“Hedge funds seemed like a natural fit, and there seemed to be a lot of synergies between my business and theirs – we’ve both emerged from big company structures,” Kelly explains. “I wanted to do something that was advice and service-led. This industry has a strong ethos of outsourcing, and we hope to be recognised as an expert partner on the insurance side.” Kelly spent most of his 22 year career in the insurance industry working for Chubb, mainly looking after its UK and Irish underwriting business. He attributes his analytical approach to insurance risks to his days as an underwriter, and has successfully transplanted this discipline into his activities as a broker. He has now contributed to AIMA’s offshore directors’ guide, has spoken at a number of industry conferences, and sits on AIMA’s sound practices committee. He is keen to help educate managers about the variety of risks they are carrying, and how proper insurance can help them to protect themselves.
Hedge fund managers today are facing a battery of risks as they go about their dayto- day business, including legal threats, regulatory dilemmas, and operational problems that can close down a business regardless of its performance record. Regulators like the FSA have been clear that managers cannot expect their clients to absolve them of responsibility, and indemnity provisions frequently do not cover negligence and fraud. Many hedge funds remain exposed to legal and regulatory attack, particularly with US clients and their strong tradition of litigation. It is easy, in Kelly’s view, for a hedge fund manager to find himself facing fraud allegations from the SEC in the US for errors that can really be put down to negligence, yet the American regulator has not proved to be particularly understanding in this respect. Some form of cover may be needed so that an investigation of this kind does not derail the entire business, taking the manager away to face a regulatory inquiry while he should be looking after his clients’ money.
This is no idle threat: at time of writing, there were at least 20 individuals in the UK awaiting extradition to the US accused of white collar crimes, and the issue had graduated to the mainstream news agenda with the extradition of the so-called NatWest Three to Texas, this despite appeals to the House of Lords, and the Home Secretary. It paves the way for the veryreal possibility of fund managers in the UK to be extradited to the US on charges that would not merit fraud proceedings on this side of the Atlantic, along with the corresponding legal fees should the manager choose to fight his case.
In addition, there is the potential for trade errors to impact the performance of a fund, always a real possibility at the best of times, and particularly frustrating when it does occur. More esoteric instruments can harm a portfolio if problems occur at the trading and settlement level. “The regulators are very interested in the scope for operational problems,” says Kelly. “Commercial credit defaults, for example, are at an all time low right now, but a deterioration in the credit environment could create operational losses where managers have dealt negligently with credit default swaps.”
Lack of performance is also a big risk factor: managers who fail to meet expectations could potentially end up on the wrong end of a lawsuit. Increased institutional participation in the hedge fund market is unlikely to lead to an upswing in litigation, but European managers who are seeking investment in the US need to be aware that American investors are far more likely to sue on performance issues than Europeans. Kelly argues that the relative cost of transferring risk via an insurance policy is small when compared to trying to protect against the downside in the financial markets, and urges managers to consider the option. “They could probably transfer their legal, operational and regulatory risk for less than one to a few basis points – intellectually, it’s quite a persuasive argument. Put in those terms, it can be a good bet.”
Kelly is seeing demand for his services from a broad range of hedge fund managers, from the small start-up to bigger and more established operations looking to fill holes in their risk profile. In addition, he is finding that nonexecutive directors of funds are also keen to ensure they are protected.
“If it is a question of cost, it is better to insure the management entity rather than the fund,” he advises. “With smaller managers, it is better to insure the managers, as they are more likely to be putting their own liquid assets into their fund. It could get awkward if they end up sitting on a $3-4m trade error. There would have to be an immediate crystallisation of the loss, which has got to accrue as a receivable in the fund’s accounts, or they have to adjust the NAV and write to investors, which is what the administrator would want to do. If they buy the right insurance product, it can act as a call option on the insurer’s capital.”
Kelly recommends that start-up managers talk to insurance providers before they even start trading. “We have a very gentle marketing approach,” he says. “It would be nice to speak to managers about these issues…We would advise that a manager spends a reasonable amount of time engaged in the process of finding appropriate coverage, meeting brokers and insurers. We like to introduce insurers to clients as well.”
Currently, there are less than 10 firms writing insurance for hedge funds in London, itself arguably the world’s largest and most diverse insurance market. Many firms are simply not taking on hedge fund exposure because they do not understand the industry, and its risks, or because they view hedge funds as a high risk business area and want to steer clear of it.. As the insurance industry builds up its knowledge base, however, and as the hedge fund sector’s profile and share of assets increases further, Kelly expects more companies to start writing hedge fund policies. This will hopefully reduce the price that managers are currently having to pay. “Two years ago insurance for hedge fund managers was too expensive,” admits Kelly. “There was a big gulf between price and value. Much of the difference is in what the policy says, and this is up to the intellectual input of the broker. It is a different valueadded from simply negotiating the price… Once you’ve got the product right, then it is a matter of managing cost expectations. Looking at insurance pricing, as a broker, you want to maintain a target premium range at the bottom end of the cycle. If you find the right product, and the client eventually has to claim on it, then they can potentially have a cheque in the millions in a matter of weeks.”
Kelly’s Baronsmead is in the business of writing proprietary insurance policies covering hedge fund exposure. “If you’re purporting to specialise in this area, and you’re not going to these lengths, then you’re not adding value,” he explains. “Off the shelf products can be a minefield. The FSA is very hot on contract certainty in the insurance industry at the moment. These things should not be complicated – if you have met the insurers, then you get that valuable rapport.”
Baronsmead specialises in insuring single managers in the hedge funds space. It currently has over 90 manager and fund clients. There are direct and indirect beneficiaries of hedge fund insurance. “Indirect beneficiaries include people like investors, basically anyone who doesn’t want to see a fund get into trouble,” Kelly says. His firm advises its clients, and indeed any hedge funds reviewing their insurance position, to also speak with their lawyers about the quality of the insurance products on offer, in order to glean a second opinion. The insurance partner at a given law firm should be able to provide this. “It is surprising how poorly some of the contracts are worded, particularly those written for hedge fund managers and their funds,” says Kelly.
Baronsmead is capable of providing insurance advice for a multi-billion dollar shop, all the way down to a $25m start-up. “Small firms are in as much need of a quality insurance product as the bigger players,” he says. “They probably need it most from a cashflow point of view.” Baronsmead has also written insurance for a handful of funds of hedge funds, but this is a market it has yet to target. “It’s a different risk exposure,” Kelly says, “but it might be an area of growth going forward.” Funds of funds are marketing themselves as experts, for example, in conducting due diligence on the underlying funds. Any insurance product they buy will need to cover them against the potential of fraud in one of the underlying managers, amongst the other risks they face.
Kelly does not see his approach changing very much going forwards: he takes a 25 year view on the market, and is growing his business progressively. In his view, there is such a thing as too many clients. “If you get too much business in, you can’t service it,” he reckons. The business model he follows is very much that of a boutique, offering specialist, tailormade services to a demanding client base.
Operating out of Mayfair offices, he is ideally placed to meet many of the diverse range of fund managers currently trading in W1.
Kelly has also been dealing with a limited number of third parties, like prime brokers. Frequently, this is based on an adviser to a fund wanting a safe pair of hands for his clients. Most of his work is focused on firms in the UK, although he has also worked with Irish and Channel Islands entities. Thus far he has steered clear of the US market, despite the fact that this is where the biggest insurance risk seems to originate. “We don’t target the US market from a domicile point of view: we only really target UK-based managers and their funds. Overseas, we would have to operate on a wholesale basis, and this is a complete anathema for us,” he explains. “There would be no way to provide the level of service and advice our clients are used to.”
Having said that, Baronsmead can arrange to underwrite overseas subsidiaries as part of a group structure if necessary. Policies can be written to respond on a global basis, and can be quite flexible from a geographical point of view.
“The key driver for buying insurance, for example as an individual, is having the wherewithal to defend your reputation and your personal assets,”Kelly says. “Institutional money, especially in the US, is keen to see the right insurance products in place. AIMA is doing an excellent job of advising hedge funds on the due diligence and sound practices side.”
Hedge fund insurance generally falls in the following categories of product:
Currently there remains a widespread lack of proper knowledge about the appropriate insurance policies within the hedge fund market: managers already buying insurance are still not clear as to whether the cover they have is appropriate for them and their businesses, and may find out it isn’t the hard way. Despite the fact that more funds are now buying cover, there has not been a corresponding increase in the range of products available, suggesting to experts like Kelly that many firms may be slotted into inappropriate policies. The range of policies on offer at the moment needs to become more flexible, and more sophisticated, in order to meet the requirements of this industry. Until then, expert and informed advice will be needed to avoid being wedded to the wrong product, and experiencing the world of financial pain this error can bring to a firm. In Kelly’s view, if a manager is investing serious time and money in making sure his firm’s operations run smoothly, it would be a pity to go without the additional peace of mind effective insurance cover can bring.