.
Just as crucial is the second step, which is to quantify risks by actuarial models that are performed by a professional accredited actuary. The actuary will compare these quantified risks against the costs of insurance policies in the marketplace and then determine the appropriate costs for your own policies.
Third, the IRS requires risk distribution/transfer, which means you can’t simply insure 100 percent of your own risks. You must have some element of risk transfer to be considered a valid insurance policy. To accomplish this step, many dealers will pool some of their risk with the risk maintained in F&I policies, depending on the volume passing through an F&I captive. If the volume of the insurance contracts is not large enough, then you must use a third-party pool, which is usually managed by the captive manager. This is another reason to perform due diligence when choosing your captive manager.
Lastly, your captive insurance company shouldn’t loan out or make dividend payments from unearned insurance premiums. Captive insurance companies typically issue 12-month policies, after which the premium is deemed earned and is available to loan or dividend out.
These four steps are necessary to have a sound captive insurance structure that can stand up to any scrutiny.
What to look for in an enterprise risk captive provider
As mentioned earlier, the selection of a captive insurance provider is essential. Do your due diligence on their business and talk to references. A dealer should generally seek an enterprise risk captive provider who has industry qualifications, provides an extensive client and referral list, is very detailed oriented, is concerned about their reputation and yours, and is willing to tell the dealer no and stick to it.
In summary, an enterprise risk captive can be a great option to protect your dealership against uninsured risks. It offers the dealer the opportunity to secure various coverages that could be difficult to procure in the market on a pre-tax basis by self-insuring risks that are not covered in typical insurance policies. By following the steps and tips outlined above, you can more effectively determine whether forming a captive insurance company is right for your dealership and ensure that, if you do move forward, you’re set up for success.