Self-Insurance 101: Is it the right choice for your business?

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Mark Battersby

-By Mark Battersby-  As the economy slowly improves, it should come as no surprise to a rural builder that insurers have begun raising business insurance premiums while reducing available insurance coverage. One increasingly popular option for many businesses is a “self-insurance” program or insuring its own risks.

Self-insurance allows a building business to lower ongoing premium expenditures and to take control of low-level risks. This is achieved by the business becoming its own insurer for either a certain level of risk or certain types of risk.

Obviously, some risks cannot be self-insured without being approved by state regulators. Workers’ Compensation can, for example, be self-insured, but must meet certain guidelines and usually requires approval. Mandatory auto liability insurance can be self-insured only by meeting state requirements.

Self-insurance usually requires a business to set aside funds to pay losses as well as to purchase high-level excess policies to ensure that the funds set aside will not be exceeded by higher than expected claims.

Since a self-insurer pays its own claims, policies can be tailored to its own needs with less impact from changes in the traditional insurance market. Self-Insurance can also help a business obtain insurance coverage that would not otherwise be available.

Premiums for insurance for various types of business risks, such as property damage or liability, are generally deductible as business expenses. No deduction is, however, permitted for any amounts paid for “prepaid” expenses, including prepaid insurance. Prepaid expenses generally fall under the heading of more permanent improvements, and must be capitalized.

Examples of business insurance commonly self-insured include the following:

  • Workers Compensation: Some states allow businesses to become self-insured without the need for a licensed insurer. However, the criteria imposed by states in order to qualify as a self-insurer normally include the acquisition of excess insurance as well as the submission of a bond or other form of collateral equal to the amount of potential liability.
  • Employee Benefits: Under federal legislation known as ERISA, employers are allowed to step away from the state regulated benefit programs and self-insure their employee benefit programs. The advantages are significant as, unencumbered by individual state regulation, employers can design their own benefit plans to suit their workforce.
  • Commercial Automobile Liability: Commercial automobile liability is often self-insured and is regulated by individual states. Because of the potential catastrophic claims that can arise from an accident, self-insuring often requires the building business to purchase “excess” insurance coverage as protection from large numbers or amounts of losses.
  • Commercial General Liability: Liability can be attractive to self-insurers because potential losses can be significant, creating a greater interest in loss prevention. Due to the fact that claims are not normally settled for a number of years, a business may see an enhanced cash flow as funds can be temporarily diverted to other areas of the operation.

Self-insurance is by no means appropriate for every business and a feasibility study and/or professional assistance should play a significant role in determining the suitability of self-insurance. The advantages to a self-insurer can be summarized as follows:

    • Cost savings: The principal aim of self-insurance is to improve profits by reducing premium costs.
    • Risk mitigation: The self-insured business structures the type of coverage and level of risk it is willing to assume.
    • Plan Design: Self-Insurance plans and risk transfer programs can often be modified to provide coverage that commercial insurers are unable to provide.
      Protection from price fluctuations: The self-insured can stabilize risk management costs.

Cash flow: The self-insured can invest the funds budgeted for insurance, structuring maturities to meet cash flow needs

Among the disadvantages of self-insuring are the exposure to risk and the possibility that the program will end up costing more than traditional insurance. While self-insurance should be viewed as a long-term strategy as some of the advantages may take time to pay dividends, the potential disadvantages of self-insurance can be summarized as follows:

  • Exposure: A self-insurer can suffer from poor claims experience. However, any potential downside can be limited by reinsurance. Naturally, if the program continues to show poor results then the cost of the reinsurance will increase and self-insurance may ultimately become uneconomic.
  • Administrative Burden: Self-Insurance requires establishing systems to settle and monitor claims as well as negotiating with other service providers such as excess insurers. However, this function is often out-sourced to a professional administrator known as a Third Party Administrator (TPA).
  • Taxes: As with most business expenses, self-insurance costs are tax deductible. However, losses can only be taken as a tax deduction when they are paid rather than incurred.
  • Workers Compensation: Claims are paid out over many years but often the self-insuring builder or contractor is able to meet claims by purchasing an annuity policy on behalf of the claimant and achieve an immediate tax deduction.

Modern captives began in Bermuda in the early 1960s, and captive insurance was formalized in the late 1970s, with a medical malpractice captive for Harvard University. In recent years, the growth of captive insurance has boomed, driven by businesses seeking to better manage their insurance needs. While captives were initially used only by large multinationals, the concept has caught on, and today captives are found in a wide variety of business endeavors.

A “captive” is an insurance company that insures the risks of its owner, affiliated businesses or a group of businesses. Captives allow building businesses to structure the type and amount of risk they wish to retain. In fact, a captive insurance arrangement may include risks that are currently uninsurable or insurable only at prohibitive costs. Risks that are not retained can be covered in the reinsurance market.

Insurance companies (of all sizes) operate under different tax rules than other companies. The U.S. Tax Code recognizes that insurance companies receive premium dollars up front, but may not pay out claims (associated with those premiums) for many years.  Therefore, U.S. tax law allows insurance companies more generous current deductions.

While some tax advantages may be established through a properly planned captive, achieving such advantages should not be a key goal for any builder or contractor. Fortunately, some states allow individual companies and groups to band together to obtain difficult-to-purchase type coverage or, for more sophisticated and larger companies, the chance to establish separate companies as new profit centers.

The IRS long-ago concluded that a captive insurance company formed by a “significant number” of unrelated insured, each having no more than 15 percent of the total risk, was a valid insurance arrangement. The IRS also went on to establish other factors that they expect to see in a bona fide transaction.

This IRS ruling paved the way for franchisees, industry groups, and other associations to form a captive insurance company with the protection of an IRS safe harbor ruling. Obviously, there are other benefits, but those would need to be explored with an insurance professional.

Self-insurance can lead to significant savings for some businesses. There are, of course, many considerations that need to be made regarding risk shifting, risk distribution, and the deductibility of captive premiums for tax purposes. While recent IRS rulings have made captive insurance arrangements somewhat more complex, the associated benefits of self-insurance and captive insurance companies continue to outweigh their negative aspects. RB

Mark Battersby has more than 35 years experience in small business issues, tax and financial matters. His articles regularly appear in Rural Builder magazine under the column “Money Talk.” Contact him at MCBatt12@Earthlink.net.

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