Several types of insurance coverage are designed specifically for hedge funds and their advisers or general partners, including Key Man Life Insurance, Directors & Officers/Errors & Omissions Liability, and Fidelity Bonds
By Andrew J. Fotopulos, Executive Vice President of Theodore Liftman Insurance, Inc., a Boston based insurance agency which specializes in providing insurance to financial institutions. This article appeared in the February 1999 issue of Hedge Fund News┐.
Several types of insurance coverage are designed specifically for hedge funds and their advisers or general partners, including Key Man Life Insurance, Directors & Officers/Errors & Omissions Liability, and Fidelity Bonds. Recent events in the hedge fund world and in the insurance marketplace have significantly impacted the latter two as discussed below.
Directors & Officers/Errors & Omissions Liability Policy, also known as professional liability, is intended to protect the hedge fund and its adviser or general partner against losses due to an unintentional (negligent) act, error, omission and/or breach of duty that could give rise to a claim. For instance, Long Term Capital Management is now being investigated by federal regulators for misleading potential investors when it was trying to raise cash before its near-collapse. D&O/E&O Insurance could protect the principals against such potential claims. In another example, it was reported last October that Rhumbline Advisers cost the AT&T Pension Fund $150 million. According to AT&T, Rhumbline engaged in hedge activity that was far riskier and for amounts far greater than authorized. Had Rhumbline carried both D&O/E&O Insurance and a Fidelity Bond (for certain fraud allegations against one of their traders), the damages paid out of Rhumbline's own pocket may have been diminished or eradicated completely.
For years, it was difficult to obtain General Partners/Directors & Officers and Errors & Omissions Insurance for hedge funds and their advisers since hedge funds are relatively unregulated and not registered with the Securities Exchange Commission. Recently, however, a number of insurance carriers have expressed interest in covering hedge funds because of a soft insurance market, greater understanding of hedge funds, and proposed increased scrutiny by U.S. Government regulators.
Whether an insurance carrier will offer coverage terms to a hedge fund depends mostly upon its debt to equity ratio. The greater the leverage the less likely that the insurance underwriters will offer terms. That's not to say coverage is unavailable, but obtaining competitive bids and favorable terms will be more difficult. Furthermore, underwriters also consider a fund's investments in determining coverage terms. For example, a Global Macro Hedge Fund may be less desirable than an Emerging Markets or Distressed Securities Fund. Insurance carriers like to see a reasonable use of leverage, transparency to investors, and experienced principals in the applicant fund and adviser.
Minimum premiums for this type of insurance can start as low as $15,000 for $1 million of coverage, however, the majority of insurance carriers start at $25,000 with deductibles of $100,000 plus. Currently, one insurance carrier is aggressively pursuing this line of coverage with a minimum premium starting at $15,000 and a minimum deductible of $50,000.
When reviewing alternative bids, one should consider certain coverage issues such as whether the insurance carrier is naming the fund itself as an insured? Several insurers are only willing to name the adviser or general partner for their activities on behalf of the fund. Other questions to be asked include whether the insurance carrier is excluding claims which allege excessive management fees, whether the policy defines the term "Investment Company", and whether that definition includes hedge funds? Quite often, the definition is limited to a registered investment company or a registered investment adviser. These are just a few coverage issues that the adviser or general partner of the fund must address.
Another area of coverage that has become popular among hedge funds are Fidelity Bonds. The Fidelity Bond protects the fund from losses due to an intentional wrongful or dishonest act by an employee. One example is an employee who works in collusion with a custodian in order to steal client funds.
When purchasing a Fidelity Bond, one must determine the appropriate limit of liability as well as specific coverage issues. Some hedge funds obtain coverage limits equal to the assets managed while others carry much less. In addition, it is important to purchase a policy that covers court costs and attorneys' fees, although this may be difficult to obtain. Most advisers or general partners refuse to believe that an employee will steal or they may be sole proprietors. As a consequence, they may only worry about frivolous lawsuits or losses due to actions by an outside service provider, such as an employee of the custodian. Since the adviser is in the line of fire, attorneys' fees must be covered until fault can be determined. The same theory holds true for D&O/E&O coverage.
A question often comes up as to whether the fund or general partner pays the insurance premiums. As a rule, insurance brokers have no say in who pays the premium. However, more often than not, a portion of the expense is allocated to the fund.
In summary, the cost of purchasing the appropriate insurance coverage is far cheaper than the price one may have to pay in the event of a claim. In addition to providing the fund with financial protection, Directors & Officers/Errors & Omissions and Fidelity Bond coverage can also serve as a marketing tool which comforts potential investors.u