What Emerging Managers Need to Know About Hedge Fund Management Liability Insurance

This article first appeared in Smart Business Magazine's April 2015 edition.

When investment professionals start their own hedge fund, one of the top priorities is to purchase management liability insurance, otherwise known as directors and officers/errors and omission (D&O/E&O) coverage.

The insurance is used to pay defense costs and any judgment/settlement amounts the hedge fund may incur when responding to litigation.

Hedge funds have come under increased scrutiny by their investors and regulatory agencies of late, and D&O/E&O coverage is critically important in protecting the personal net worth of the individuals and the assets of the investment funds.

What is covered under D&O/E&O insurance, and who sues?

The insurance is triggered by claims alleging acts, errors or omissions in the performance of investment advisory services or in the management of the advisory business. Insured parties under the policy include the individual directors, officers, partners and employees, as well as the adviser entity and the investment funds themselves.

Protection for the individuals is most critical in circumstances when indemnification from the funds or the adviser entity is unavailable, such as instances when the fund has been wound down and assets have been distributed, or in the case of bankruptcy.

The policy, however, also pays on behalf of the insured entities their indemnification obligations to the individuals, and for costs associated with their own liability.

This last piece is important, since non-buyers often voice objections about the coverage that theyre relying on the broad indemnification language in the fund to protect them.

That may be the case, but in addition to those circumstances where indemnification is unavailable, any litigation costs paid out of fund assets will directly impact the investment return of the fund which could be substantial depending on the nature and scope of the claim.

Two additional coverage components that can be included are employment practices liability (EPL) and trade error/cost of corrections coverage.

EPL coverage responds to claims by employees alleging wrongful termination, sexual harassment and discrimination. Trade error/cost of corrections coverage reimburses the fund and/or adviser for costs to proactively correct trade errors that could have otherwise resulted in claims by clients/investors.

The type of claimant and nature of the allegations are dictated primarily by investment strategy.

All strategies are susceptible to claims by investors, regulatory bodies such as the Securities and Exchange Commission and employees. But more complex strategies may lend themselves to claims in other instances.

What does it cost?

The cost is influenced by a variety of factors, but the primary drivers are investment strategy and total assets under management (AUM). Other considerations will include experience/pedigree of the investment managers, prior litigation history, etc.

The annual minimum price per million is about $15,000, but that rate is often discounted when purchasing higher limits.

How much coverage is an adequate amount?

Most startup hedge funds with AUM under $100 million are purchasing $1 million to $2 million in coverage. Bigger launches of $200 million and higher will seek $3 million to $5 million and even higher in some instances.

Once the AUM gets above $1 billion, firms generally purchase limits equating to 1 percent of AUM for straightforward liquid strategies and more for more complex, illiquid or hard-to-value strategies.

Notwithstanding the above, there are generally three types of buyers:

1. Check the Box, those only wanting to satisfy minimum investor requirements.
2. Coverage for Defense Only, those who realize the nature of todays litigious environment and that anyone can get sued for anything, but they have a straightforward strategy and wont do anything wrong.
3. True Alpha Protection, those that realize that litigation is a reality of their strategy, purchasing enough to fund a vigorous defense, with enough left over to pay judgment/settlement amounts.