Insurance/ReinsuranceAugust 2013NEW REGULATIONSFOR ALTERNATIVEINVESTMENT FUNDMANAGERS ANDOPPORTUNITIES FORINSURERSSummaryn On 22 July 2013, new Regulationswere enacted in the UK which regulateAlternative Investment Fund Managers(AIFMs). The Regulations are intendedto form one coherent rule book, whichwill result in smooth and efficientpassporting arrangements betweencountries for AIFMs and the funds undertheir administration.n With regard to Operational Risk, AIFMsare required to either (a) take outinsurance or (b) set aside part of theircapital to cover liabilities arising fromtheir activities (or a mixture of these riskmitigants).n The activities cover a spectrumof risks from employee infidelity,professional negligence, electronicliability and mitigation of loss. Many ofthese activities can be addressed byconventional financial institution/IMIproducts.n At the end of this Briefing we identify theinsurable risks/regulated activities andresponsive products.The poor rates of return on traditional investmentshave resulted in the growth of a significant parallelinvestment market: the Alternative InvestmentFund Management market. The considerablereturns enjoyed by the market, often throughhighly leveraged structures, which carry theirown risks, are making investment (fund)management vehicles increasingly attractive. Theirattractiveness to investors has also caught theattention of EU Regulators who have now soughtto bring consistency to the Euro 2.2 trillion marketthrough the Delegated Regulation (2011/61/EU).This Delegated Regulation has been reflectedin UK law by the recent amendments to theFinancial Conduct Authority’s (FCA) GeneralPrudential (GenPru) Source Book (FCA 2013/51)(collectively, the Regulations).This briefing considers these Regulations insofaras they impact insurance offerings (and notreservation of capital).
The Regulations are intended to focusprimarily on the Alternative InvestmentFund Managers rather than thefunds themselves, and will includehedge funds, private equity funds,retail investment funds, investmentcompanies and real estate funds. TheRegulations were implemented by theFCA on 22 July 2013 and there is a12-month transitional period to ensurethat all relevant permissions andauthorisations are obtained.The Regulations seek to legislatefor all activities of AIFMs. Of interestto insurers, is the focus on riskmanagement and the part whichRegulators believe insurance can play.The requirement in connection with offloading Operational Risk (OpRisk) isthat either the AIFM holds additionalown funds or Professional Indemnity(PI) insurance “to cover potential liabilityarising from professional negligence”.In relation to insurance, to date,the concerns have focused on theoft found exclusion of liability fornegligence, save for gross negligence(the “exoneration clause”) found inmany AIFM agreements with investors,and much of the debate has focusedon this aspect when professionalpolicies will, in any event, give coverabsent these contractual exclusions 1 .In the writer’s view, this is not theprincipal issue which should beexercising underwriters which, asnoted, can be capably addressed withincurrent PI or Investment ManagementInsurance (IMI) wordings – it is what ismeant by professional negligence inthese Regulations and the multitudeof activities which do not fall withinprofessional negligence which arerequired to be covered and how PI/IMIpolicies are required to respond.The Regulations go to great lengths todescribe what comprises professionalliability risks, which include, withoutlimitation 2 , risks of:1. Loss of documents evidencingtitle of assets of the AlternativeInvestment Fund (AIF).2. Misrepresentations or misleadingstatements made to the AIF or itsinvestors.3. Acts, errors or omissions resultingin a breach of:(a) Legal and regulatory obligations(b) Duty of skill and care towardsthe AIF and its investors(c) Fiduciary duties(d) AIF rules or instruments ofincorporation(e) Terms of appointment of theAIFM by the AIF1 These contractual exclusions have exercised regulators for a number of years – the FSA felt that itconstituted a conflict of interest and, as observed in this paper, many investors are not prepared tocountenance such exclusions. And see also the requirements of section 2.1.4R of the Conduct ofBusiness Source Book.2 (and therefore a broad form cover is advisable given this gloss)The Regulations seek to legislate for all activitiesof AIFMs. Of interest to insurers, is the focus on riskmanagement and the part which Regulators believeinsurance can play.JOHN BARLOW4. Failure to establish, implement andmaintain appropriate proceduresto prevent dishonest, fraudulent ormalicious acts.5. Improperly carried out valuation ofassets or calculation of units/shareprices.6. Losses arising from businessdisruption, system failures, failure oftransaction processing or processmanagement.The Regulations stipulate (forexample, see section 2.1.71 ofthe GenPru Source Book) that anyprofessional indemnity policy shouldcover professional liability. What theRegulations fail to appreciate is thatthe risks which are identified in Article12 of the EU Regulations, and whichare replicated exactly in the GenPruSource Book, are not all synonymouswith professional liabilities – an obviousexample being business disruption,which may stem from the failure tosupervise or from the activities ofthird parties.02 Insurance/Reinsurance
Moreover, these activities do not fallwithin one single line of insurancebusiness. The activities which theRegulations countenance range fromthe Crime Bond or Bankers BlanketBond (Fidelity and On Premises)through to forms of electronic (orcyber) liability and (potentially) businessinterruption cover. Some, but notall activities are to be found withintraditional IMI products.Aside from the impetus from theRegulator, a further issue (absent theRegulator’s input) is the pressure frominvestors. Certainly, in the UK thereason for these products is becauseinvestors (for example, local authorities,pension administrators) are requiringinsurance as a precursor for investing(as opposed to capital being setaside), as well as removing contractualexclusions where liability may onlyaccrue where there is gross negligence(and where there are repeated actsof negligence, the view taken by theRegulator is that this, in itself, couldconstitute gross negligence). Finally,ERISA exclusions are now beingbought out.As with many new products whichrespond to changes in the regulatoryenvironment, lifting the text from theRegulations and reflecting this in theinsuring clauses is a firm favourite.However, such a solution fails toappreciate in this context that differentlines of business are identified in theRegulations and that certain activitiescan be addressed by a number ofdifferent insurance solutions, and notnecessarily referenced to the loss orperil. Accordingly, a clear underwritingview needs to be taken as to howthese risks are to be accommodatedwithin the more traditional (and triedand tested) wordings. What can besaid is this:n The principal requirement ofcovering professional negligence,which generally involves theaccruing of liabilities by themanagers (which has beenexpanded to cover trustees,fiduciaries and administrators)to third parties, can beaccommodated comfortablywithin standard form PI/IMI policywordings with the addition of adishonesty extension to deal withthe fraud elements, where thedishonest activities of an employeecauses loss to an investor.n Certain PI and IMI wordings willaddress first party infidelity (i.e.theft by employees, similar to thecover offered by Section 1 of theBankers Blanket Bond (BBB)) andthe loss of documents (again, thesehave been addressed previously bythe traditional On Premises cover(e.g. see Insuring Clause 2 of theNMA 2626) whether stolen, lost,damaged, destroyed or mysteriousdisappearance)).n A greater challenge is the BIelement (or business disruptionas the Regulations term it), whichalso envisages forms of cyber risk;for example, denial of service.Certainly, the latter risks togetherwith transmission of viruses/computer crime are covered by the“traditional” forms of computer/cyber liability policies and obviouslyassume some importancewhere time critical transactionscannot be completed (and aData Breach Response Packagewould undoubtedly be a prudentpurchase too if individual’s data isretained).n An alternative way of regarding the“BI” element of this requirementis to consider Mitigation of Losscover. Whilst these covershave been scrutinised followingStandard Life v ACE EuropeanGroup and Others  EWCACiv. 1713, there is no denying (inthe writer’s view) that where theyseek to recover trades or mitigatetheir impact (e.g. resulting from“fat finger syndrome” and similaractivities that can be ascribed tothese funds) such covers inure tothe benefit of underwriters andinsureds, and would seem toaddress many of the hallmarks of“business disruption”.One should not lose sight of theother insurances which may beresponsive either through theunderlying activities or the failure tomanage risk – the obvious candidateis D&O – and, given the structuresof these investment vehicles, theOutside Directorship Liability extensionassumes importance. Often IMIproducts will include D&O cover withinthe main policy as well as those othercoverages which are now to be foundwithin broad form D&O covers e.g.Employment Practices Liability covers.The insurance requirements also mirrorthe Basel II requirements as appliedto banks’ OpRisk capital mitigation,insofar as the policies are providedto banks adopting the AdvancedMeasurement Approach, e.g. an initialterm of 12 months (although thereis no requirement that there be 12months of cover at any point in time),a minimum cancellation period of 90days and the cover being placed witha third party entity (and not througha captive).One final aspect which willundoubtedly benefit both AIFMs andunderwriters in seeking to understandthe risks is the requirement that AIFMsimplement OpRisk managementpolicies, including the establishmentof an historical loss database in whichoperational failures, loss and damageexperience shall be recorded (theserequirements are reflected in the FCA’sown Source Book).Insurance/Reinsurance 03
Professional liability risks and corresponding insurance coverActivity(i) Loss of documents evidencing title of assets of the AIF.(ii) Misrepresentations or misleading statements made to the AIF or its investors.CoveragePI/IMI (akin to IC2 BBB)PI/IMI(iii) Acts, errors or omissions resulting in a breach of:(a) Legal and regulatory obligations(b) Duty of skill and care towards the AIF and its investors(c) Fiduciary duties(d) AIF rules or instruments of corporation(e) Terms of appointment of the AIFM by the AIF(iv) Failure to establish, implement and maintain appropriate procedures to preventdishonest, fraudulent or malicious acts.(v) Improperly* carried out valuation of assets or calculation of units/share prices.(vi) Losses arising from business disruption, system failures, failure of transactionprocessing or process management.PI/IMIPI/IMIPI/IMIPI/IMIPI/IMIPI (Dishonesty Extension)/IMI/CrimePI/IMIPI/IMI/Mitigation of Loss/Cyber* This would seem to countenance an activity over and above one which would give rise to negligence and which would impact crime elements of cover.For more information, please contact John Barlow, Partner, on +44 (0)20 7264 8188 or firstname.lastname@example.org or your usualcontact at HFW.For more information, please also contact:Robert FinneyLondon PartnerT: +44 (0)20 7264 email@example.comGuillaume BrajeuxParis PartnerT: +33 (0)1 44 94 40 firstname.lastname@example.orgSam WakerleyDubai PartnerT: +971 4 423 email@example.comRichard JowettMelbourne PartnerT:+61 (0)3 8601 firstname.lastname@example.orgHOLMAN FENWICK WILLAN LLPFriary Court, 65 Crutched FriarsLondon EC3N 2AEUnited KingdomT: +44 (0)20 7264 8000F: +44 (0)20 7264 8888Lawyers for international commercehfw.com© 2013 Holman Fenwick Willan LLP. All rights reservedWhilst every care has been taken to ensure the accuracy of this information at the time of publication, the information is intended as guidance only. It should not be considered as legal advice.Holman Fenwick Willan LLP is the Data Controller for any data that it holds about you. To correct your personal details or change your mailing preferences please contact Craig Martinon +44 (0)20 7264 8109 or email email@example.com