Insurance for Hedge Fund Managers

Recent political and economic events have changed the landscape for hedge funds (and likewise for funds of hedge funds). Hence, fund managers have become more vulnerable to lawsuits, which can be expensive to defend and even more costly to settle. Litigation threats are arising from dissatisfied investors and regulatory investigations.

They pose new levels of risk to hedge funds, as well as to the personal assets of their managers and employees. Even though, fund managers or general partners can protect themselves from direct demands of investors by contractual means, an agreed indemnity in the event of gross negligence may be void.

The revised Swiss Collective Investment Schemes Act, aiming at equivalence with the new EU Directive on Alternative Investment Fund Managers (AIFM directive), have specified the standards for the fund managers' professional liability.

The regulation’s detailed definition of professional liability risks, however, is neither meant to be complete nor exhaustive. Indeed, the fund manager shall implement effective procedures in order to identify its own specific risks related to its professional liability.

Fund managers' liability
Limited partners expect general partners to manage the fund according to guidelines outlined in private placement memorandums. Investors expect due diligence, good faith, loyalty, care and other fiduciary duties from general partners. Lawsuits can be filed when it appears that any of these responsibilities have been breached. Although partnership agreements provide protection for the general partner, such indemnification can be circumvented by lawsuits alleging general partner gross negligence. Investment management insurance can cover liability risk exposures related to fund management.

'Fund of fund'-specific risks
for a 'fund of fund'-structure the liability exposure arising from delegation has to be considered. The liability exposure depends also on the fund structure (e.g. 'manager of manager' vs 'fund of funds'). The insurance program of a 'fund of fund'-structure may need to be co-ordinated with the insurance solutions of the invested funds in order to avoid duplicate cover or lack of insurance cover.

Crime / financial fidelity
Criminal schemes can last for years and cost an organization dearly. Financial fidelity risk exposure includes employee dishonesty, forgery, theft, destruction and disappearance of property.

Offshore structures
Offshore funds are often part of the investment solution for structures initiated in Switzerland. Therefore, in addition to 'indemnity' or ‘hold harmless’ agreements between the fund and its manager, it needs to be considered whether a foreign insurance policy (e.g. out of Switzerland) is admitted in the offshore jurisdiction concerned, to compensate the fund or its directors.

Fund’s investment returns at risk?
Consider the fund’s risk. A general partner's liability is often guaranteed by the partnership agreement’s indemnification provision (except for gross negligence). However, when third-party suits are filed against the general partner and/or the partnership, the fund may ultimately become responsible for defence/legal costs, judgments and settlements. Such claim expenses may likely reduce the fund’s investment returns.