Professional Liability Insurance

Using insurance as a way of managing exposures

Originally published in the October 2007 issue

Over the past five years, hedge funds have risen to prominence in coverage by the financial media. This coverage, in turn, has dramatically increased their public visibility and brought along the scrutiny that attends such high-profile business sectors. As a result, hedge funds’ exposure levels have also risen sharply. Professional liability insurance is a way for hedge fund managers to protect both the assets of the funds that they manage and their own personal assets against lawsuits. The cost of defending against a professional liability lawsuit alone can be sizable, but the cost of a damaged reputation is crippling.

Often underestimated, the exposure to personal and professional liability is one of the greatest risks faced by hedge funds and their managers. As is the case with many business ventures, those in charge often concern themselves more with building the organiszation and growing its assets than protecting the company and themselves. In such organiszations, insurance is often viewed as a commodity to be selected based on price and not as an asset protection vehicle that must be individualiszed according to the unique risk of each firm.

Many firms approach insurance without the level of strategy used to pursue other business decisions, purchasing only what is required or treating insurance as an afterthought. Unfortunately, by relying only on required coverages, funds can be severely underinsured. In order to be sufficiently protected, a firm’s managers must approach insurance in terms of what their assets are, how the assets are at risk, and from what sources they are at risk: only after these factors have been determined can appropriate coverages be designed.

Hedge funds can be sued for mismanagement, misrepresentation, breach of duty, and failure to adequately disclose the risks involved in the hedge fund. Such suits may be brought by investors or other third parties, such as regulatory agencies, and will name not only the fund and investment manager but also the fund’s general partner and/or directors, officers, or managing members, depending on the structure of the fund. There is therefore an overlap between Directors & Officers liability and Professional Liability/Errors & Omissions liability insurance. Because of this overlap, coverage gaps can occur if the insurance broker designing the program is not familiar with the structure and nature of hedge funds and the varying policy triggers in an insurance policy.

Unless the proper protection is in place, the personal assets of the fund, the management company, and the individuals are exposed. Specifically, Professional Liability/Errors & Omissions liability insurance covers the management company and its directors, officers, partners, and employees for allegations of negligence and mismanagement of the fund’s assets; Directors & Officers Liability coverage and General Partners Liability coverage provide protection for the respective directors and officers or general partner of the fund for claims of misstatement, misrepresentations, breach of duty, and failure to supervise the management firm; finally, coverage is provided to the fund itself, both for its own liability and for its indemnification obligations to its directors or general partner and investment manager. In addition, such policies can be negotiated to include Employment Practices liability coverage. Employment Practices liability insurance provides coverage for claims by employees and potential employees alleging harassment, discrimination, wrongful termination, retaliation, defamation, or unfair hiring practices. Employment practices lawsuits can do lasting damage to a firm’s reputation, and, therefore, liability coverage can be extremely valuable by mitigating the overall effect of the suit.

Because hedge funds can be extremely complicated investment vehicles with very unique operations and exposures, the term ‘”hedge fund'” is far too broad and generic to sufficiently describe the types of exposures faced by individual hedge funds. Many insurance brokers and carriers may not fully understand the intricacies involved in hedge fund operations, specifically how their varying structures and strategies greatly affect their exposures. Therefore, utiliszing an insurance broker with extensive, diverse knowledge of the sector is an important aspect of correctly insuring a hedge fund.

Due to differences in sizes, structures, and investment strategies, not all hedge funds should be insured by the same ‘”off-the-shelf'” policy. It is extremely important that each insurance policy be customiszed to cover the entity’s unique risks. Using standard policies may lead to large gaps in coverage, especially for funds with unique characteristics or structures. Examples of funds that would have non-traditional exposures are a fund that takes private equity positions in the companies in which it invests and an activist fund where board positions within outside companies are maintained. These exposures can lead to suits not only from the fund’s own investors but also from the investors and other third parties affiliated with the companies in which the fund has invested.

Current market conditions

Over the past several months, there has been a significant amount of media coverage on the increasing volatility in the sub-prime mortgage and other credit markets. Many funds that have invested heavily in these markets are experiencing significant losses. Most recently, two Bear Stearns’ funds have filed for bankruptcy after their target loan markets collapsed.

As with past high-profile hedge fund losses, such as Amaranth in September 2006, these bankruptcy filings have led to a significantly heightened risk of litigation and regulatory scrutiny. As such, many hedge fund managers are taking note of the lawsuits that have been filed as well as the increased number of regulatory investigations into hedge fund investment practices. Hedge fund managers are beginning to examine their exposures and the insurance options availableto address these exposures far more closely. Insurance companies are also looking more closely at the risks that they have in the hedge fund sector in general and the credit markets in particular. Though there is plenty of capacity for hedge funds in the insurance marketplace at this time, funds with untested investment strategies and those with large exposures to the credit markets will face far more scrutiny and will need the aid of knowledgeable insurance brokers in order to adequately communicate their specific exposures to insurers.

Over the past five years, assets invested in hedge funds have increased exponentially. This increase has created far more, and far larger, funds over a short period of time. As the funds get larger, so do their exposures, especially as they expand into new investment strategies. Furthermore, several of the largest firms are beginning to consider becoming publicly traded entities or selling a percentage of the firm to outside investors, which will again create additional exposures.

As the prominence of hedge funds continues to grow, the investor base in hedge funds is becoming far more institutionaliszed. Institutional investors, such as pension funds and state retirement funds, are increasingly placing monies in hedge funds. These investors have a fiduciary duty to their participants and may face political considerations that can add pressure to bring action against a fund in the event of a loss.

Moving forward

The trend over the past decade has been for large funds to continue to dramatically increase in size. If this trend continues, we would expect to see the largest firms looking to further diversify their investments and expand their investment strategies. As these firms expand into new markets, they will face continually changing and expanding exposures. Moreover, if large hedge fund firms continue to look to IPOs and private placements in order to monetisze the value of the management company, such changes will again lead to new and increased risks for the firm. The onus is on us in the insurance industry to be on top of these and other developments and to be ready to respond with appropriate and meaningful insurance counsel and solutions.