Hedging Against Losses

By Sandy Crystal | February 24, 2008

How to navigate risk and find coverage solutions for hedge funds and their managers


Hedge funds manage financial risk every day. Managers constantly seek out new strategies and investments, and then weigh the potential reward of each investment against its risk and the fund’s ability to bear that risk. Unfortunately, one of the most important areas of risk management is often underestimated — the importance of insurance. A hedge fund that does not possess relevant, effective insurance could place itself at unnecessary risk, seriously affecting its assets and performance and perhaps even resulting in irreparable financial damage.

As is often the case with many businesses and individuals, many hedge fund managers spend more time planning and building the fund than protecting it. And, even when they focus on insurance, they usually try to determine what is required instead of what is best. It is vital to the long-term viability of the firm that time and consideration be given to ensuring that adequate and appropriate coverage is in place to address the myriad of exposures faced by a hedge fund. In general, hedge funds need to be aware of and address three main areas of business risk: professional liability exposures, property/casualty exposures, and employee benefits exposures.

Professional Liability

The professional liability exposure of hedge funds has grown significantly in the past five years as the financial media has focused more coverage on these funds. This coverage, in turn, has dramatically increased the funds public visibility and brought along the scrutiny that attends such high-profile business sectors. 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. With this in mind, comprehensive insurance is clearly a necessity, not an option.

Hedge funds can be sued for mismanagement, misrepresentation, breach of duty and failure to adequately disclose the risks involved in the fund. Investors or other third parties, such as regulatory agencies, may file such suits, naming not only the fund and investment manager but also the fund’s general partner, directors, officers, or managing members, depending on the fund’s structure. In such cases, the protection afforded by directors and officers or general partners insurance may overlap with professional liability/errors and omissions 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 triggers in an insurance policy.

For funds structured as limited liability companies or offshore companies, as well as for the corporate general partner and the manager, directors and officers liability insurance provides coverage for the individual directors, officers and managing members in their capacity as such. Similarly, for funds structured as limited partnerships, general partners liability insurance provides coverage for the corporate general partner to the fund. Typical claims under these policies include allegations of misrepresentations or misstatements in the offering documents, breach of duty, and failure to adequately disclose the risks involved in investing in the fund.

Errors and omissions insurance provides coverage to the fund’s manager, as well as its past, present and future directors, officers, partners, managers or employees. In the event of allegations related to breach of duty, neglect, error, misleading statement or omission in giving financial, economic or investment advice or investment management services to the funds, this policy will protect the fund and its managers. Typical claims under this coverage section include allegations of mismanagement and negligence in the management of the fund’s assets.

Finally, coverage should be included for the fund itself, both for its own liability, and, more importantly, for its indemnification obligations to the general partner, directors, officers, etc. By including coverage for the fund itself and for its indemnity obligations, the insurance policy will protect the fund’s assets.

While the professional liability policy is designed to insure the hedge fund’s operational risks, of equal concern to many investors is protection for fraud and the theft of the fund’s assets. A fidelity bond provides coverage for loss of money or securities due to dishonesty of the firm’s employees. Protection is also available for forgery or alteration of checks and other instruments that are drawn by the fund; theft, disappearance and destruction of money and securities; and fraudulent transfer of property via a computer.

Property/Casualty

As with any business, a hedge fund leases or owns office space, has tangible assets and has employees, all of which create insurance needs.

Once a lease is signed or a property is purchased, the fund must purchase a package policy. The package policy addresses a number of different exposures, and the coverage sections can be tailored to meet each fund’s particular needs. The property section insures tangible items owned or leased by the firm, including furniture, computer software and equipment, and fine art, and it provides for the replacement value of these items due to a covered loss, such as fire damage. The policy also provides a general liability section. The primary exposures for an office are slip-and-fall incidents involving non-employees and water damage to offices on lower floors.

Coverage should also be obtained for business interruption and extra expenses. Business interruption insures against loss of income due to a covered loss. The counterpart to this is extra expense coverage, which provides coverage for those costs over and above normal expenses to continue your business operations.

Finally, liability associated with rental vehicles (non-owned and hired auto) is also provided under the general liability section. Physical damage coverage for rented vehicles can also be obtained.

An umbrella policy provides excess liability limits over the general liability section of the package policy, business auto policy including non-owned and hired autos, and the employers liability section of the workers’ compensation policy. Generally, the limit of liability required by the office lease is determined by the lessor (e.g. $5 million); however, you should definitely explore with your client the benefits of additional limits of liability.

Workers’ compensation coverage covers employee injuries occurring in the course of business activities. The employee is reimbursed for a portion of his salary along with all medical expenses. Most states mandate that this coverage be maintained at all times. In addition, many states also require mandatory short-term disability coverage to cover employee injuries occurring outside of business activities.

Employee Benefits

In order to attract quality employees, a hedge fund must not only offer competitive salaries but must also offer competitive benefit packages as part of employees’ overall compensation. Benefits, including a medical plan, dental plan, group life insurance and group disability insurance can be offered to some, most or all employees. Benefit packages can be tailored to provide some or all of these insurances and can be structured with a variety of options. In addition, a fund may choose to provide additional life or disability coverage above the group program to the firm’s executives.

More specific to a hedge fund business is the need for key person life and disability insurance. Many hedge funds are dependent on a small number of individuals who are vital to the success of the fund. Key person insurance is designed to protect the firm against the financial loss it would suffer following the death or disability of a key employee. The firm itself is the beneficiary of the policy benefits, thereby providing a source of funding to indemnify the hedge fund for the loss of the key employee’s skills and experience, to replace lost profits and to locate, hire and train a replacement.

Funds must also seriously consider securing other policies to thoroughly protect their assets. These include fiduciary liability insurance to protect the firm and trustees of its employee pension plan and employment practices liability insurance for coverage in the event of a wrongful termination, discrimination or harassment claim.

Emerging Challenges

The assets invested in hedge funds have increased exponentially in recent years. This increase has created far more, and far larger, funds over a short period of time. With this greater pool of potential insureds, there comes a greater interest in insuring the sector. Additionally, as the funds get larger, so do their exposures, especially as they expand into new investment strategies. A few of the largest funds have taken steps toward becoming publicly traded entities or selling a percentage of the firm to outside investors, which poses new exposures. The insurance industry must continue to provide comprehensive solutions to these firms and their evolving needs.

The increased levels of institutional investors combined with high-profile hedge fund losses and increased regulatory scrutiny all lead to greatly increased risk. Moreover, the changing mix of investors in hedge funds toward a more institutional client base will have a significant impact on the potential for litigation. Hedge funds and the tremendous amounts of dollars flowing into them have definitely attracted the attention of the plaintiff’s bar.

If the current trend for large hedge funds to get even bigger continues, the largest funds will increasingly look to diversify their investment strategies. With this diversification will come new exposures. In addition, some of these large funds may seek to monetize the value of the management company, either through an IPO or in the private placement market. This will again lead to new and increased risks.

The onus is on us in the insurance industry to be on top of these and other similar developments and to be ready to respond with appropriate and meaningful insurance counsel and solutions. There are more policies and needs for planning than many hedge fund managers realize. Those outlined above are crucial to the long-term safety of a fund’s assets and financial health. They also provide the security and support that many employees in the industry seek.

As with successful long-term investing and financial planning, there are many options and risk levels to consider in order to maximize the protection of a fund’s assets from the many liability risks inherent in its daily operations. As such, a firm’s insurance investment is one of the most important decisions it can make.

About Sandy Crystal

Sandy Crystal is executive vice president of Frank Crystal & Co. Frank Crystal & Co., headquartered in New York City, is one of the largest privately-held insurance brokerages in the U.S. with regional offices across the nation, including Houston, Palm Beach, Philadelphia, Portland, San Francisco and Seattle. Web site: www.frankcrystal.com.

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