Alternative Investment Management Association
By Shyam Moorjani, Managing Partner
Baronsmead Partners LLP
The survey examines the buying trends for professional indemnity (pi) insurance and directors’ and officers’ liability (d&o) insurance amongst hedge funds. We analysed data from 120 London-based hedge fund managers with combined assets under management of over US$200 billion. The data covered all hedge fund strategies and ranged from start-ups through to established, multi-billion dollar hedge funds.
The purpose of this report is to allow COOs to benchmark coverage limits, premiums and claims service against their peers. Additionally it will give them an understanding of the latest trends in the insurance market as well as compare the insurance industry’s view of hedge fund risks. Whilst the survey provides quantitative data it doesn’t comment on the quality of the product being sold to hedge funds.
One of the main factors behind the rise in purchase of PI insurance is the increasing demand by investors that managers have this insurance in place. In addition to asking about the limit purchased by the managers, investors are now also looking at the quality and structure of cover, with particular emphasis on the scope of exclusions and having separate cover for the fund and manager. The AIFMD is also an influencing factor in the increased purchase of PI insurance and combined, these factors have resulted in 82% of hedge fund managers purchasing PI insurance, compared to 64% previously.
Of the 18% of managers that did not take out PI insurance, the decision not to purchase could not be explained by the length of time in which the manager had been trading; some start-ups decided to delay purchasing PI insurance due to financial considerations. In addition, a number of managers looked after internal/family money and did not feel the need to purchase insurance.
A small number of hedge fund managers commented that price was a major consideration but the majority stated that quality of cover was the decisive factor with the scope of policy exclusions being a key concern.
The exposure to claims against directors has resurfaced with the recent Weavering Capital judgment, which was handed down in the Cayman courts in August 2011. In that case the court commented on directors’ duties in a hedge fund context. Directors continue to demand that they are adequately protected by their D&O insurance and not surprisingly 93% of respondents had D&O insurance in place, up from 86% previously. Many directors continued to express concern about being insured under a single composite policy alongside the manager.
An increasing number of investors are insisting that fund directors and the fund itself are adequately covered so the fund does not have to indemnify the directors in the event of a claim. One firm highlighted that they had purchased separate insurance policies for each of the major fund strategies to help minimise the potential of a strategy specific issue eroding cover for all the funds.
The survey confirms that premiums have been steadily dropping over the past 24 months but at the same time the average limit of cover purchased has increased. 12% of respondents had seen an increase in premiums in 2011 with the remainder seeing premiums flat or falling by around 10% throughout the range of AUMs. Whilst nearly 90% of insurers believe that this falling level of premium is not sustainable, only a few indicated that their hedge fund book is unprofitable.
Whilst it appears that premiums are unlikely to start increasing dramatically, an increase in financial crisis legacy claims may cause insurers to review historic profitability. Prices have been coming down because there have been so few claims against directors. However, when insurers’ margins are continually eroded, some will inevitably become tougher on the claims they do have, in order to maintain profitability.
Hedge fund claims can arise from a variety of different issues but generally speaking the key exposures to insureds are either operational (fat finger errors), regulatory, litigation or employment claims. Despite the anticipation that claims against fund managers would rocket after the financial crisis of 2008, the level of claims remains reasonably low and within expected levels. Of the 120 managers, only 8% declared that they had made a claim. 80% of the claims made were against the manager with only 20% of claims against the fund/its directors. Statistically, newer managers are equally likely to have claims compared to established managers.
By severity, litigation claims were the largest proportion of claims settled due to the costs involved. While litigation claims are often settled before reaching court without any finding of liability, they tend to result in more severe losses for insurers. In terms of frequency, operational claims accounted for the majority of the PI claims followed by regulatory and then litigation claims. Insurers anticipate regulatory claims becoming more prominent in the coming years as new regulations start to take effect.
There has been a significant rise in the number of managers unhappy with the way their claim was handled. In this survey, 83% of those that had made a claim stated that the claim could have been handled better, compared to only 50% previously.
The general consensus was that claims settlements were not concluded in a timely manner and that the managers were not being kept informed of progress by their brokers. In cases where claims management was outsourced to a third party company or regional office, there was the most dissatisfaction among respondents.
These findings reflect a need for a robust claims reporting and management process. Although many hedge fund managers may be lucky enough not to make a claim, claims management is and will remain a crucial factor in the insurance-buying process.
The survey indicates that the ability to raise new capital and performance returns are a key concern for managers in 2012. Hedge funds rated these of high importance compared to insurers who saw these of medium importance. Contrary to the noise surrounding the introduction of new regulations, the impact of the AIFMD and US regulation was given a low rating by managers compared to insurers who saw these as the highest importance. As one GC stated, “the AIFMD will have a low impact on my business, but it will increase my workload.” The general consensus was that it was an administrative burden, but that they had no choice on implementation. Virtually all managers acknowledged that it would significantly increase operational costs.
A number of respondents suggested that the lack of any “significant impact” of US regulation on UK hedge funds was perhaps a reflection of the level of interaction that some of the respondents had with the US. A number of those interviewed said they had chosen to avoid US investors.
A more significant finding is that the recommended purchase of PI insurance of 1% of AUM, in place of holding capital, appears to be more of an arbitrary figure. In reality, managers under $500m AUM are buying much more than 1% of AUM. Of those that take out PI insurance, most buy between 2 - 5% of AUM with some managers buying up to 10% at the lower AUM level.
It was a similar story for UCITS hedge funds with some managers revealing they had launched UCITS funds in anticipation of the requirements of the AIFMD. One respondent explained that the initial draft of the directive indicated they could not market a fund into the European Union, so a UCITS fund was set up instead.