Captive insurance com-panies—entities created by firms to manage the same types of risks that are normally covered by traditional insurance companies—are increasingly being embraced by hedge funds.

Hedge Fund Risk
Hedge funds, which are always looking for innovative ways to mitigate enterprise risk, are using captive insurance companies to address risks such as general partner disability and liability, and director and officer liability. Moreover, hedge funds are also finding that creating captive insurance companies brings tax benefits.

Hedge funds also have risks specific to their industry that can be effectively handled with a captive insurance company:

• Disclosure: Hedge funds currently have limited disclosure requirements. This could change with increased regulation, resulting in additional expenses to the fund. Even if legislative efforts stall and disclosure requirements do not change quickly, investors (limited partners) can and have brought suits against principals. A disclosure insurance policy can indemnify the fund for the additional legal cost to fight such suits.

• Cyber Liability: Data breaches seem to occur every day. Recently, companies such as Target, Home Depot and Citibank have all fallen victim to hacking. Breaches are a recognized threat and are expensive. They are not the most common form of data loss, however. Three out of every four data losses are a result of human error. Captive insurance can cover computer forensics and defense against suits brought by injured parties. These policies can also pay for upgrading or overhauling an entire technology system.  

• Tortious Interference: Hedge funds are almost always dependent upon one or more managers for investment decisions.
Great fund managers or sub-advisors are always in demand. The fact that many funds are started with seed money from just a handful of large investors can further complicate matters. It is not uncommon for these investors to account for half or more of the fund’s assets. Situations often occur where a manager leaves to start a new fund and poaches clients. Because this happens so frequently, traditional coverage for these types of losses can be very expensive. A captive policy can be the perfect vehicle to provide this type of coverage.

• Intellectual Property Infringement: The hedge fund marketplace is very competitive. The slightest edge can mean an influx of billions of dollars. An intellectual property infringement abatement policy reimburses the hedge fund should they elect to enforce a patent, copyright or trademark. This type of insurance also pays legal costs when the validity of patents, trademarks or copyrights is legally challenged. The policy can be written to U.S. and foreign patents, trademarks and/or copyrights, as well as patent applications. These policies are often written to include coverage for provisional patent applications. This insurance covers the hedge fund in cases where there are allegations of infringement on another entity’s patents, copyrights or trademarks. Although these cases are rare, the costs can be staggering.

• Administrative Actions: Although you cannot write insurance that is contrary to public policy, hedge funds face an uncertain economic, regulatory and tax future. Many policies available today can help to defray the cost of any restructure that will occur in the future.

Aside from providing superior coverage, captive insurance companies often bring hedge funds significant financial benefits. Consider the example of a fund company we’ll call XYZ Capital.

The company manages $15 billion in assets. XYZ carries a traditional market premium of $650,000 for a policy that has a $250,000 deductible per claim and a $10 million dollar limit. In its eight years in business, the firm has never faced any claim or even a disgruntled investor.

XYZ decided to form a captive to write the E&O, D&O and professional liability policies for their fund. The company went to the reinsurance marketplace and determined it could purchase $10 million separate limit reinsurance for $225,000. The reinsurance also had a deductible of $250,000. Through this process, XYZ was able to triple their coverage for less than half the cost.

Following negotiations with additional reinsurers, XYZ was able to obtain an additional $40 million per line to bring total coverage to $150 million.

The captive insurance company also brought tax benefits to the hedge fund. If the captive insurance company has sufficient capital to issue a dividend, the monies are taxed to the partners at 20% rather than at prevailing income tax rates. Also, if the captive insurance company were to be liquidated, the money in the company would be taxed to the captive owners as long-term capital gains.

Most hedge fund partners are financially sophisticated and many are already actively using captive insurance companies to mitigate taxes. A hedge fund domiciled in the U.S., for example, can move a percentage of profits into an offshore captive insurance company. When those profits are repatriated, the taxes can be 30% less than they would have been with a U.S.-domiciled captive insurance company.

In conclusion, captive insurance companies are a powerful way to manage hedge fund risks with substantial tax savings over traditional insurance. 

Frank W. Seneco is an advanced planning life insurance specialist. He is the president of Seneco & Associates Inc., a boutique advanced planning firm in Connecticut. He can be reached at [email protected].

R. Wesley Sierk III is the author of Taken Captive: The Secret to Capturing Your Piece of America’s Multi-Billion Dollar Insurance Industry and You Can Make It, But Can You Keep It? He is the president of Risk Management Advisors Inc., which creates and manages captive insurance companies.

Alan S. Kufeld, CPA, MST, is a partner at Flynn Family Office. He specializes in wealth preservation and income and estate tax planning strategies for ultra-high-net-worth individuals and families. He can be reached at [email protected]