The coming wave of ownership changes

According to PwC’s US Family Business Survey 2019, around half of all small and middle-market businesses will change hands in the next five to 10 years. The trend is not confined to the smaller players, with the turnover rate of Fortune 500 companies also accelerating. Innosight, a consulting firm, predicts that around half of the Fortune 500 will be replaced over the next 10 years, with a significant factor for that turnover being mergers and acquisitions (M&A).

This big wave of ownership changes will affect thousands of captives. Indeed, the biggest factor affecting how many captive insurance companies stay in operation in the future will likely not be regulatory, but rather how the business is transitioned in the coming ownership change.

Well over 10,000 businesses are involved in captive insurance. Those numbers come from the approximately 6,000 reported single parent captives in US and Caribbean domiciles. In addition, there are several thousand producer-owned reinsurance companies (PORCs) in the Turks & Caicos handling auto dealer extended warranty transactions. Add to that several thousand group captive participants handling primarily workers’ compensation, general liability, and auto, and a newer entrant of medical stop loss.

When a business is sold to a third party, management of the captive often changes hands, or the captive goes into run-off. When a business is not sold to a third party but is transferred to the owner’s descendants or sold to senior management, the captive has a greater chance of continuing. However, even then, a third-party review is often conducted to determine whether any changes should be made.

While this article specifically references the captive, similar fates await the commercial insurance broker, accountant, and attorney.

Captive managers and risk managers of all types—single parent, group, programme—can protect their client base by taking the following steps.

Optimise operations
Optimise operations today and make sure key decision-makers understand your role.

Many captives today are underutilised and underappreciated by the key decision-makers who decide their fate. The original cheerleader for the captive when it was formed is often not the same person who is currently handling its ongoing activities.

Sometimes that is because the owner who supports the captive delegates ongoing maintenance to a controller or some other person who had less involvement in its setting up. Sometimes it is because the risk manager who established the captive has moved on to another job and the new person in that job is not as invested in the continued success of the captive.

Without an active cheerleader in the organisation the captive may atrophy. This has led to many captives being “active” from a licensing standpoint with the regulators, but writing only the bare minimum insurance business, meaning unfulfilled potential. Without intervention now, this captive may be shut down with a future ownership change.
To prevent this, it is recommended that captive managers perform regular strategic reviews and ongoing education. Periodic strategic reviews, whether by the current advisors or an independent advisor, ensure that the captive is operating at its highest and best use.

The value proposition of the captive should be communicated to the leadership team and to those inside the organisation who are currently handling insurance matters.

The value proposition of the captive should also be communicated to potential successor management. If the current insider cheerleader were to leave her/his position, who would be the next logical point person to handle captive insurance matters for that insured business? Does that person understand the business plan and benefit of the captive?

While that person may not want to spend much time today learning about the captive, some basic education may plant the seed necessary to grow a future captive insurance cheerleader.

Get involved early
When a business owner is considering an ownership transition, the outsider advisors are often given an early heads-up that the owner is exploring options. A proactive insurance advisor can provide huge value to the deal or can be passive about it and be blamed when problems arise. What other insurance matters need to be addressed as part of ownership change?

If insurance matters are not brought up until financial terms are being negotiated, you are late in joining this discussion and your role as an advisor is being reactive, not value-additive. The preparation, marketing, and negotiation stages of selling a business typically last at least a year, if not two. For a third-party sale, the business needs six to 12 months to prepare the company’s books and financials to have things in order to be able to go to market.

Then the marketing stage of selling the business takes months to well over a year. Once a potential suitor is identified, the time it takes for the dealmakers and lawyers to come to agreement on financial and legal terms can be a few months more.

If captive insurance and other insurance items are not brought up until the negotiation stage, there is a lower chance that the future owners of the business will appreciate the value the captive brings to the business, and strategic opportunities to use the captive as part of the deal, or for the future business, may be lost.

Does the business or captive have legacy liabilities that need to be addressed when the business is sold? These could come from a high deductible workers’ compensation programme or other high deductible programmes, known pollution claims, or other liabilities with potential long tails lasting into the future.

What about the D&O policy for the owner? Will this policy properly cover the reps and warranties obligations in the deal contract? Can or should these be handled through a captive policy or a new insurance carrier policy?

If the solution to a legacy liability issue is to transfer the liabilities to a commercial carrier through a loss portfolio transfer (LPT), keep in mind that this transaction will require months of lead time to prepare, market, and negotiate the LPT deal. With the LPT it may be possible to have both financial and legal liabilities removed from those books of the acquired business.

Early involvement is also needed when a captive is owned not as a subsidiary of the operating entity, but outside the operating enterprise. Even if the captive can provide a solution, is it owned in such a way that it still operates within its licence to insure risk only in affiliated or controlled business?

In these situations, a thorough exploration should be undertaken to analyse whether the captive can or should be transferred as part of the sale, or kept outside. If kept outside the transaction, the captive may not be able to continue offering insurance coverage to the legacy business because such coverage may be outside the scope of the single parent captive licence.

In this case there are options: the captive may be able to undergo a business plan change and be used to insure another business affiliated with the owner.

Type of buyer
Your role as an insurance advisor and the longevity of the captive insurance company will be greatly influenced by the type of purchaser.

Broadly speaking there are two categories of business purchasers: third-party acquirers, and friends and family acquirers. The third-party acquirers include private equity, strategic buyers, and competitors. Friends and family purchasers include the owner’s children, current management, and selling the business to an employment stock ownership plan (ESOP).

While there are many factors that go into why an owner would choose to sell to one over the other, as an advisor you should be aware of options and help to advise on the consequences of each as it relates to the insurance programme.

For example, many owners of closely-held businesses say their ideal exit strategy is to leave the business to a family member. However, for various reasons this exit strategy is often not chosen or not available. One survey reported that less than one-third of family businesses survive the transition from first to second generation ownership, and another 50 percent of those don’t survive the transition from second to third generation.

Further, in its Investor Watch note for Q1 2018, UBS found that 82 percent of heirs would rather have the cash than the business, and 80 percent of millennials say the stress of owning a business is too high.

A third-party acquisition will usually generate a higher sales price than a friends and family buyer, but giving up control of the business is a big concern to a business owner who is worried about how the new owner will treat the employees. The owner also may not be ready to retire immediately or to work as an employee taking directions from the new owner. As it relates to insurance, the third-party buyer typically has its own set of advisors that sooner or later will be taking over.

One option that may be the best of both worlds is to utilise an ESOP as the buyer. By doing so the seller gets a selling price at fair market value that, net of all fees and expenses, compares favourably to that of a third-party buyer. The new business owners are the current employees, and typically all the employees and outside advisors continue on as before. The owner can stay in control of the business. The ESOP can also be structured as a partial sale, providing liquidity today to the owner and leaving part of the ownership to the next generation or key management.

Whether and how the captive will continue in an ESOP will depend on many factors, but there is not the outside pressure from new owners to preemptively eliminate the captive without a thorough analysis of the options.

The deal team
Choose a deal team that understands and supports captives. Whether the ownership transition is to friends and family, or a third-party buyer, if given the choice, choose attorneys and advisors that understand and will take the time to properly evaluate and where possible continue on the legacy captive. The captive insurance programme is a product of large amount of time and expense to set up, and when done properly provides significant benefit to the risk management programme.

It is a shame to see the captive underutilised or terminated because the deal team did not take time early in the process to consider how to incorporate the captive. This advice applies regardless of the type of sale.

The vetting of the right deal team is more than asking if they understand captives, because all investment bankers today will say they understand captives and are supportive of them when they make sense. Many of these “supportive” deal advisors unfortunately treat an offshore group captive insuring workers’ compensation in the same class as an offshore terrorism insurance captive with zero claims history. The right type of experience matters when it comes to captives and insurance items.

Final thoughts
Transitioning ownership in a business through a third-party sale or to close family and friends is a process that typically takes years, not months. The retiring of baby-boomers is happening now and will continue for the next 10 years. The continued usage of a captive by the successor business owner will turn greatly on what we do today to prepare for this transition.

Jeremy Huish JD, CPA is a director with Business Transition Advisors, a division of Capstone Headwaters. He can be contacted at:  jhuish@capstoneheadwaters.com