Captives and the Construction Industry: Building on Solid Ground

Captives and the Construction Industry: Building on Solid Ground

The construction industry ranked sixth worldwide in the use of captives, according to Marsh’s 2013 Captive Benchmarking Report.

Whether a firm involved in construction should consider setting up a wholly owned captive depends on several factors, including the role it plays in the construction process — large general contractor, smaller general contractor, subcontractor, or owner/developer, its size, and its overall approach to risk management.

General Contractors

For general contractors (GC), a wholly owned captive serves as a tool to bear not only the retained corporate risk, but also the risk of subcontractors under master programs. Typically, a commercial admitted licensed insurer “fronts” the policy on a first dollar basis and then reinsures the designated layer to the contractor’s captive.

Benefits to contractors from this approach include:

1. Providing a first-dollar policy to provide a fixed premium for reimbursement purposes in an efficient manner with an owner, while also providing a means for the GC to retain risk on the back end.
2. Providing the contractor with control in setting the premium rates at a desired level to ensure solvency of the captive and any potential volatility in claims.
3. Recognizing underwriting profit associated with insuring the subcontractor risk — assuming the GC controls claim costs and institutes effective loss control measures — rather than a commercial insurer capturing such profit from insuring each subcontractor separately.

In addition to the above, the general contractor may be able to achieve certain tax benefits for funding retained corporate risk, including an accelerated tax deduction when the reserve is established versus when the claim is paid (suited well to casualty or long-term liability risk).

Smaller General Contractors and Subcontractors

The value derived for smaller contractors and subcontractors (generally those with less than US$1 billion in revenue) from using a captive focuses more on the traditional benefits that a captive can afford an organization regardless of its industry.

Benefits include:

• A vehicle for privately held companies to transfer wealth to the next generation in the form of underwriting profits from the captive (whereby the heirs serve as owners), versus transferring wealth in the form of a gift subject to estate tax.
• Formal evidence of insurance coverage from a regulated insurance entity for reimbursement purposes to support bid figures when needed.
• Ability to potentially build up underwriting profits in the captive on a tax-exempt basis, as long as annual premiums do not exceed US$1.2 million. This provides greater tax savings when funding more profitable risks (when comparing premium to losses), such as retentions for property or subcontractor risk.
• The means to access the government-sponsored terrorism reinsurance pool (TRIA and later TRIPRA) for catastrophic insurance protection for terrorism risk at no cost to the captive owner.

Owners and Developers

For owners looking to sponsor master wrap up programs for workers’ compensation and general liability risk associated with a project, the first decision they face involves the appropriate deductible they will assume. The next question is whether there is an advantage to funding the deductible layer in a captive versus retaining it on the owner’s books.

There are two primary drivers for funding the deductible layer of an owner-controlled wrap up in a captive:

• The ability to recognize (for federal income tax purposes) an accelerated tax deduction when the loss reserve is established versus when the loss is paid (if retained by the contractor) for the owner’s portion of the risk.
• The risk of the contractors, assumed and funded through the captive, may constitute unrelated risk and thus support the existence of risk distribution, which is needed to treat the captive as an insurance company for US federal tax purposes.