Captive Insurance and ESOP Strategies for Construction Companies

What many are calling the biggest wealth transfer in history is underway. While that term is generally used to describe the generational transfer of personal wealth, there's a parallel in business. As the baby-boomer generation transitions into retirement, companies now owned by boomers seek ways to turn their equity into liquidity. The ready availability of private equity has fueled liquidity events in a wide range of industries.

While the construction industry is seeing a growing share of liquidity events using private equity dollars, there are many construction companies considering other approaches. Those handling large projects are typically highly leveraged, and the value of their projects can vary wildly based upon the economic environment. They're also often saddled with legacy liabilities that can lead to hesitancy on the part of strategic buyers such as private equity firms, limiting the owners' exit strategies.

Those limited options for liquidity events frequently lead construction companies to turn to employee stock ownership plans (ESOPs) as an alternative to other types of transactions. ESOPs offer a way to reward team members for the part they've played and help the company's name and hard-earned reputation endure in the marketplace.

Identifying and managing executive risk is normally a priority for ESOP trustees, given the potential for unforeseen claims. Trustees often request limitations that shield them from unforeseen claims. Creating a captive insurer allows coverage to be tailored to specific needs.

Unlike commercial coverage, in which construction companies pay regular premiums as an expense for a set period, the money paid into the captive is essentially an investment. While it continues to be classified as a business expense for tax purposes (in most cases), that investment becomes the reserves of the captive, used for paying out claims. When the amount of claims is lower than expected and reserves are prudently invested, the construction company can use the surplus for any number of business purposes—such as enhanced worker-safety programs that lead to further savings and surpluses.

While establishing a captive insurer is a sensible strategy in most industries, the nature of construction companies makes them especially well suited to the approach. Given the broad range of risks with significant potential to meaningfully affect operations and profitability, successful construction company owners tend to become sophisticated at recognizing, quantifying, and managing those risks—whether that involves preventing and minimizing the impact of worker injury claims or dealing with the inherent price volatility of key commodities like steel and wood.

Successful ESOPs are generally well organized businesses with rich data and better-than-average loss profiles. Those traits make construction ESOPs particularly well suited for using the captive insurance strategy. The discipline and data needed to operate an ESOP are just as applicable to establishing and sustaining a captive insurer. They both require a strong sense of control, transparency, business processes, and risk profiles, along with a desire to adopt best practices and a focus on reducing avoidable costs.

ESOPs and captives are effective long-term strategies that can be deployed to help construction businesses manage risks and exposures while addressing the needs of their employee-owners. While the two strategies may not overlap, they're clearly complementary, so a company that is a good candidate for an ESOP is usually an equally good candidate for using a captive.

In tight labor markets, having an ESOP suggests a higher-than-normal interest in the well-being of employees and a willingness to support their own long-term financial health. That can help companies with both attraction of new employees and the retention of their existing team. Companies and employee-owners also benefit from predictable costs, more effective loss controls, and being able to retain and redirect profits.

Advantages such as those explain why we've seen a significant uptick in construction companies making use of the captive strategy. Fannie Mae's recent updates to mortgage requirements also boosted the value of the strategy by making the rules more favorable for captives.

Whether a construction company chooses to transition to an ESOP, a captive, or both, the value of outside expertise cannot be understated. ESOPs can be tricky to structure and implement, and a poorly designed program can lead to negative year-over-year impacts on share prices, undermining the business and its new owners.

Similarly, captives may seem like an easy strategy for addressing risks, but the do-it-yourself approach is rarely a wise move. The complexity and ever-changing nature of construction risks call for specialized expertise that may not be available internally, and the wide variety of structures, domicile options, and the other aspects of initiating a captive make engaging experienced and knowledgeable consultants mandatory.

Drawing upon that outside expertise dramatically increases the likelihood that both an ESOP and a captive program not only effectively address current challenges, but that the company will be poised and able to adapt to new and unforeseen types of risks.

The above information does not constitute advice. Always contact your insurance broker or trusted advisor for insurance-related questions.