Writers of professional liability insurance for hedge funds face new vetting challenges in the wake of both the Amaranth scandal and failed regulation efforts, warned one industry attorney.

But with a market penetration estimated at less that 20 percent, such writers still say the main challenge they face is persuading their clients they need the coverage.

Richard Bortnick, a partner at the New York-based firm of Cozen O'Connor, said a spate of shareholder suits has already arisen in the aftermath of the estimated $6 billion loss by Amaranth Advisors LLC.

The wrong-way natural gas bet by one fund manager at the Greenwich, Conn.-based firm has sent shock waves through the industry, but so far nothing like the reaction to a similar event in 1998 when federal government involvement was required to calm markets, he said.

“Given the lack of regulation by the government, and given the exposure for which the hedge funds are going to be potentially liable, underwriters need to do a far better job of vetting and underwriting [hedge funds] because there is nobody else watching them,” Mr. Bortnick said.

Michael White, executive vice president for New York-based Willis Executive Risks, said underwriters are now tightening up on how leveraged hedge funds have become.

“The main issue with Amaranth is the fact that they had leveraged the positions significantly and thus magnified [the fund's] exposure,” he said, referring to the fact that hedge fund managers borrowed money to take positions.

Underwriters will look at the prospectus for the funds and see what kind of limitations there are on how leveraged the funds can be, he said.

“If the fund makes no mention of leverage, theoretically they could leverage out the wazoo,” Mr. White said. “What they really want to look for is the funds that do not make use of leverage because that will be a real positive risk factor for them.”

In addition, professional liability underwriters will have to take a closer look at both the past performance and character of the hedge fund managers themselves in addition to the overall management of the fund.

For example, Amaranth claimed it had all sorts of risk management checks and balances in place to protect against the kind of losses incurred, according to Mr. Bortnick.

So underwriters must somehow check to see if they are really in place before issuing policies, he said.

There are indications that some hedge fund professional liability insurers are getting cold feet, according to Michael Klaschka, principal with New York-based Integro Insurance Brokers.

While Chubb, AIG and XL remain the writers of the primary portions of the business, other writers who have dabbled in the excess layers now seem to be getting a bit skittish, Mr. Klaschka said.

Although relatively few hedge funds purchase the coverage today, according to John Bayeux, financial industry practice leader for Willis Risk Solutions, that may be changing as investor profiles change.

“Those [hedge funds] that did purchase the insurance often found that insurers did not understand the complexity of their operations,” he said. “As a result, they were charged inflated premiums.”

The widening market for the kind of returns that hedge funds promise has attracted a new breed of investor.

“Regulated investors, such as pension funds, have continued to insist that their investment managers hold professional liability insurance, and more and more investment management agreements are making this a legal requirement,” Mr. Bayeux said.

The key elements of hedge fund insurance consist of directors and officers liability and errors and omissions components that cover things such as a breach of agreed investment parameters and lack of due diligence prior to trades. In addition, crime-fidelity insurance covers fraudulent or malicious acts by employees.

Fred Gaston, president of InsureHedge, said that in the hedge fund arena, D&O and E&O claims present unusual challenges. “The insurance community firmly believes that there is a big gray area between these coverages with respect to hedge funds, and that pure D&O does not offer adequate protection,” he said.

For that reason Mr. Gaston said insurance companies will not, as a rule, sell simply D&O coverage.

Smaller funds typically purchase $1 million limits with retentions up to $150,000. While the limit may seem low compared to possible losses, Mr. Gaston said these kinds of policies are for the most part to pay defense costs for a mistake, not to fund the loss of tens of millions of dollars of trading losses.

“The policy would be prohibitively expensive if it covered 25 percent or 50 percent of fund assets,” he said.

Opinions vary on the effect on the insurance market of the Securities and Exchange Commission's efforts early in the year to gain greater oversight of the hedge fund industry through new registration requirements.

That effort was derailed by the Goldstein decision of the U.S. Court of Appeals, DC circuit, in June that in effect nullified that requirement. (Phillip Goldstein, et al., v. Securities and Exchange Commission).

SEC Chairman Christopher Cox said the agency would not appeal the ruling and would seek alternatives to provide a safer hedge fund investing environment.

Mr. Bortnick said the fact that the original SEC effort threatened the hedge managers with new scrutiny meant that they will look to insurance for further protection from the wrath of investors in the wake of Amaranth-like losses.

Mr. Klaschka, on the other hand, said the fact that hedge funds will no longer face direct SEC scrutiny will make them less likely to get liability insurance. “I don't think Amaranth will lead to too many hedge funds getting this kind of insurance. It may make them think a little bit about it, but after all, you are dealing with people who have high egos and the like,” he said.

The Amaranth losses could spur new regulation both at the federal and state level. For example, Connecticut Attorney General Richard Blumenthal said he is investigating the losses with an eye to future regulation.

He said that particular representations made by the hedge fund appear to have been false. “Such claims–if made–would contradict the spirit and letter of the current law,” he said in a statement.

“The facts about mammoth losses by Amaranth offer additional powerful and compelling evidence about the need to reform disclosure and oversight requirements,” he said.

Standard & Poor's analyst Tanya Azarchs said the fact that the recent Amaranth losses did not lead to any general systemic issues for capital markets was a positive sign and an improvement from the 1998 Long Term Capital Management affair. “That such a large loss does not lead to default is comforting in the context of ratings for hedge funds, as it extends the track record of low default rates for the industry,” she said.

As for the possible threats to insurance companies as investors from wayward hedge funds, Standard & Poor's analyst Tom Upton said that was more of an issue for life companies than property-casualty enterprises.

“In general, investment strategies for life insurance companies are more integral to their ultimate profitability than they are for p-c,” he said.

Special Reports /

Hedge Funds Still Wary of Insurance

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