September 30, 2024

I recently wrote an article for Mr Family Office on the significant shift in how family offices approach retaining risk vs. transferring risk.

With traditional insurance markets becoming increasingly restrictive and expensive, up to 30% of billion-dollar family offices are exploring alternative risk financing strategies.

In this article, we’ll uncover three common types of alternative risk transfer and financing, each providing unique benefits for family offices seeking more flexible solutions:

High Deductibles
Captive Insurance
Self-Insurance

Whether you’re a family office considering alternative risk financing or simply interested in this growing trend, this article offers actionable insights on effectively implementing these strategies while navigating their complexities.

Rethinking Risk Management

The use of captives and self-insurance among family offices is rising in popularity.

Many family offices are exploring or establishing captives, especially as they expand their asset bases and face increasingly complex risks.

This trend is partly driven by dissatisfaction with rising premiums and reduced capacity for coverage in the commercial insurance market.

Others seek tax advantaged solutions or value having a higher degree of control of their own program and loss payouts.

There is no central registry for family offices, largely due to their private nature and the emphasis on confidentiality.

However, surveys indicate that up to 30% of larger family offices (managing at least $1 billion USD) have considered or are actively using captives, though not all have fully implemented them.

Alternative Risk Financing

All forms of alternative risk financing require more ‘skin in the game’ as opposed to the traditional insurance market and can be structured creatively based on each family office’s needs.

It is typically wise to determine the desired level of Risk Retention, and then weigh strategies for risk transfer above that layer.

Some common types of alternative risk transfer and alternative risk financing include:

High Deductibles

Maintaining a high deductible level with traditional insurance layers placed in excess of the deductible layer.
Depending upon the deductible level chosen, a captive layer or dedicated ‘self-insurance’ fund may be prudent to address losses the family office will be responsible for under that threshold.

Captive Insurance

A captive is an insurance company created, owned and operated by its stakeholders. The people in charge of the captive are the ones who benefit from its insurance coverage.
Captives may include many small to medium organizations of similar size (group captives), or can be made up of one parent company with only related entities, often referred to as a ‘single parent captive’.
Captive insurance companies purchase reinsurance directly to ensure they have enough capital to pay for large losses.

Self-Insurance

Self-insurance is often utilized unintentionally, when there is a failure to acknowledge or adequately address certain risks associated with an organization.
However, formal self-insurance is another form of coverage where there is no insurance policy issued to the insureds.
According to IRMI, the International Risk Management Institute, self-insurance is “a system whereby a firm sets aside an amount of its monies to provide for any losses that occur – losses that could ordinarily be covered under an insurance program.”
When an organization takes part in self-insurance, it does not hold an official insurance policy.

Key Takeaways

The main difference to note between self-insurance and captive insurance is how each is set up.
With self-insurance, the owner sets up a type of savings account where they save money to use when claims arise.
Captive insurance, on the other hand, is more formal because it is essentially a small, dedicated insurance company.

Benefits for Family Offices

Self-insurance and alternative risk financing, such as the use of captives, have been increasingly popular with family offices for many reasons.

Some of the main considerations which make alternative risk financing attractive compared to traditional insurance market, include:

Cost Management

Family offices, which often manage complex and diverse assets, may find traditional insurance policies to be cost-prohibitive.
By self-insuring, they can avoid premium hikes and the profit margins of commercial insurers, tailoring risk management strategies to their unique needs and potentially reducing long-term costs.
There is also a cash flow advantage.

Customization of Coverage

Family offices typically deal with a range of risks, including real estate, art collections, private investments, and family businesses.
Self-insurance or captives allow them to design customized insurance policies that address these specific risks rather than relying on standard commercial offerings, which may not be flexible enough.

Better Risk Control

Self-insuring gives family offices more control over how risks are managed.
With traditional insurance, risk management practices are often dictated by the insurer, who may or may not reward its insureds with premium reductions for increased risk control measures.
Self-insurance allows these offices to implement their own risk management strategies, potentially leading to fewer claims and more efficient operations.

Tax Benefits

Captive insurance structures can offer tax advantages when structured properly.
Premiums paid to captives are often tax-deductible, and under the right circumstances, profits from the captive’s underwriting activities can accumulate at favorable tax rates.

Wealth Preservation

For family offices, which typically focus on multi-generational wealth, the ability to self-insure can align with their long-term wealth preservation strategies.
Self-insurance and captives allow them to retain and invest premium funds, rather than transferring those funds to an external insurer.

Investment Opportunities

Captive insurance can create investment opportunities for the family office.
Funds accumulated within the captive can be reinvested, generating returns that would not be possible with a traditional insurance premium payment structure.

Greater Transparency

Self-insurance provides family offices with clearer insight into the true cost of risk.
Traditional insurance involves a layer of intermediary costs (brokers, underwriters, etc.), whereas self-insurance allows for direct tracking of claims and expenses.

Key Risks and Considerations

There are also potential increased risks and downsides to captives and self-insurance which should be considered prior to making any material changes to an insurance procurement strategy.

Some of these considerations include:

Upfront Costs & Capital at Risk

Establishing a captive insurance company or implementing a self-insurance plan requires significant upfront capital, legal, and regulatory setup costs.
The office also bears the responsibility for paying claims and covering losses. Poorly managed risks could deplete the captive’s funds.

Operational Complexity

Managing a captive or self-insurance arrangement requires expertise in insurance, risk management, and compliance, adding operational burdens to family office staff.

Regulatory Oversight

Captives are subject to regulatory scrutiny in the jurisdictions in which they are domiciled.
Family offices must navigate complex legal and compliance requirements, which can be time-consuming and costly.

Higher Administrative Costs

The family office is responsible for managing the captive or self-insurance program, which includes claims processing, regulatory reporting, underwriting, and other administrative functions that may require additional personnel or outsourced services.

Potential for Unanticipated Losses

Without the risk-sharing that traditional insurance provides, family offices may be vulnerable to large, unexpected losses, which could negatively impact liquidity and financial planning.

Time-Consuming Management

Running a captive or self-insurance program requires continuous attention, from assessing risks to managing claims and ensuring compliance with evolving regulations.

Possible Loss of Reinsurance

While captives can access reinsurance markets, some reinsurers may hesitate to work with newer or smaller captives, limiting the family office’s ability to manage large, unexpected risks.

No Guarantee of Tax Benefits

While captives can offer tax advantages, they must be properly structured and compliant with regulations.
Improperly managed captives could face scrutiny from tax authorities, resulting in disallowed deductions and other penalties.
They are also subject to regulatory change, such as the potential for 831(b) captive regulation in the United States to change in 2025 as being decided by their Congress.

Key Takeaways

As family offices increasingly manage larger pools of assets and more complex risks, these alternative risk financing structures can provide an attractive solution to maintain control, reduce costs, and enhance wealth preservation strategies.
It is critical to assemble a strong insurance team of internal and external advisors, which allows family offices to make informed decisions about the most cost-effective and efficient strategies for managing risk and preserving wealth.
Feasibility studies are important in determining appropriate retention levels and structures for alternative risk financing based on the specific needs of each organization.

Conclusion

As traditional insurance markets continue to present challenges, alternative risk financing strategies offer family offices compelling opportunities for cost control, customization, and wealth preservation.

While the benefits of high deductibles, captive insurance, and self-insurance can be substantial, success depends on thorough preparation and proper infrastructure.

Family offices should approach these strategies not as mere alternatives to traditional insurance, but as sophisticated financial tools that require careful evaluation of their risk profile, operational capabilities, and long-term objectives.

Those who take a methodical approach to selecting and implementing these strategies, supported by experienced advisory teams, will be best positioned to realize their benefits while effectively managing their inherent challenges.

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