Family offices, which are estimated to control somewhere between $3 trillion, the current size of the hedge fund industry, and $7 trillion, the current size of the hedge fund and private equity industries combined, are increasingly moving toward direct investing as a way to avoid management fees, increase returns and exert greater control over their investments. An April 2016 survey by the Family Office Exchange showed that almost 70 percent of study participants engaged in direct investing.
But as they make this shift, they will need to take control over certain aspects of investments—such as insurance—that they may have left to others in the past.
The following are five of the most common insurance-related risks that can have a significant impact on the family office and investing outcomes, yet can be easily avoided with the right risk management strategy.
Investing in operating businesses that do not have adequate insurance.
When family offices invest in operating companies via a fund, they do not have to worry about the insurance programs of the portfolio companies. That is handled by the private equity firm and its advisors. As a direct investor, uncovered insurance claims suddenly become the family office’s responsibility. Family offices need to make sure they know before making the investment that all of the appropriate policies are in place, with adequate limits, and coverage appropriate to the offices’ exposures.
Investing in operating businesses that have significant outstanding liabilities associated with insurance programs.
Family offices need to understand all potential outstanding liabilities associated with the insurance programs in place. If the operating company is self-insured, or has a large—$50,000 or more per claim—deductible program, family offices need to understand the nature of any open claims. If they are doing a stock purchase, then they are taking on the liability associated with those open claims. Depending on the nature of the business, the open claims and the structure of the program, this can be a big number. Open claims from an employee or third party that suffered a permanent disability can run into the millions of dollars. Before making an investment, family offices should understand the estimated exposure for open claims.
Investing in an operating business and not understanding the costs, risks and compliance status of employee benefits.
For most operating businesses, the second-largest expense after payroll is employee benefits and health insurance. One of the upsides of investing in a private equity fund is that investors don’t have to get involved with employees and the related administrative burden. As a direct investor, family offices need to understand these new responsibilities.
There are four primary areas that should be assessed before investment, including employer-sponsored benefit programs, such as health and welfare and retirement planning; employment agreements and incentive compensation plans; the material impact of benefit programs on a company’s financials; and the impact to the enterprise value calculation as well as the sufficiency of benefit-related balance sheet reserves and any unfunded obligations.
Investing in real estate projects that are not adequately insured to protect the equity partners.
As direct investors in real estate, it is in a family office’s best interest to understand how the project will be insured to protect its equity. This includes insuring the project while under construction and after project completion. Depending on the sophistication and expertise of the project sponsor, the insurance program may have major holes that expose the family office to unnecessary loss.
The loss of rents coverage within a builder’s risk policy is a good example. Loss of rents coverage pays for a loss of rental income caused by a covered loss. If you were building a student housing project, for example, this coverage is really important. If your project is delayed because of a fire and as a result the building is not ready in time for students to move in, you would miss an entire school year of rental income. This coverage can only be purchased by an owner. Contractors are not eligible to purchase it because they do not have an ownership interest in the property. A family office that relied on a contractor to buy builders’ risk coverage would be unintentionally putting itself at risk.
Not having its own Directors & Officers (D&O) liability program.
Another detail that often gets overlooked as family offices transition from fund investment to direct investment is D&O liability insurance. Family offices need to be sure that every company in which they invest has D&O insurance, and that the family office itself has D&O insurance. The family office D&O policy should contain a provision that will protect the family office in the event that a portfolio company D&O policy does not cover a particular claim or its policy limits are exceeded.
We are in the midst of a big shift in how capital gets deployed into our markets. Now more than ever, family offices are taking steps to control their own destiny, make their own decisions and deploy their assets in a way that is the most rewarding and meaningful to them. A solid insurance and risk management strategy is a crucial part of the infrastructure that will enable this shift to happen.
Scott Kegler is Family Office Practice Leader for Aon, based in Philadelphia. He works with family offices that are making direct investments in operating companies (majority or minority) and real estate.
