G. Kristin Delano, Esq.
Introduction
In recent years commercial real estate owners have faced higher windstorm deductibles than in the past. While the standard deductible is 5% of the insured value, higher deductibles have been quotes, and some property owners have been unable to get windstorm coverage at all. On $20 Million in insured value, the windstorm deductible at 5% would be $1 Million. If the landlord self insures that deductible, he has no common area maintenance (“CAM
”) expense to pass on to tenants. However, bearing the windstorm risk is a real cost of owning and operating a building; it is a legitimate CAM
expense. In the event of windstorm damage, the landlord will bear the entire amount of the deductible, and may or may not be able to impose a portion of that expense upon tenants as an after the fact CAM charge.
Putting The Captive Solution To Work
A captive insurance company can be used to routinely raise funds from tenants to cover at least a portion of the windstorm deductible. As long as the premiums paid are within the range of commercial reasonableness and satisfy all of the tax requirements for deductibility, they can be a means of raising funds from tenants to create reserves against future storm damage.
An Example
Assume real estate worth $20 Million and a windstorm deductible of 5% or $1 Million. Also, assume that a fair premium for the first layer of property risk is $1 for every $5 of insurance coverage. The amount that constitutes a fair premium for coverage will vary depending upon the location of the property and whether the general status of the market for wind coverage.
The premium for a $1 Million policy would be $200 Thousand. The captive will need capital to cover the entire $1 Million in liability on its policy plus its administrative expenses. The additional $800 Thousand can’t come from the insured as no risk would be shifted; the structure wouldn’t’ qualify as insurance for federal income tax purposes. Instead the owners of the insured will need to make a contribution to the capital of the captive. This can be done through a combination of cash and other secure non-cash instruments.
If there is a serious windstorm in the first policy year, the landlord will have $200 Thousand of tenant money (less applicable expenses) to effect repairs and will only have to supply $800 Thousand of its own funds - rather than the entire $1 Million.
However, to the extent that there is no significant wind damage, the premium becomes earned premium. The lessor will be entitled to retain the profit from the policy – to create reserves for future losses, or otherwise.
Again, if there is significant storm damage, the tenants will contribute to the repair of the property, if not, the ownership group will profit from the tenant contributions.
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