Hedge fund heyday: explosive growth in the number of hedge funds, coupled with increased regulatory scrutiny, has led to this niche market increasing its demand for insurance.

Key Points

* The number of hedge funds is growing by 20% annually, increasing the demand for directors and officers and errors and omissions insurance.

* Regulators are considering stepping up oversight of hedge funds, which also could increase their demand for insurance.

* Only about 30% of hedge funds purchase D&O or E&O coverage today.

Hedge funds march to a different drummer, boldly seeking out unusual investment strategies for their sophisticated, high-net-worth clients.

Yet, faced with additional regulatory scrutiny, these lords of alternative investments are turning to a traditional risk management strategy--insurance--to protect their executives.

This interest has opened a new niche market for brokers and insurers who take the time to understand hedge funds' risks.

New Opportunities

"Three years ago, less than 10% of hedge funds bought any kind of directors and officers or errors and omissions coverage. We've seen the interest in buying insurance appreciate four or five tunes in the last three years," said Scott Meyer, senior vice president of American International Group's National Union Fire Insurance Co of Pittsburgh, Pa.

Meyer, who recently was tapped to head up AIG's newly established Financial Institutions Practice, said part of the increase is due to the explosion in the sheer number of hedge funds.

Hedge funds have been growing by about 20% annually. An estimated 8,350 hedge funds, with about $875 billion under management, are active today, according to the Hedge Fund Association, a trade group. Some estimate the industry to be closer to $1 trillion in assets.

Insurance penetration in the hedge fund market is still relatively low. Meyer estimates that 30% or less have some sort of D&O or E&O coverage.

"The explosion in the number of hedge funds means there are more inquiries coming in, which is a good thing," said David Waiters, director of the U.K.-based Miller Insurance Services. The brokers' hedge fund business has grown from a "standing stop" three years ago to representing 30% of the brokerage's D&O business today.

Understanding the Risks

Hedge funds always have been a niche area for insurers. "The insurance market used to write a lot of hedge funds, but the markets had a contraction in 2002-2003. Insurers became less willing to underwrite hedge funds, perhaps because they were seen as being risky," Waiters said.

R. Mark Keenan, an attorney and partner with Anderson Kill & Olick, said hedge funds have a reputation for being a riskier type of business, but that the reputation isn't always deserved.

"One of the problems is the insurance industry doesn't totally understand the hedge fund industry. 'Hedge fund' is too global a term. Any investment pool can be called a hedge fund, but the investments, managers and business models can be totally different among 'funds' and the risk factors can be dramatically different," Keenan said.

He said about 10 insurers are currently offering D&O coverage to hedge funds. "You don't have a choice of hundreds of companies," Keenan said.

In London, Miller Insurance Services and other brokers offered to do educational presentations to underwriters on hedge funds.

"We wanted to dispel some of the myths," Waiters said. "The whole point of hedge funds is to be risk averse."

For instance, the Hedge Fund Association's Web site clarifies a "popular misconception that all hedge funds are volatile--that they all use global macro strategies and place large directional bets on stocks, currencies, bonds, commodities, and gold, while using lots of leverage. In reality, less than 5% of hedge funds are global macro funds. Most hedge funds use derivatives only for hedging or don't use derivatives at all, and many use no leverage."

Contributing to the difficulties in underwriting, and understanding, hedge funds is their penchant for secrecy. Because they have little regulatory oversight, hedge funds don't have to report extensively on their activities. And because they look for profits off the beaten path, they're reluctant to let others know when they've struck gold.

"Their strategies aren't well documented for a good reason," Walters said. "You don't want to necessarily advertise it to everyone else."

Insurers will want to know a hedge fund's business plan, but don't have to know specific investments, Keenan said. They'll also want to know who is running the hedge fund. "A lot of hedge funds are run by institutional investors, and you have to do a lot of homework to find out who you are dealing with and what their history is. I think the insurance industry wants someone with a pretty clean track record," he said.

With education, more underwriters have become comfortable underwriting hedge funds. "The happy result is the market has softened, improved and there's more capacity available," Walters said.

Threat of Increased Oversight

Hedge funds have historically been able to operate as they like with little regulatory scrutiny. However, the U.S. Securities and Exchange Commission is stepping up its oversight of the funds. While hedge funds used to be able to operate without registering with the SEC, the SEC will require most to register beginning next year. Many have already registered so that SEC-regulated entities, such as pension funds, could invest in them more easily.

Other regulations are likely to follow.

"We're not exactly clear on what kind of regulation there will be ultimately," Meyer said. "But the hedge fund world is seeing what's happened to the mutual fund world, which is maybe a cousin to the hedge fund world. And they've seen what's happened to other industries, like the insurance industry, and they are concerned that the regulatory authority is more far reaching than it was three or four years ago," Meyer said.

It's not just increased regulation that hedge funds worry about.

Hedge funds are concerned that a regulatory entity might do a sweep of the industry. Or that an authority might just focus on one specific hedge fund with problems, but then apply the findings from that hedge fund across the board. Whether or not those findings are accurate, once publicized, trial attorneys could use those findings for ammunition to fire against the hedge fund industry, Meyer said.

"We haven't seen lawsuits yet, but it's a concern," said Kevin Koehler senior vice president, Financial Institutions Group, of National Union. "As regulators get involved, there's a greater likelihood that hedge funds could have a target on their back."

"It's a $1 trillion industry," Keenan said. "The plaintiff's bar follows the money. All you have to do is wait for the downturn in the market, and then you will get sued."

Hedge funds could be sued by investors, limited partners, competitors, regulatory agencies and even companies that the hedge fund invested in, he said.

Of course, if additional regulation on hedge funds means they have to disclose their strategies more clearly, that could help insurers underwrite the industry, Meyer said. "But on the other side of the coin, hedge funds may decide to get out of the business depending on the extent that they are forced to share their very secret, proprietary trading operations."

National Union asks for detailed information when underwriting hedge funds, he said. "But do we receive it? It depends. If we can't get comfortable with the advisers and their strategy, then we would take a pass on the risk. The premiums are based on the assets and the strategy," Meyer said. "A hedge fund that has $100 million, but is leveraged 10 to 1 becomes a lot bigger, and therein lies the importance of underwriting."

How Much Coverage

Insurers often are reluctant to cover start-up hedge funds with less than $150 million in assets, Keenan said. At the $150 million level, insurers will sell a $1 million D&O policy with a $100,000 retention, he said. Larger funds may buy more coverage. Keenan said he's seen an investment fund with $10 billion in assets under management purchase more than $60 million in coverage.

However, he said future claims are likely to be more related to a hedge fund's loss history than its assets under management.

Walters said Miller Insurance will quote a range from 5 million [pounds sterling] to 100 million [pounds sterling] (about $9 million to $180 million). "We wouldn't recommend buying less than 5 million sterling pounds," Walters said. "The key thing is what assets are used as a rating base point. Are you going to insure up to the value of the assets? If you are running a multibillion dollar fund, the answer is no. But if you do end up with spurious allegations, you need defense quickly and efficiently, and the key thing then is D&O."

Meyer said he's seen limits ranging from $5 million to $10 million. "Typically, as we get more clarity on where the regulatory environment goes, you may see an increase in the interest for higher limits," he said.

Also, another area that some insurers are still reluctant to cover is "fund of funds," which is a hedge fund that invests in other hedge funds, much like mutual funds buy stock from different companies.

"Insurers say, 'I can see insuring you, but I am not insuring the 150 people you sit on top of. I can't really fully examine the risk because it gets too far afield,'" Keenan said.

National Union is one insurer that will cover fund of funds, said Koehler. "We are no more or less comfortable with [fund of funds] vs. your average hedge fund. Because of the diversification, you could argue that there's less of a chance for the whole thing to go up in flames," Koehler said.

National Union would look at a fund of fund's liquidity, the redemption period and the due diligence it follows to invest in other hedge funds.

What Lies Ahead

Rates for D&O coverage for hedge funds have stabilized, but exclusions are getting wider and limitations getting larger, Keenan said.

"Insurers are asking for what are in essence warranties. For example, managers, directors or officers must warranty that x, y or z will not or has not happened, and if that turns out to be incorrect, then they will try to walk away from the insurance," Keenan said.

The increased regulation of hedge funds is definitely a concern, he said.

"What sells insurance is fear, and the fear has penetrated to about 30% of the [hedge fund] industry," Keenan said.

He said insurers also are limiting coverage for regulatory investigations, and widening exclusions for personal profit and wrongful acts. Some also have excluded specific tactics, such as market timing and late trading, allegations that have scarred the mutual fund industry.

As participation in hedge funds has grown, and traditional stock market returns have been lackluster, some hedge funds have been able to attract less affluent and less sophisticated investors.

Hedge funds are supposed to deal with "accredited investors" those who have a minimum of $1 million in assets or $200,000 in income. "Some 'hedge funds' are soliciting investors not accredited. [Even] Having that income does not necessarily make you sophisticated," Koehler said.

"We have concerns about those investors putting their assets in highly sophisticated investments. The potential exposure the industry might have is from suitability claims," he said.

Keenan said that as hedge funds open up to become more of a retail operation, they will also open themselves up to being the subject of lawsuits. A fund that adds investors is a fund that adds to its litigation risks, Keenan said.

"You won't see the class action lawsuits, because hedge funds by definition are private investment pools. So plaintiff's attorneys won't be suing on behalf of 30,000 shareholders. But what is the difference between string on behalf of 30,000 shareholders for $150 million vs. suing on behalf of a single plaintiff for $150 million?" Keenan said.

Hedge Funds Risks

* Misrepresentation: These include claims that the fund misrepresented the investments risks, its performance or financial condition.

* Fiduciary Breaches: If the fund acts as an administrator or investment adviser to a pension, employee benefit, group life or medical expense plan, there could be claims of violations of fiduciary obligations, including claims under the Employee Retirement Income Security Act of 1974.

* Oversight Failures: Claims based on the alleged failure to supervise outside service providers.

* Negligence: Incorrect sales, mismanagement or inadvertent failure to follow investor instructions.

* Fidelity or Crime: If a rogue employee embezzles from the fund.

* Employment Practices: Similar to risks of any employer, including claims of sexual harassment, wrongful termination, failure to promote and so forth.

Insurance for Hedge Funds

* Directors and Officers or General Partnership Insurance: Protects the fund's decision makers.

* Professional Liability Insurance or Errors and Omissions Insurance: Protects the fund and the managers.

* Fiduciary and Trustee Insurance: Protects the fund in dealing with pension funds.

* Key Man Life Insurance: Protects the fund if it is highly dependent on the expertise of one or a few key men and women.

* Crime/Fidelity Insurance: Protects the fund from an employee's criminal acts.

* Employment Practices Insurance: Protects the fund from risks of being sued by employees.

Source: R. Mark Keenan, partner, Anderson Kill & Olick

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National Union Fire Insurance Company of Pittsburgh, Pa.

A.M. Best Co. # 02351

Distribution: Brokers

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