Retaining vs Transferring Risks

Partner content by Skylar Romines, Founder at ATW Advisors.

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.

While there is no central registry, largely due to the private nature and respect for confidentiality of family offices, surveys of family offices generally 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.  

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. Captoves 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 adequatelt 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. 

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.

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:

1. 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.

2. 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.

3. 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.

4. 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.

5. 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.

6. 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.

7. 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.

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:

1. 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.

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

3. 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.

4. 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.

5. 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.

6. 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.

7. 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.

8. 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

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.

ATW Advisors is an independent risk advisory and insurance consulting firm - find out more at atwadvisors.com