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Hedge Fund Monthly
 

What is an Adequate Limit of Indemnity?

Martin Giggins, Cooper Gay

February 2008

 
When a problem occurs, regardless of the originating cause, all roads tend to lead to the directors, who, individually and collectively have unlimited personal liability and stand to lose everything if things go wrong.

Although good internal controls and governance reduces the risk of an operational breakdown, transferring the cost of any litigation or investigation off the respective balance sheets to an insurance policy is one of the few ways a director, investment advisor, manager and funds can truly limit the financial impact of the cost of an operational breakdown.

Due to the proximity of the investment advisor, manager and the funds, protection can often be bought on a blended basis that covers the respective entities and directors by absorbing the cost of such litigation and investigations.

The following diagram outlines some typical channels of responsibility, liabilities and how directors and officers and professional indemnity insurance policy can be positioned to absorb those liabilities. 

The red lines indicate some of the exposures to liabilities from claims for damages arising out of allegations of a breach of duty by a director or officer. The blue lines indicate how the liabilities from potential “professional negligence” claims usually occur.


Click on the image for an enlarged preview

The most cost efficient way of maintaining a blended policy is to carry a single “aggregate” limit of indemnity. This means that only a set amount is available under the policy which can be eroded by a single or number of claims or circumstances throughout the policy period.

Careful consideration needs to be made as to how the “blended” programme structures its “aggregate” limit. A single shared aggregate works best where the board of directors on each fund and the owners/directors of the investment advisor/manager are the same or very similar individuals and they can afford to spread their aggregate limit across the insured entities.

However, sharing an aggregate limit with another fund or investment advisor/manager can cause its own problems, should one party make a recovery under the policy that uses up the aggregate limit, the result being other parties are then left without coverage in the event they in turn need to defend themselves.

Potential conflicts can also occur in the event the directors of the funds need to claim against the fund manger. The language of the policy needs careful attention in order to ensure it responds to one insured seeking to make a recovery due to the actions of another insured.

As it is common for several funds to be covered under one policy, separate and distinctly allocated “aggregate” limits may prove to be the most secure way of ensuring that each respective board or directors (and funds balance sheet) maintains the coverage they require for the duration of the policy. 

It is mainly due to the proximity of the relationship (and often common directorships) between the fund manager, investment advisor and the funds that a blended policy is viable; however as an alternative to a blended policy, it is quite possible to maintain separate policies for each fund, manager and advisor depending of the specific concerns and exposures.

The above addresses the structure of the limit of indemnity; the question still remains “What is an adequate limit of indemnity?”

Maximum exposure and potential settlement amounts can only be predicted where the particular class of litigation has a cap at law. Outside of this, the extent and severity of awards and settlements will be determined by the Courts, regulators and arbitrators when mitigating a claim or simply the cost of defending an allegation against directors or the company from a third party.

Although there is no set formula in calculating a limit of Indemnity, there are a number of considerations when assessing what limit would be suitable when deciding what you want from your policy and how it protects you.

Do you want the peace of mind knowing your operating margins are protected? Or a policy that protects you and your company in the event a claim is made against you that potentially exhausts all the assets?

The following are some considerations in cost and exposure to potential losses to the directors of a fund:

  1. What are the singular or collective total amounts potentially exposed to a single investment at any one time?

  2. Where are the funds registered, distributed and what are the regulatory regimes in that region? What is the potential cost of complying with an investigation or employing local law firms to conduct a compliance with an investigation in that regime?

  3. Are any of the investors, funds, insured entities domiciled in the US or regulated by SEC registration or filing? Are you familiar with the regulatory requirements and the cost of complying with them? Are you familiar with any duties of due diligence in accepting investors in certain jurisdictions?

  4. How complex/volatile are the investment strategies? Are all investors sophisticated enough to understand the strategies? Are there sufficient internal controls to ensure compliance with the strategy in PPM?

  5. Are there any planned changes in the structure of the funds? Are investors fully aware of the changes in strategies?

  6. Are all service providers such as administrators, auditors and investment managers well established and contracted with strong liability conditions? Can recovery be made against them in the event they make a mistake which in turns provokes an action against the directors of the fund?

Considerations in assessing limits of liability for investment managers:

  1. What are the assets under management? How much could be lost at any one time?

  2. What is the collective potential amount that could be lost in any one trend of transactions?

  3. Where is the investment advisor/managers registered and regulated? Is there a thorough understanding, and know-how in dealing within the regulatory regime you need to be compliant with?

  4. Where are the investors domiciled? How much would it cost to defend an allegation of negligence from the investors?

  5. Are there strict internal operating guidelines/ risk management procedures?

  6. With regard to employee litigation, how many employees are employed in the US and in what states?

In considering the above, knowing what you want from your policy and how much it protects you is the next step.

Here are two trains of thought:

Do you want the peace of mind knowing your operating margins are protected from the cost of defending an allegation or complying with an regulator investigation or do want a policy that protects you in the event a claim is made against you that exhausts all the assets by large damages due to an unsuccessful defense for an allegation of breach of duty.

  1. A catastrophe:

    Limit of indemnity assessed based on:

    The size of total assets under management or assets of the company, it is rare that a director or asset mangers needs to be indemnified for more than they could potentially lose. (Other than where punitive damages are insurable at law.)

  2. The average probable maximum loss (PML):     

    Limit of indemnity assessed using a blend of: 

    • Potential cost of complying with a regulator investigation.
    • Cost of defending any allegations in the territories where you can be exposed to legal jurisdiction.
    • What is the likelihood of an accumulation of losses from the same originating action.

The above can sometimes be too much to take in, with so many “what if’s” in assessing how much protection you will need if things go wrong. This issue is endemic of any exposure to third party legal liability where your clients and investors rely on your professional advice and conduct.

Your broker should be able to provide you with a benchmark limit of indemnity relative to your assets under management; this can be based on what your industry peers buy and the brokers’ experience in handling claims of other comparable organisations. However, unfortunately there is no crystal ball to predict how much cover you will need.

Enlisting the services of the right broker will ensure that at the very least, an assessment of your risk profile will assist in understanding what you want to protect yourself from.

Finally, as you can see there is no easy answer. A concluding remark could be, given the unquantifiable nature of the result of any actions, the only limit of indemnity that will offer the most protection is the one that your premium budget allows you to buy.

 

The above is a discussion document only and is not designed to offer legal opinion. For a formal legal opinion you should always seek the advice of your lawyer and for thorough risk profile assessment, selecting an appropriate insurance broker.

 

If you have any comments about or contributions to make to this newsletter, please email advisor@eurekahedge.com

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