By Jimmy Bynum, Founder & CEO of Alexander & Preston.

As I detailed in my previous article, business-to-business extended protection plans are valuable risk management mechanisms that not only help manage the cost of ownership, but support a more integrated relationship between the dealer and customer. When optimized, these plans create a circular economy, providing both direct and indirect value for manufacturers, dealers, and customers.

When it comes to managing the liabilities associated with warranties or extended protection plans, there are three options:

1. Leave it on your balance sheet, essentially self-insuring;
2. Insure it through a third-party insurance company; or
3. Establish a captive insurance company.

This article explores the advantages and disadvantages of each option and draws insight from experts in the field to provide a complete picture of the ways to manage liabilities. See Figure 1 for an overview of these three options.

It is important to stress that each company will have different goals and risk management needs. To help guide them and determine which option makes the most financial and strategic sense, each company should look to their corporate strategy and answer a few questions: What are the main financial drivers? What is the risk appetite? What level of expertise exists within the organization? Another point to keep in mind is that the specialized nature of these programs requires expertise beyond a traditional insurance risk manager.

This article will hopefully broaden your understanding of risk management options and determine when to engage a risk management firm, such as Alexander & Preston, to help determine your needs.

Establishing a Captive Insurance Company

A captive is a closely held, licensed insurance company that is owned and controlled by the insured parties. Captives are highly regulated under special legislation, depending on where the captive is domiciled. There are specific regulations depending on whether the captive is on-shore, meaning it is located within the United States, or off-shore, meaning it is located outside the United States.

Establishing a captive requires a strategic review of the company and programs being considered, including a feasibility study, to confirm the need for a captive, as well as the recommended domicile location.

Michael Corbett, director of the Captive Insurance Section of the Tennessee Department of Commerce and Insurance, lent his expertise to this section. The state of Tennessee has one of the most progressive captive statutes in the country.

"Tennessee is a recognized leader in the captive space, with an entire section dedicated to serving the needs of all captives," said Corbett. "Since 2011, we've seen exponential growth in the number of Risk Bearing Entities (RBEs) in the state. We understand that companies face a lot of options when it comes to risk management. We're a business-friendly state with a central location that makes us an ideal candidate for those seeking to take control of their risk."

Setting up a captive is a long-term strategic decision, not one taken lightly or to meet short-term goals. The primary reason a company should use a captive is to increase leadership's engagement and focus on the value of active risk management. Corbett adds that "the owners must want to be in the insurance business and be willing to assume and share insurance risk." A captive will allow a company to increase control over:

• Ultimate cost -- reducing the cost of insurance and increasing control over risk;
• Coverage offerings, including by setting specific terms and conditions depending on the business; and
• Claims and loss control.

A captive also provides more options than the commercial insurance market, allowing a company to personalize its coverage offerings depending on their operational needs. However, as Corbett reminds us, "a captive must be operated as an insurance company, observing certain formalities and operating at arm's length with the insureds."

For example, Tractor Holding Company formed a captive entity to house risk from Tractors R Us, Inc., a wholly owned subsidiary. Tractors R Us transferred 25 percent of their risk from a traditional carrier to the captive and added previously uninsured risks to the captive, such as theft and deductible reimbursement.

As you can see from the income statement in Figure 2, the captive will build surplus over time. Because the $1 million in premiums paid to the captive is owned by the parent company, the parent company is more involved in risk management. Dividends or loans to the parent can provide cash flow benefits when the parent needs additional funds. This example shows that establishing a captive with a long-term vision can have substantial benefits.

In Figure 3, you will see how the use of captive insurance shifts the income and expenses resulting in a $375,000 reduction in net income. This flows through the balance sheet, reducing current assets and liabilities by the same $375,000. Another result of the captive is that the company has reduced the amount of insurance paid to an outside firm. While that requires taking on risks, with a strong balance sheet and actuarial sound pricing, it is in many cases a sound decision. Companies with an active program and captive manager become more engaged in the risk management process.

When structured properly, extended protection plans can be insured through a captive to underwrite both the plan, as well as enterprise risks and other common liabilities. Examples of other risks include medical stop loss, auto physical damage, workers compensation, flood, directors and officers, and cyber risk.

Third-Party Insurance Company

Managing risk by buying insurance from a third-party carrier is most commonly used if your company has specific revenue recognition requirements, is seeking guidance on regulatory compliance, or simply wants to transfer all or a portion of the risk. There are many reputable third-party insurance companies in the market, each with their own strengths and areas of focus.

I spoke with Jeff Manuel, Assistant Vice President, Underwriting & Program Development at CNA Insurance, about the benefits of buying from a third-party insurer. With more than 30 years of experience in the warranty industry, CNA is one of the largest domestic warranty underwriters, with licensed admitted and non-admitted insurance companies, contractual liability policies, and a suite of obligor companies to pursue all lines of business. CNA National Warranty Corp., a wholly-owned subsidiary of CNA, is a leading automotive warranty and service contract provider.

As Manuel states, there is typically a "combination of reasons" as to why companies consider insuring through a third party. As previously noted, companies may prefer to pass uncertain risk on to an insurance company that specializes in warranty risk management. Manuel adds that a company "may also want to recognize more revenue up-front and transfer the risk, as opposed to holding reserves and earning revenue over the term of the obligation."

Another important reason why a company may consider engaging a third-party is for regulatory compliance management. Most states have financial responsibility requirements for service contract providers involving reserves, insurance, or other financial backing. These requirements are complex, ever-evolving, and can be difficult to navigate, particularly if risk management is not an area of expertise for the staff.

A company managing their own nationwide service contract program could potentially have posted reserves or bonds in several states and have contractual liability insurance policies in others. Simplifying the structure with a single contractual liability insurance policy for all states can often be the best solution for the company. Regulatory compliance becomes even more complex for companies operating in multiple countries.

Companies should also consider the marketing benefits of engaging a third-party insurer. By entering into an agreement with a third-party insurer such as CNA, a company can market that their warranty and service contract is backed by an A-rated carrier. This can be critical to a company's growth plans and their ability to target a broader audience.

Lastly, distribution can be a significant advantage of third-party insurance. For some products, an insurance carrier can leverage distribution partners -- including brokers, managing general agents, and associations -- to market and distribute the company's products and programs to more customers.

"By leveraging our extensive insurance knowledge and warranty experience, we are able to partner with our clients to create customized solutions that fit their unique risk management needs," said Manuel. "When we enter into a new client partnership, our goal is to provide a superior support experience that will benefit them over the long term. The tenure of our client relationships, several lasting more than 20 years, is a testament to the value we bring to our clients every day, year-after-year."

As with establishing a captive, there are multiple reasons why a company should consider engaging a third-party to manage risk. The best way to determine what makes the most strategic sense is through a feasibility study.

Balance Sheet

Finally, a company may choose to retain risk on their balance sheet or income statement. This is the simplest structure of the risk management options, but -- as with the other options -- comes with advantages and disadvantages. Among the benefits, keeping risk on a balance sheet allows you to control cash. A company is not purchasing insurance from a third-party or putting money into a captive, so all money is kept in-house until there is a loss.

Like a captive, a balance sheet offers pricing and coverage flexibility. When strategic drivers point to leaving the liabilities on the balance sheet, it is imperative to seek tax and accounting counsel on impact to the income statement. This is especially important given that typical extended protection plans cover multiple fiscal years and recognizing the revenue and claims is important.

Chief among the disadvantages is the fact that retaining risk -- which, in and of itself, opens the company to additional risk -- may not be among the core competencies of the company. Lacking the skills to manage the liability in this manner may result in missteps, which could create additional risk and even expose the company to compliance risk.

Additionally, revenue is recognized only when a specific critical event has occurred and the amount of revenue is measurable. This has a direct impact on earnings before interest, taxes, depreciation, and amortization, commonly referred to by its shorthand EBITDA. Some public companies have a focus on delivering EBITDA to their shareholders, and this strategy will clearly have an impact on their decisions on how to manage extended protection risks.

Choosing a Risk Management Option

For any company that has warranty or extended protection plan liabilities, it is imperative to take the time to evaluate all three options. To conduct this evaluation effectively, a company needs to have a clear understanding of their financial goals, as well as their appetite for risk. If the company is currently self-insuring risk on their balance sheet, moving to a captive will have an impact on their balance sheet and income statement. Working through that exercise will give them the answers as to whether establishing a captive or engaging a third-party insurer would be beneficial.

It is worth noting that the answer may be a hybrid solution depending on a company's operational needs. Such a solution is particularly common for multinational companies who face different regulations in the countries where they operate. Simple is not always the right answer, which is why a feasibility study is often recommended to support the decision on which of the three options makes the most sense, while taking a broad view of the business and strategic drivers.

Regardless, communication is key to both determining the right risk management option and ensuring its success over the long term. A business owner or president and chief financial officer must understand the implications of each option and how it will impact their strategic objectives.

Ultimately, each party needs to determine the best solution for their company. Risk management firms, such as Alexander & Preston, can help companies walk through these options, conduct a feasibility study, and provide a recommendation for liability management in line with the financial goals.

DISCLAIMER: This article and the information provided by the contributors is for general informational purposes only and not a solicitation of any type, and the contributors are not rendering advice or providing guidance. Informational statements regarding insurance coverage, captive insurance companies, risk management, generally-accepted accounting principles, legal, tax, warranty and or extended protection plan structures are for general description purposes only.

About the Author:

Jimmy Bynum founded Alexander & Preston LLC in 2014 following a career specializing in extended protection plans and warranty. The company partners with OEMs and distributors of commercial and industrial products to optimize their risk management solutions. A&P services are available to commercial and industrial manufacturers of heavy equipment, agricultural equipment, medical devices, aerospace, and information technology equipment.

Prior to forming Alexander & Preston, Jimmy spent 12 years with Cat Financial Insurance Services, the extended protection plan (EPP) and captive insurance division of Caterpillar Inc., the global leader in industrial equipment, most recently as Global Marketing Manager, where he led efforts to integrate the insurance organization into the finance team.

Jimmy is active in the Nashville community and within the industry by serving as Vice Chair of the Board at Oasis Center, past Board Member at the Texas Captive Insurance Association, and Vice President of the Global Warranty and Service Contract Association from 2011 to 2017.

Jimmy can be reached at Jimmy.Bynum@AlexanderPreston.com or +1 (832) 699-7911 extension 101.