There are three primary reasons for the coverage:

1. Most, if not all, suits against hedge funds are settled and the policy is used primarily to fund defense costs and indemnify the fund for these expenses, should the fund managers be indemnified by the fund. The coverage prevents a fund from needing to liquidate positions or use cash to pay for defense costs.
2. To give investors and service providers an extra degree of security and comfort. This broad coverage is an excellent selling point to potential investors.
3. To provide employment practices liability coverage to protect the firm against employee suits. You definitely need this coverage,
4. Optionally some funds buy the outside directorship liability module to provide additional protection in connection with the outside boards they serve on (non-profit, for profit).

Insurance companies are moving to higher standard retentions due to the current market conditions and the regulatory environment surrounding hedge funds. Over the last several years we have seen minimum retentions move from a range of $100,000 to $250,000 to $300,000-$500,000 for larger funds. For funds with less than $250 million under management the retention can still be as low as $100,000.

No matter how well-run your firm is, you are not insulated from management liabilities, particularly in the current environment. In the midst of volatile market conditions, an increased focus on corporate governance and the potential for greater regulatory scrutiny, hedge funds face a wide array of liability exposures for the fund, its general partners and affiliated service providers.

For example, a hedge fund assumes vicarious liability for the actions of its outside service providers. If an error is made in misstating performance or in the financials, the fund bears responsibility.

Among other reasons, hedge funds can be sued for mismanagement, misrepresentation, employment practices violations, breach of duty, and failure to provide adequate disclosure of the investment risks involved. These suits can be brought by a myriad of sources: customers, members, employees of the fund, and may be directed at the general partner, managing member, directors and officers, investment manager or the fund itself.

The insurance community firmly believes there is a big gray area between these coverages with respect to hedge funds, and that pure D&O does not offer adequate protection. There is also a concept called allocation which makes the case for comprehensive coverage. Insurance companies will not, as a rule, sell D&O coverage only to hedge funds, and since the incremental cost to include E&O is not that great, we feel you should purchase the comprehensive policy. You might be interested to review this table, which explains the differences in coverage as well as this document on “allocation”.