Private Equity, Hedge Fund Appetites For D&O, E&O Coverage Seen Changing

Demand for insurance declining for private equity, while growing for hedge funds

By Mark e. ruquet

In the midst of a crisis, buyers of property-casualty insurance will want more coverage for their increased potential exposure, but some insurers may become reluctant to sell it because of the increased perception of risk.

According to insurance brokers, such sentiments are now evident in the markets for director and officers liability insurance and errors and omissions coverage for hedge fund and private equity managers, in the midst of economic turmoil gripping the financial sector. However, the emergence of the current situation is not affecting both equally simply due to the different nature of the two types of vehicles.

The major difference is that hedge funds do not take an active role in the management of a portfolio company like private equity investors do, said Michael J. White, senior vice president, financial institutions industry leader of the Executive Risks practice of Willis HRH, a unit of Willis Group Holdings.

Private equity is usually broader coverage and extends to outside directors who are appointed to company boards, he said. “With hedge fund coverage, you are not envisioning a risk of the fund going out there and actively asserting itself or getting involved in the management of another company,” Mr. White noted.

Some hedge funds can be activist and try to influence management at a company, but that is very different from controlling its operations, he said.

Likewise, Michael Klaschka, managing principal of the Management Risk practice for New York-based Integro Insurance, said insurance contracts for private equity firms differ primarily because of exposure arising from the advice and management the private equity fund is involved in. Some hedge funds may see their coverage extend beyond the managers to outside directors liability, where the fund has named a director or directors to a company’s board.

“Hedge funds are a good business to be in because they value a broker who knows what [he or she] is doing since most of these funds don’t have risk management departments,” Mr. Mr. Klaschka observed. “Typically, the chief financial officer or general counsel or compliance officer got stuck with the job and that is where we provide a lot of value.”

Despite the general soft market and observations that rates continue to decrease in the professional liability area, in the financial services segment, the market is taking a different turn, the brokers noted.

“Markets are constricting and reducing capacity, increasing premiums and especially retentions in this space,” according to James O’Brien, managing director and co-leader of Aon private equity and transaction solutions practice in New York. This is happening in the face of increased claims and litigation driven by the financial crisis and general economic downturn, he said.

The financial market crisis has produced different dynamics in the purchasing of the coverage. Private equity firms, who were major purchasers of this coverage, are not purchasing the coverage like they were in the past. Credit has dried up, the brokers noted, reducing their activity.

However, interest in the coverage among hedge funds has grown. Typically, hedge fund managers were not purchasers of insurance due to the broad indemnification in the terms of the fund’s contract. But with regulators scouring the books of these funds and investors pulling their money out, prompting banks to make margin calls where funds are overleveraged, the desire to transfer risk is growing.

“The increased exposure these days is driving hedge fund managers to get insurance,” said Mr. White.

He noted that it is important for a client to differentiate [its] risk from other hedge funds and explain effectively why they are not a bad risk. “It’s a good market, but a very cautious market these days,” he said.

D&O and E&O coverages are not sold in separate policies but combined in this sector, Mr. White noted. Not all insurance company markets will write both hedge funds and private equity firms, he added. Two distinct issues that hedge funds face that private equity firms do not are market timing and cost of corrections, making some underwriters more cautious, he said.

Explaining cost of corrections, he said it involves a coverage grant that applies where an asset manager makes an error on a client’s account and wishes to correct it and make the client whole before it actually rises to the level where the client is asserting a claim against it. Under this coverage, the manager can seek reimbursement from the carrier for any funds expended in making the account whole.

Brokers say the insurers involved in this segment are few–primarily the major names associated with providing coverage to the financial markets such as American International Group, Chubb, Travelers, ACE, CNA, XL and HCC Insurance Holdings.

Capacity is shrinking, according to Mr. O’Brien. Last year there may have been $300 million capacity available, whereas today “we would be hard pressed to find $200 million,” he said.

Finding insurance, however, is less of a problem than finding it at an acceptable price with terms and conditions favorable to the insured, the brokers noted.

Mr. White said that on renewals where an account was able to get $10-to-$15 million of coverage, that may now be down $5-to-$10 million.

Insureds looking for greater insurance coverage amounts, primarily for defense costs but also including regulatory investigations and settlements, will often need to layer programs, the brokers said.

Participation among insurers is “narrow,” Mr. Klaschka said, and “if you have coverage, that’s great; if you don’t, it will be difficult, but not impossible to get.”

While insurers are very circumspect in reviewing the overall financial condition of a fund and its loss history, often the insured is as concerned about the financial condition of the insurer. In a way, the brokers noted, it is almost ironic that insurers who were concerned with the financial sustainability of a client are now getting the same scrutiny from the insureds.

“Who would have thought back in February that AIG would have issues,” Mr. Klaschka said, underscoring the insureds’ concerns.

The biggest challenges for brokers to deal with are capacity limitations and the need to reassure clients about the financial security of the carriers, Mr. O’Brien said.

“We are constrained by not enough capacity created by events and the need for this insurance. And there are questions about what the counterparty risk is. [Buyers] want to know they are transferring their risk to a financially viable insurer.”

“The increased exposure these days is driving hedge fund managers to get insurance.”

Michael J. White, Senior V.P.

Willis

“If you have coverage that’s great; if you don’t, it will be difficult, but not impossible to get.”

Michael Klaschka, Managing Principal

Integro Insurance