Franchisors can supersize cost savings with captives

A captive insurance programme is an effective way for franchisors to ensure their franchisees have access to high-quality insurance coverage that’s better and more affordable than they can find in the current market, say Jeannie Hylant and Sarah Williams of Hylant.

Franchise restaurants and other franchise businesses aren’t what we usually think of when it comes to sources of innovative management strategies. Well-defined business models, rigid standards, and professional marketing support might seem to limit the opportunities to try something different.

Franchise operators are struggling for survival like never before. Beyond a competitive landscape with a constant stream of new players, pressure to add trendy menu items, third-party delivery services cutting into margins, gaps in the supply chain, and the tightest labour market in decades, franchisees and their franchisors are highly motivated to find creative solutions to remain profitable.

A challenging landscape

Then there’s insurance. Consider how your favourite franchise location appears through an insurance carrier’s eyes. High-turnover, low-skill employees dealing with fryers, greater risk for slips and falls, and food safety rules. Lobbies with kiosks for ordering and self-service beverage centres where spills are commonplace. Walk-up customers trying to get past their impatient drive-up counterparts. 

These are just a few of the elements contributing to the significant rise in rates. Little wonder franchisees have seen double and sometimes triple-digit premium increases driven by general liability, property and umbrella coverages—if they can get someone to write it for them—as carriers walk away from the sector.

When franchisees feel pain, franchisors hear the groaning. The relationship between the two is fundamentally symbiotic, but franchisees can be pretty demanding about what they receive in return for the large portion of sales the franchisor pockets. Good franchisors work hard to help their franchisees thrive. In turn, the franchisors have strict standards for every aspect of business. Ensuring franchise operators have adequate insurance coverage reduces the potential for the franchisor’s assets or reputation to suffer as the result of a claim gone wrong.

Better, more affordable coverage

Establishing a captive insurance programme is a remarkably effective way for franchisors to ensure their franchisees have access to high-quality insurance coverage that’s better and more affordable than they can find in the current market. It helps franchisees trim one of the biggest components of their margins. Additionally, the captive approach can create significant financial incentives for adopting ideas such as worker safety programmes that reduce claims. And a captive may provide tax efficiencies to both franchisor and franchisees.

As in so many industries, the challenges franchisees face when trying to obtain liability insurance reflect the spate of nuclear verdicts being awarded in US courtrooms and the tactics being used by some personal injury attorneys to put pressure on franchisees by dragging cases out. Not that long ago, a franchise customer might slip and fall, and the owner would promptly file a claim the insurance carrier would settle quickly. Today, the same customer is likely to call one of the attorneys advertised on the billboards they see all over town, making the process far more complex and costly. As a result, the owner has few options to cover the added cost except to increase the price of future customers’ meal orders.

“The captive’s use of funds to support claim reduction activities will help them realise significant reductions to their overall insurance spend.” 

Similar to group purchasing

Many franchisors help their franchisees increase profitability by offering group purchase programmes. Rather than having to find and negotiate individual vendors for food, packaging, and other needs, the franchisor negotiates one discounted contract for everyone. In addition to providing lower costs, the franchisor knows working with a single vendor will ensure consistency in what the franchisees receive and sell. 

Developing a captive insurance programme is a similar concept. Instead of individual franchisees being forced to negotiate with insurers on their own, a captive structure assembles a group of owners, develops actuarially sound funding levels based on their specific business risks to ensure long-term programme success rather than relying on general industry standards, and provides focused support to drive reductions in the frequency and severity of claims.

Insurance carriers who may have baulked at providing coverage to individual owners are more willing to partner given the elevated claim support provided to the captive. After all, the programme’s structure is designed to give them a clearer assessment of the risks, so they can price their portion competitively.

Strong participation is key

Generally, captive programmes established by franchisors encourage participation by the top-performing franchisees. That can create some heartburn for the franchisees, most of whom have an inherent aversion to being told what to do. However, one of the keys to a successful captive programme is the sheer scale of what’s being insured. The more high-quality franchisees who participate, the better the data, and the more control the franchisor is able to exert over claim reduction efforts. 

The captive typically needs to have at least $3 million in total premium volume to interest most fronting carriers and reinsurers.

Private equity issues

The growing flow of private equity money into the franchise industry creates an issue that franchisors and their franchisees are wise to resolve from the beginning. Typically, when a private equity group takes control of a franchisor, it is not focused on long-term performance. Instead, its goal is to maximise the returns for five to seven years and then sell the company to another company or group of investors. When that happens, does the captive belong to the franchisees? 

The franchisees might assume that’s the case, given their role in providing capital to fund the captive, but unless that’s clearly defined in the documents, the franchisees might find themselves essentially being insured by a previous owner who no longer has a stake in their success.

The franchisor has to begin with the end in mind. Is the goal to make the captive a member-owned effort, or is its primary interest creating a new stream of revenue from franchisees? What are the tax-related goals, and who should benefit? Multiple decisions like these will determine how the captive will be structured and operated.

Selling the concept

It can be difficult initially to convince franchisees that a captive insurer offers the smartest, most affordable approach to their insurance needs. Like most small business owners, franchise operators typically don’t have a deep understanding of insurance, viewing it as a frustrating labyrinth of terms and coverages packed with double negatives about exclusions that invariably costs far too much. 

That’s especially true with the specialised insurance they may need as part of the franchise agreement to address business-related exposures such as liquor liability, sexual harassment or assault and battery coverages.

That makes franchisee education an important element in exploring and pursuing the captive strategy. Business owners who are normally focused on short-term performance and expenses must be encouraged to take a longer-term view. Most franchise systems have some sort of franchisee advisory council that acts as a representative for addressing the concerns of all franchisees and relaying information they need to know about business decisions. 

Educating the council’s members is a good starting point for addressing the idea of a captive insurer. Involving them early may not only head off potential resistance from the larger group of operators, but they’ll be able to contribute to the efficacy of the captive plan.

Promote advantages

The key message they can deliver to their peers is that the shift to a captive will offer both short- and long-term advantages. In the near term, they won’t have to scramble to find coverage, they can expect to gain cost efficiencies and pricing consistency, and the coverage will be more closely aligned with the realities of their business. In the long run, the captive’s use of funds to support claim reduction activities will help them realise significant reductions to their overall insurance spend. 

In addition, captives that are efficiently funded and managed create a nest egg, with each franchisee’s share used to improve their balance sheet through the dividends received, increasing the value of their business when they’re ready to exit.

Usually, larger and more influential franchisees—and corporate-owned stores—are quick to recognise the benefits of the captive strategy. When they support the approach as a creative opportunity to control and stabilise insurance costs while building up equity, the smaller franchisees will be more eager to participate.

Expanding the captive

Once a franchise-focused captive is up and running, the franchisor or franchisee council might explore incorporating additional lines of coverage. For example, the captive could be used to support a more robust employee benefits programme that helps franchisees find and keep more employees. Franchise concepts that involve delivery may find the captive an excellent way to replace a patchwork of vehicle insurance programmes with solid protection and claim reduction. 

Cyber-related risks might also be addressed through the captive. Continuous improvement is a hallmark of effective captive structures.

While the captive strategy provides a lengthy list of advantages, it also involves many complexities, such as determining the proper domicile and complying with regulators. That’s why a franchisor considering bringing the captive strategy to its business should work with a captive partner that has experience in helping other franchisors take full advantage of the benefits.

Jeannie Hylant is executive vice president, client executive, Franchise & Hospitality at Hylant. She can be contacted at: jeannie.hylant@hylant.com 

Sarah Williams is director of group captives at Hylant. She can be contacted at: sarah.williams@hylant.com

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