Captive Insurance Considerations for Franchises

McDonald's realized it could assert greater control over its franchisees by creating a captive insurance company that would better mitigate risks while reducing costs and tax obligations. McDonald's Corp. would own the captive insurer, which would then make available insurance coverage to franchisees.

Now, McDonald's stipulates that if a franchise is insured through the company captive, it must report product liability incidents within a 24-hour period, along with a detailed explanation. This enables the corporation to manage the incident from the beginning. By assessing the scenario, the corporation can use its resources to make the best determination of whether to settle or argue the claim, thereby reducing costs and risks in the long run to itself and other franchisees.

The McDonald's incident demonstrates just one way in which captive insurance can play a significant role for those within the franchise marketplace. In addition, franchisees can use captives to fill in the gaps to cover liabilities that their traditional liability insurance will not cover and reap potential cost savings through competitive insurance rates and tax incentives.

What Is Captive Insurance?

Captive insurers are insurance companies formed by a business owner or a group of business owners to insure the risks of related or affiliated businesses, rather than relying on an outside commercial insurance company to provide coverage. Captives come in many forms. The “pure captive” model is a captive insurance company that has a single owner which it insures. An “association captive” is a captive insurance company that is generally formed by a trade association or members of an industry to provide insurance for members. An “industry captive” is similar to an association captive in that it is owned by organizations within the same industry. These are often relied upon to solve a specific insurance problem, such as covering a liability for which insurance is not readily available within the commercial market. Other types of captives include “diversified captives” and “agency captives,” both of which are useful in very particular scenarios.

Creating a captive insurance company can reduce costs by eliminating the overhead typical of big commercial insurance companies. In addition, because the captive is connected to the insured entity, premiums that are not paid out to cover a claim remain within the corporate enterprise, rather than becoming profits for an insurance company. These premiums can be held to protect against future risks or invested in growing the business.

Captives can also help control risk. First, the mere establishment of a captive incentivizes the owner or owners to manage their risks proactively. With commercial insurance, risk management tends to be viewed as a cost center, but the captive model turns risk management into a profit center. Additionally, captives can provide companies with access to the reinsurance market and can provide coverage for certain liabilities that would otherwise be uninsurable or cost-prohibitive on the commercial market.

Finally, captive insurance companies can operate in a tax-efficient manner. For example, captives that make an election under Section 831(b) of the Internal Revenue Code with premiums of $1.2 million or less per year are exempt from recognizing premium income. (While in the past, some parent companies chose to establish their captives in offshore, tax-friendly locations, this is no longer a recommended option. With the Stop Tax Haven Abuse Act of 2009, the federal government has taken strides to cut down on captive insurance companies that were established largely as offshore tax shelters. Now, parent companies are establishing their captives in domestic localities while still enjoying a number of tax benefits.)

Franchisees and Captives

Franchisees also can consider captive insurance to cover against a liability that is not readily insurable. For example, some franchisees have been burned during the recession by a franchisor's bankruptcy filing. This exact scenario affected a number of Chrysler dealers when the car company sent shutdown notices in 2009 after its bankruptcy filing. The dealers had little recourse but to battle Chrysler in court using their own post-tax dollars to litigate against the franchisor. If these dealers had established a captive insurance company in advance and self-insured against such a loss, they could have either received some form of compensation from the captive insurer to cover their “business interruption” or used the captive's pre-tax premium dollars to write litigation coverage.

Another commonly uninsurable yet significant liability for franchisees is the risk to the franchise's reputation. A negative incident that occurs at one franchise may have a direct and real impact on the business of all franchisees. Outbreaks of food-borne illness that are linked to a particular restaurant chain are a prime example. Such liabilities, while not readily insurable through commercial insurance companies, are insurable through the use of a captive insurance company.

Forming a Captive

Forming a captive insurance company can take as few as 30 days, depending on the jurisdiction in which the captive is being established. That said, significant planning and assessment must be made initially to ensure that the entities that stand to benefit from the captive are insuring the proper liabilities at the proper cost. Such an assessment can be conducted by an experienced captive management company that relies on the shared knowledge of legal, risk assessment, and accounting experts who have a solid understanding of the captive marketplace. Initial considerations of the would-be captive owners include what risks to insure against, what type of captive to form, and who will be the shareholders of the captive (whether businesses, trusts, or individuals).

Once certain preliminary questions are answered, the franchise or franchisees can move forward with pooling the proper amount of capitalization required to receive an insurance license. Throughout the captive's lifespan, the captive insurance company must maintain an adequate amount of capital relative to the risk or risks underwritten ' a task best left to an experienced insurance management company. Also, a captive will need an actuary to help assess the risks that are being insured against, conduct underwriting, and develop policies around the insurance that is being provided to captive members. Because the insurance industry is highly regulated, there are many technical reporting requirements that captive insurance companies must adhere to, including accounting records, quarterly financial statements, and regulatory filings, and reporting.

In conclusion, forming a captive insurance company provides a number of unique advantages to franchisors and groups of franchisees, starting with reduced premiums. Quite possibly the most significant advantage of the captive insurance model, especially for franchisees, is the ability to protect against liabilities that would otherwise be difficult to insure.

Keith Langlands is principal at Synergy Captive Strategies, which provides captive insurance formation, management, and alternative risk-transfer strategies for middle-market companies. He can be contacted at [email protected].

The 1994 product liability lawsuit Stella Liebeck v. McDonald's Restaurants, P.T.S., Inc., and McDonald's International, Inc., is one of the most famous pieces of litigation of all time. It's also every franchisee's nightmare.

The facts of the case are well known. After ordering a cup of McDonald's coffee from one of the store's franchises, Stella Liebeck, 79, accidentally spilled the hot liquid on herself while sitting in the passenger seat of a parked car. The incident resulted in third-degree burns on 6% of her body, resulting in two years of medical treatment. She initially approached the franchisee for a settlement to help cover the costs of her medical treatment and lost wages, but the franchisee refused. The matter then snowballed into court and onto national television, resulting in a public relations snafu that has stuck with McDonald's and its franchises since that day.

Although there are many takeaways from the hot coffee incident, one has been a significant change to how McDonald's Corp. and its franchises deal with insurance. The corporation saw how its franchisee had exposed it and other franchisees to unnecessary liability by neglecting to handle the incident in a way that could have mitigated risk exposure. Instead, the franchise let the incident fester, which resulted in a media frenzy and a judgment of more than $600,000.

McDonald's realized it could assert greater control over its franchisees by creating a captive insurance company that would better mitigate risks while reducing costs and tax obligations. McDonald's Corp. would own the captive insurer, which would then make available insurance coverage to franchisees.

Now, McDonald's stipulates that if a franchise is insured through the company captive, it must report product liability incidents within a 24-hour period, along with a detailed explanation. This enables the corporation to manage the incident from the beginning. By assessing the scenario, the corporation can use its resources to make the best determination of whether to settle or argue the claim, thereby reducing costs and risks in the long run to itself and other franchisees.

The McDonald's incident demonstrates just one way in which captive insurance can play a significant role for those within the franchise marketplace. In addition, franchisees can use captives to fill in the gaps to cover liabilities that their traditional liability insurance will not cover and reap potential cost savings through competitive insurance rates and tax incentives.

What Is Captive Insurance?

Captive insurers are insurance companies formed by a business owner or a group of business owners to insure the risks of related or affiliated businesses, rather than relying on an outside commercial insurance company to provide coverage. Captives come in many forms. The “pure captive” model is a captive insurance company that has a single owner which it insures. An “association captive” is a captive insurance company that is generally formed by a trade association or members of an industry to provide insurance for members. An “industry captive” is similar to an association captive in that it is owned by organizations within the same industry. These are often relied upon to solve a specific insurance problem, such as covering a liability for which insurance is not readily available within the commercial market. Other types of captives include “diversified captives” and “agency captives,” both of which are useful in very particular scenarios.

Creating a captive insurance company can reduce costs by eliminating the overhead typical of big commercial insurance companies. In addition, because the captive is connected to the insured entity, premiums that are not paid out to cover a claim remain within the corporate enterprise, rather than becoming profits for an insurance company. These premiums can be held to protect against future risks or invested in growing the business.

Captives can also help control risk. First, the mere establishment of a captive incentivizes the owner or owners to manage their risks proactively. With commercial insurance, risk management tends to be viewed as a cost center, but the captive model turns risk management into a profit center. Additionally, captives can provide companies with access to the reinsurance market and can provide coverage for certain liabilities that would otherwise be uninsurable or cost-prohibitive on the commercial market.

Finally, captive insurance companies can operate in a tax-efficient manner. For example, captives that make an election under Section 831(b) of the Internal Revenue Code with premiums of $1.2 million or less per year are exempt from recognizing premium income. (While in the past, some parent companies chose to establish their captives in offshore, tax-friendly locations, this is no longer a recommended option. With the Stop Tax Haven Abuse Act of 2009, the federal government has taken strides to cut down on captive insurance companies that were established largely as offshore tax shelters. Now, parent companies are establishing their captives in domestic localities while still enjoying a number of tax benefits.)

Franchisees and Captives

Franchisees also can consider captive insurance to cover against a liability that is not readily insurable. For example, some franchisees have been burned during the recession by a franchisor's bankruptcy filing. This exact scenario affected a number of Chrysler dealers when the car company sent shutdown notices in 2009 after its bankruptcy filing. The dealers had little recourse but to battle Chrysler in court using their own post-tax dollars to litigate against the franchisor. If these dealers had established a captive insurance company in advance and self-insured against such a loss, they could have either received some form of compensation from the captive insurer to cover their “business interruption” or used the captive's pre-tax premium dollars to write litigation coverage.

Another commonly uninsurable yet significant liability for franchisees is the risk to the franchise's reputation. A negative incident that occurs at one franchise may have a direct and real impact on the business of all franchisees. Outbreaks of food-borne illness that are linked to a particular restaurant chain are a prime example. Such liabilities, while not readily insurable through commercial insurance companies, are insurable through the use of a captive insurance company.

Forming a Captive

Forming a captive insurance company can take as few as 30 days, depending on the jurisdiction in which the captive is being established. That said, significant planning and assessment must be made initially to ensure that the entities that stand to benefit from the captive are insuring the proper liabilities at the proper cost. Such an assessment can be conducted by an experienced captive management company that relies on the shared knowledge of legal, risk assessment, and accounting experts who have a solid understanding of the captive marketplace. Initial considerations of the would-be captive owners include what risks to insure against, what type of captive to form, and who will be the shareholders of the captive (whether businesses, trusts, or individuals).

Once certain preliminary questions are answered, the franchise or franchisees can move forward with pooling the proper amount of capitalization required to receive an insurance license. Throughout the captive's lifespan, the captive insurance company must maintain an adequate amount of capital relative to the risk or risks underwritten ' a task best left to an experienced insurance management company. Also, a captive will need an actuary to help assess the risks that are being insured against, conduct underwriting, and develop policies around the insurance that is being provided to captive members. Because the insurance industry is highly regulated, there are many technical reporting requirements that captive insurance companies must adhere to, including accounting records, quarterly financial statements, and regulatory filings, and reporting.

In conclusion, forming a captive insurance company provides a number of unique advantages to franchisors and groups of franchisees, starting with reduced premiums. Quite possibly the most significant advantage of the captive insurance model, especially for franchisees, is the ability to protect against liabilities that would otherwise be difficult to insure.

Keith Langlands is principal at Synergy Captive Strategies, which provides captive insurance formation, management, and alternative risk-transfer strategies for middle-market companies. He can be contacted at [email protected].