Insurance Expense Allocation for Investment Managers: A Primer

At a high level, the SEC may have concerns about any expense borne by a fund (1) that only benefits the manager, and not the fund; and/or (2) that is not adequately or accurately disclosed to fund investors. Insurance premiums—like any other expenses—may fit this bill.

Anecdotally, private fund managers have faced questions in the past from the SEC EXAMS staff about insurance premium expense allocations. The SEC’s commentary in the adopting release for the defunct Private Fund Adviser Rules—discussing the requirement for tabular disclosure of fees and expenses charged to funds—demonstrates that insurance premiums are on the SEC’s check list:

• For example, if the fund paid insurance premiums, administrator expenses, and audit fees during the reporting period, a general reference to “fund expenses” on the quarterly statement will not satisfy the rule’s detailed accounting requirement. Instead, an adviser is required to separately list each category of expense (i.e., in the example above, insurance premiums, administrator expenses, and audit fees) and the corresponding total dollar amount.

Elsewhere in the release, the SEC highlighted a potential nexus between the non-pro-rata allocation rule and insurance:

• [T]he adviser’s non-pro rata allocation must be fair and equitable under the circumstances. Whether it is fair and equitable will depend on factors relevant for the specific expense. ... another factor could be that one private fund client may receive a greater benefit from the expense relative to other private fund clients, such as the potential benefit of certain insurance policies.

Finally, the SEC acknowledged the interplay between indemnification and insurance in withdrawing its proposal to prohibit funds from indemnifying managers for negligent behavior.

What do these isolated references to insurance mean? Recent developments strongly suggest that the SEC has no near-term plans to resurrect the Private Fund Adviser Rules. But the commentary in the adopting release remains relevant because it reflects the SEC staff’s observations of adviser practices on the ground—practices that will remain focus areas under the current SEC regime.

While insurance premium expenses are not typically material in comparison to other fund expenses, the SEC staff often shows interest in seemingly minor foot-faults by investment advisers. You want to get this right the first time, not when it is raised as a potential issue by the SEC staff.

Insurance Premium Expense Allocation

Most fund managers purchase a coverage package with several different insuring agreements, each designed to respond to different types of claims. For a good summary of these different types of coverage, check out our insurance guide for investment managers.

To get insurance coverage, of course, managers must pay premiums. Are these premiums expenses of the manager alone or the fund and the managers? If the latter, how should premiums be appropriately allocated between the manager and the fund?

Well, it depends. Certain portions of the premiums should be borne by the manager. Under some circumstances, however, it may be appropriate to allocate other portions of the premium to the fund.

To answer this question, you need to take a holistic view of the regulatory and insurance environment. How does your insurance coverage perform and who does it benefit? Which portions of your premium are attributable to which insuring agreements? How have you disclosed your expense allocation methodology to investors? How would a skeptical SEC examiner react to your premium allocation methodology?

Rather than waiting for an SEC examiner to knock on your door, now is the time to review your premium expense allocations. This analysis should be undertaken in close consultation with your insurance advisors, ideally advisors who have a deep understanding of both the regulatory and insurance environment.