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Frenkel & Co., Inc. Company
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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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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:
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The policy is comprised of four distinct parts:
The first two or three pages of the policy contain all the basic policy information, including:
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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:
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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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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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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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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.):
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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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Hedge Fund E&O/D&O policies are written for a term of one year.
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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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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:
Underwriters require the following information to quote an E&O/D&O policy:
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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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Here are some of the factors underwriters look at when deciding whether to quote an account and what terms and conditions to offer:
| E&O / D&O | Type | Size |
|---|---|---|
| AIG E&O / D&O brochure |  |
76K |
| AIG E&O / D&O sell sheet | |
179K |
| AIG Investment Banking Engagement E&O sell sheet | |
70K |
| CNA E&O / D&O brochure | |
93K |
| Hartford E&O / D&O sell sheet | |
59K |
| XL E&O / D&O brochure | |
24K |
| Hartford Independent Directors Liability sell sheet | |
63K |
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