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E&O / D&O

Coverage details

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What Does an E&O / D&O Policy Cover?

The policy covers claims made by investors, regulators, and other third-party stakeholders for any actual or alleged negligent act, error or omission, misstatement or misrepresentation, or breach of fiduciary or other duty in the operation of the hedge fund. The policy is written with an insuring agreement that provides a broad coverage grant for any wrongful act except those acts that are specifically excluded. The policy pays for your defense costs, as well as any judgment or settlement up to the policy limit, but only after you have paid the retention (deductible) amount. In the better policies a "claim" also includes any administrative or regulatory proceeding (i.e.; an investigation), commenced by the filing of a notice of charges, formal investigative order or similar document.

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Who is Insured?

The policy is written with the Investment Manager (the Investment Adviser entity) as the Named Insured. The named insured appears on the Declarations Page (the front page) of the policy and is the entity that purchases and controls the policy. The policy covers as Insureds all of the following individuals and entities connected with the hedge fund:

  • Individuals
  • Past, present or future partner, principal, officer, director, member, trustee or employee of the Investment Manager
  • Past, present of future partner, principal, officer, director, member, trustee or employee of:
  • A covered hedge fund
  • The general partner or managing general partner of each covered hedge fund that is organized as a limited partnership
  • The managing member of any covered hedge fund organized as a LLC (limited liability company)
  • Entities
  • The Investment Manager (Investment Adviser)
  • Each covered hedge fund. Many, but not all, policy forms provide automatic coverage for new funds formed during the policy year.

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Policy Structure

The policy is comprised of four distinct parts:

  • Policy Declarations
  • The first two or three pages of the policy contain all the basic policy information, including:

  • The name and address of the insurance company
  • Notification statement advising that the policy is written on a "claims made" basis, that defense costs erode the policy limit, and that the insurer has no duty to defend
  • The policy number
  • The name and address of the named insured
  • The policy period
  • The limits of liability
  • The retentions (deductibles)
  • The cost and length of time of an extended reporting period ("Tail Coverage")
  • The address to be used for notifying the insurer of a claim
  • The annual premium
  • List of policy forms and endorsements attached at issuance
  • Signatures of the officers of the insurance company
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  • Base Policy Forms
  • Every insurer has its own proprietary base policy form. Unlike Workers' Compensation or Automobile insurance, there are no industry-standard forms. In fact, there is tremendous variability in the forms used by Hedge Fund E&O / D&O underwriters. That's why it is so important to choose a knowledgeable broker who can point out the differences and recommend the best form for your fund.

    The typical Hedge Fund E&O / D&O base policy form has a General Terms & Conditions part - plus at least three other coverage parts as shown in the illustration below:

    EandO_DandO Policy Structure
  • The Investment Manager E&O Coverage Part covers the Investment Manager (Investment Adviser) entity and the individuals who own/manage/work for the entity for claims alleging wrongful acts in providing or failing to provide investment management services to the covered fund(s). Think of this part as professional liability or malpractice insurance for the adviser. The policy also covers the Investment Manager's vicarious liability exposure for outside service providers who perform professional services on behalf of the company.
  • The Investment Manager D&O Coverage Part covers the Investment Manager (Investment Adviser) entity and the partners/members (or directors and officers, if the Investment Manager entity is a corporation) of the Investment Manager for claims alleging wrongful acts in the conduct of the business, other than claims alleging wrongful acts as adviser to the covered fund(s). The policy will also pay on behalf of the Investment Manager entity amounts it pays as indemnification to the partners/members (or directors and officers) as prescribed by the entity's by-laws. Some insurers include coverage for Employment Practices Liability claims within this Coverage Part, while other insurers break this out as a separate Coverage Part. Employment Practices Liability provides coverage for claims by employees alleging wrongful termination, discrimination, or sexual harassment.
  • The Hedge Fund E&O/D&O Coverage Part covers the insured Fund(s) and the individuals who are responsible for oversight of the Fund(s) for claims alleging wrongful acts in the operation of the Fund(s). The Directors & Officers Liability (D&O) coverage in this Coverage Part is a misnomer: it really should be called E&O/GPL or General Partners Liability because most funds are organized as either a partnership or limited liability company (LLC) and the policy covers as Insureds any general partner or managing member of the fund(s).
  • The optional Fiduciary Liability Coverage Part covers claims alleging a breach of fiduciary duty under ERISA as well as other wrongful acts arising out of the Insured's role as a fiduciary of one or more qualified plans. Hedge Funds with more than 25% of their AUM from ERISA and other benefit plan investors may be deemed to be fiduciaries under ERISA rules. Fiduciaries may be held personally liable for damages under ERISA. This Coverage Part may also be used to cover the Investment Manager's own sponsored 401(k) or pension plan.
  • The optional Outside Directorship Liability Coverage Part covers Hedge Funds that have representatives on the boards of directors of portfolio companies. Coverage usually applies excess of any indemnification provided by the portfolio company, and excess of the portfolio company's own Directors & Officers Liability policy. This added layer of protection ensures that coverage will be available for the director representing the Hedge Fund, in the event the portfolio company's D&O policy limits are exhausted or the policy is rescinded or canceled due to fraud or non-payment of premium.
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  • Endorsements
  • The base policy is always accompanied by one or more endorsements which serve to broaden or restrict the terms and conditions of the base policy. Some endorsements, known as State Amendatory Endorsements, are required by insurance regulators in the state in which the Investment Manager is located. Endorsement wordings vary not only from insurer to insurer, but sometimes a given insurer will have multiple versions of the same endorsement. Many endorsements that provide broader coverage are available without additional premium cost - but your broker needs to know enough to ask for them. Hedge Fund Insurance maintains a library of endorsements currently used by all insurers. We use our knowledge of available endorsements to craft state-of-the-art policies for our clients.

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  • Application
  • The completed and signed application is the fourth part of the policy. Not only is the application physically attached to the policy, but most policies state that all information submitted to the insurer along with the policy, such as performance data and roadshow presentations, will be considered physically attached to and part of the policy. The application and all the statements therein are considered material representations. Any errors or misstatements in the application could allow the insurer to disclaim coverage in the event of a claim. The better policy forms provide for severability of the application so that misstatements made by an insured in completing the application are not imputed to innocent insureds who did not complete the application and had no knowledge of the misstatements.

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Claims Made Form

Hedge Fund E&O/D&O policies are always written on a Claims Made form - a policy that covers claims first made during the year the policy is in force, or during an Extended Reporting Period (also known as a "Tail"). This form of coverage is in contrast to an Occurrence form policy, which covers a wrongul act committed while the policy is in force regardless of when the claim arising out of that wrongful act is made.

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Coverage for Prior Wrongful Acts

If you purchase a Hedge Fund E&O/D&O policy you want to make sure your policy covers unknown prior wrongful acts. Some underwriters will try to exclude coverage for wrongful acts committed prior to the policy effective date. As you would expect, there will be no coverage for known prior wrongful acts (you must disclose these in your application), or for claims arising out of circumstances reported to any prior insurer.

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Hedge Fund E&O/D&O policies are written with minimum limits of $1,000,000. Additional limits are purchased in increments of $1,000,000. The policy limits apply for each claim and also as a policy aggregate. The maximum aggregate limit of liability is the most the policy will pay for all costs under the policy, including defense costs, judgments and settlements. It is important to note that defense costs erode the limit of liability. So if your policy has a limit of $1,000,000 and it costs $600,000 to defend a claim, then there will only be $400,000 left to pay any judgment or settlement.

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What Limits to Purchase?

Hedge funds should not purchase a policy with the idea that it will pay for investor losses if the Investment Manager makes bad investment decisions. For most funds, adequate limits to cover investor losses are simply not available due to market capacity constraints - and even if they were, the cost would be prohibitively expensive. For example, Amaranth Advisers LLC lost more than $6 billion for its investors in September 2006 trading natural gas futures. Amaranth could only have purchased a small fraction of the E&O/D&O limits that would have been needed to make all their investors whole. Instead, funds should purchase an E&O/D&O policy to cover the cost of defending a lawsuit or investigation. These costs can easily run into seven figures. Many of our clients are purchasing coverage as a marketing tool: potential investors like to hear that a fund manager is protected by an E&O/D&O policy written by a major insurer.

The chart below shows the distribution of limits purchased by a large sample of hedge funds (data courtesy of Advisen Ltd.):

Benchmarking Limits Purchased

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Hedge Fund E&O/D&O policies are subject to a retention or deductible, which is the amount you must pay out of pocket before the insurer starts paying a claim. The retention applies to both defense costs and any judgment or settlement. The insured must pay the retention amount for each claim. Retentions for Hedge Fund E&O/D&O policies are high - typically from $150,000 to $250,000. Larger funds with AUM over $5B may have a retention of $1,000,000.

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The cost of defense is covered under a Hedge Fund E&O/D&O policy and the insurer will start paying defense costs on behalf of the insureds once the amount of loss paid out of pocket by the Insureds has exceeded the retention (deductible) amount. Defense costs erode the policy limit. So if you have a policy with a $2,000,000 limit of liability and if costs $700,000 to defend a claim, then only $1,300,000 will be left to pay any judgment or settlement. Unlike a Commercial General Liability policy, the underwriter has no duty to defend a claim. Instead, the Insureds are responsible for their own defense. The Insureds may choose their own defense counsel, subject to the insurer's approval. The insurer usually retains the right to consent to any settlement.

Some policies contain an unfavorable provision known as a "Hammer Clause" which limits the amount of the insurer's payment if the insurer recommends a settlement and the Insureds opt to continue to litigate. In that case, the insurer's obligation is capped at the recommended settlement amount. The Insureds will be responsible for the amount in excess of the recommended settlement amount if they choose to keep litigating and ultimately lose the case. Thus the term "Hammer" is used to describe the leverage the insurer applies to the Insureds to get them to agree to the recommended settlement amount when the policy contains a "Hammer Clause".

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Policy Period

Hedge Fund E&O/D&O policies are written for a term of one year.

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Extended Reporting Period

If the Investment Manager closes the fund(s) and ceases operation it is advisable to purchase an Extended Reporting Period or Tail Coverage which allows more time - one or more years - to make claims under the policy. The length and cost of the Extended Reporting Period is usually stated in the policy declarations. A typical Extended Reporting Period is one year at a cost of 150% to 225% of the annual policy premium. Longer tail periods of up to six years can be negotiated.

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Policy Territory

Some U.S. insurers limit coverage to claims brought in the United States and Canada. We think it is important that your Hedge Fund E&O/D&O policy cover claims made anywhere in the world.

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Every Hedge Fund E&O/D&O insurer has its own exclusions - and for any given exclusion, the variations may range from subtle to dramatic. Some exclusions can be deleted, while others can be softened. At Hedge Fund Insurance, we know which exclusions can be eliminated or modified so as to provide the broadest possible coverage for our clients. Here are some of the most common exclusions:

  • Any dishonest, fraudulent or criminal act by an Insured
  • Any willful or intentional violation of any statute, rule or law by an Insured
  • The gaining of any profit, remuneration or advantage by an Insured to which the Insured was not legally entitled
  • Any wrongful act, circumstance or claim reported under a prior policy
  • Any wrongful act, circumstance or claim reported in the application
  • Pollution or nuclear activity
  • Personal injury, bodily injury, and property damage liability
  • Contractual liability
  • Claims made by one insured against another insured
  • Service as a director of officer of an outside entity
  • Acting as an Investment Banker
  • Acting as a Broker/Dealer
  • Bankruptcy or insolvency (but any claim arising from the negligence of an Insured in rendering or failing to render professional services is covered)
  • ERISA claims (unless optional Fiduciary Liability coverage is included)
  • Soft dollar disclosure claims
  • Late trading and market timing
  • Claims based upon commissions or fees charged by any Insured

Information needed to quote

Underwriters require the following information to quote an E&O/D&O policy:

  • Fully completed and signed application, including schedule of funds with AUM for each
  • PPM for each fund
  • Latest audited financial statement + interim statement for the investment adviser (business plan and/or pro-forma statement if start-up)
  • Historical performance of fund(s)
  • Resumes/CVs of investment adviser principals
  • "Road Show" presentations, if any
  • URL of website, if any
  • Summary and status of any litigation filed within the last five (5) years against any person(s) or entity(ies) proposed for this insurance (including any litigation that has been resolved)
  • Employee Handbook for investment adviser entity (if Employment Practices Liability coverage is desired)

Hedge Fund Insurance, a division of Frenkel & Co., Inc., has access to every major market in the U.S., London, and Bermuda. As brokers, we represent the policyholder and not the insurance company. Among the largest brokers in the country as ranked by Business Insurance magazine, we have the market clout necessary to get you the best possible price. Some of the markets we place Hedge Fund E&O/D&O policies with include:

  • Allied World Assurance Company (AWAC)
  • American International Group (AIG recently changed the name of its property casualty operations to AIU Holdings, Inc.)
  • Arch Insurance Group
  • AXIS
  • Catlin
  • Chubb / Executive Risk
  • CNA
  • Hartford
  • Houston Casualty (HCC/PIA)
  • Lloyds of London
  • Travelers
  • XL
  • Zurich

Hedge Fund E&O/D&O policies cost roughly $20,000 to $35,000 per million of coverage. The price per million does decrease with the purchase of higher limits. The chart below shows the premiums recently quoted for a number of Hedge Fund E&O/D&O policies:

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Fund AUM ($millions) Strategy Limit Retention Premium Cost per $mil
Fund A 54 Municipal Bond Arbitrage 4,000,000 500,000 76,000 19,000
Fund A 54 Municipal Bond Arbitrage 4,000,000 250,000 90,000 22,500
Fund B 700 Long/Short Equity 5,000,000 250,000 100,000 20,000
Fund C 579 Emerging Markets 2,000,000 250,000 43,290 21,645
Fund C 579 Emerging Markets 2,000,000 150,000 48,500 24,250
Fund D 1,624 Multistrategy FoF 5,000,000 150,000 123,200 24,640
Fund E 300 Quantitative Multistrategy 3,000,000 250,000 78,000 26,000
Fund E 300 Quantitative Multistrategy 3,000,000 150,000 84,000 28,000
Fund E 300 Quantitative Multistrategy 2,000,000 250,000 56,750 28,375
Fund E 300 Quantitative Multistrategy 2,000,000 150,000 61,800 30,900
Fund F 260 Structured Products 3,000,000 500,000 80,000 26,667
Fund G 1,600 Debt/Preferred Stock 5,000,000 250,000 140,000 28,000
Fund H 1,000 Emerging Markets 9,000,000 350,000 285,700 31,744
Fund I 4,500 Long/Short Equity 5,000,000 250,000 170,000 34,000
Fund J 2,000 Long/Short Equity 5,000,000 250,000 175,000 35,000
Fund K 3,000 Bonds/ Derivatives 5,000,000 250,000 175,000 35,000

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Key Underwriting Factors

Here are some of the factors underwriters look at when deciding whether to quote an account and what terms and conditions to offer:

  • Claims history
  • Has the firm been the subject of any investigations or inquiries of any kind by any regulator in the past year?
  • Investment strategy
  • Leverage
  • Liquidity
  • Counterparty risk
  • Experience of the management team
  • Number of partners / viability of firm without key personnel
  • Experience of the chief compliance officer
  • Compliance / internal audit function
  • Due diligence regimen
  • Disaster recovery preparation
  • Historical fund performance
  • AUM
  • Minimum and average investment amount
  • Net flows ($ amount of subscriptions and redemptions past year)
  • Investor profile / percentage of institutional investors
  • Quality of outside service providers
  • Recent changes of outside service providers
  • Transparency / communications with investors
  • Use of independent custodian
  • Whether the adviser is registered with the SEC
  • Redemption restrictions
  • Use of side letters
  • Number of funds managed
  • Whether any funds have been closed, and if so, why?
  • Outlook for next 12 months
  • Strategic plan

Claim Examples
Since 2008, there has been an explosion of claims against hedge funds and their managers. The fraud perpetrated by Bernard Madoff has spawned many of these lawsuits. "Exhibit A" is hedge fund Fairfield Greenwich Group which was sued in New York State Supreme Court by two investors who claimed the fund and its adviser "failed to manage properly their investments and to carry out necessary due diligence that would have uncovered the massive Ponzi scheme."

Allegations made against hedge funds, investment advisers, and their respective directors/partners/members include:

  • Mismanagement
  • Misstatement
  • Negligence
  • Misrepresentation made in the PPM or other communication
  • Fraud
  • Breach of duty
  • Failure to supervise the investment adviser
  • Failure to perform adequate due diligence in evaluating potential investments
  • Failure to provide adequate disclosure of the investment risks involved
  • Investing in assets or using strategies not mentioned in the PPM
  • Failure to follow investment guidelines
  • Failure to properly value assets
  • Failure to invest
  • Failure to redeem investor funds in a timely and orderly manner
  • Manipulation or misrepresentation of historical performance
  • Excessive fees
  • Contracting with substandard vendors/submanagers
  • Conflicts of interest / related party transactions
  • Claims against individuals serving as directors on the boards of portfolio investments
  • Claims by the SEC or state attorneys general or other regulatory body alleging violations of rules or statutes. It is important to note that coverage under some E&O/D&O policies can only be triggered by the filing of a notice of charges, formal investigative order or similar document.
  • Market timing / Late trading
  • Claims made by employees alleging discrimination, sexual harassment, or wrongful termination

Sell Sheets

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Copyright © 2009 Frenkel & Co., Inc.

Hedge Fund Insurance
a division of Frenkel & Co., Inc.
350 Hudson Street, 4th Floor, New York, NY 10014
Phone: 212-488-0270  Fax: 212-488-0432