Guernsey: AIFMD: Ensuring Your Insurance Is Right

Last Updated: 23 May 2013
Article by Paul Richards

Most Read Contributor in Guernsey, September 2018

Paul Richard of Willis Finex Global explains how the AIFMD will impact fund managers from an insurance and capital requirements perspective.

While you may have been following the progress of the Alternative Investment Fund Management Directive (AIFMD) since the publication of its first draft in April 2009, we feel it both timely and important to examine this directive further and to examine its implications for professional indemnity insurance (PII).

Background

The stated aims of the directive include establishing a harmonized European Union (EU) framework for monitoring and supervising the risks that alternative investment funds (AIFs) and their alternative investment fund managers (AIFMs) could pose to financial stability, investors, counterparties and other financial market participants. It applies to any entity wishing to manage or market AIFs to EU professional investors.

The directive covers a wide variety of AIFs and their managers, ranging from hedge funds to funds investing in illiquid assets, such as real estate, infrastructure or goods such as wine or art, as well as their investment strategies and legal forms.

With the directive, all collective investment funds in the EU will fall into one of two categories; they are either Undertakings for Collective Investment in Transferable Securities (Ucits) or AIFs. The directive does not, however, cover existing Ucits funds. To operate in the EU, all AIFMs with assets under management (AuM) exceeding €100m (or €500m for closed-ended, unleveraged funds, which are effectively investing in illiquid assets) must obtain initial authorisation from their member state regulators. AIFMs whose AuM do not reach these thresholds may also opt in.

It is therefore expected that the directive will apply to a significant number of UK-based firms as well as non-EEA AIFMs, who will be affected if they are marketing the fund in the EU. For an EU-based AIFM managing a non-EU AIF, the full directive requirements will apply (barring certain depositary rules and reporting requirements if not marketing in the EU).

Current status

On 19 December 2012, the European Commission, the European Parliament and Council adopted the AIFMD Level 2 regulation and formal entry into force of the regulation has now taken place.

The implementation date of the directive is 22 July 2013 although, under current Financial Services Authority (FSA) proposals, existing UK AIFMs operating have a year's transition period and will only need to comply by July 2014. It should be noted however that firms wishing to market to EU investors from July 2013 may need to be authorised to do so.

Insurance and capital requirements

The directive requires AIFMs to hold appropriate additional own funds or professional indemnity insurance to cover potential liability risks arising from professional negligence. Potential professional liability includes damage or loss caused by persons who are directly performing activities for which the AIFM has legal responsibility, such as the AIFM's directors, officers or staff, and persons performing activities under a delegation arrangement with the AIFM. The liability of the AIFM will not be affected by delegation or sub-delegation and the AIFM should provide adequate coverage for professional risks related to such third parties for whom it is legally liable.

Limits of indemnity for PII

PII limits of indemnity are deemed appropriate to protect investors from damage resulting from any Professional risks of the AIFM at the following levels:

  • 0.9% of AuM for claims in aggregate per year; and
  • 0.7% of AuM per individual claim

Conversely, an AIFM's additional own funds to cover professional liability risks are considered to be appropriate if they represent at least 0.01% (0.008% where the FSA deems appropriate based upon risk profile and capital adequacy) of the value of AuM. The rationale for the lower value of additional own funds is that coverage through PII is by nature more uncertain than coverage provided through additional own funds, therefore different percentages should apply to the two different instruments used.

While the rationale is understood, it is questionable whether it is appropriate to deal with such uncertainty regarding the amount available to cover losses arising from professional liability risks. Certainly the adequacy of the additional own funds amount appears low to achieve the objective of protecting investors and paying for professional liability losses when compared to the limit of indemnity required under the regulation or indeed the PII limit of indemnity already purchased by many AIFMs. For example, one insurer's own assessment relating to the hedge fund sector based on their predominantly EU-based customer portfolio indicates that the average limit of indemnity of their insured firms when compared to AuM is 2.39%.

Bearing in mind the additional own funds amount is a one-off capital charge, whereas the PII will be subject to payment of an annual premium and an annual aggregate limit of indemnity (albeit such limit being higher than the capital requirement and therefore, in theory, offering greater protection) it will be interesting to see which option is chosen.

Many investment managers already purchase PII and it is, in our view, unlikely they will cancel existing PII to rely on additional own funds. Reasons for the PII approach include investor pressure, existing good corporate governance and operational risk management, maintaining existing insurance cover or simply a preference for (and comfort with) an insurance solution to cover such operational risks over relying on (smaller) capital amounts. However, there are practical implications to adopting the PII approach and existing PII policies must be amended to be AIFMD-compliant.

Exoneration clause

The cover provided by a PII policy is based on a legal liability existing with the party seeking compensation and most policies available already cover risks that go beyond the scope of 'negligent' activities. Therefore, although some further policy amendments will be required to ensure compliance with the directive, an AIFM who chooses the insurance route should at least find this relatively easy to deal with.

However, there could be a more fundamental conflict between the directive's requirements and the practice among some alternative investment managers, to agree a higher 'gross negligence' standard with the fund via contractual terms.

While it is not specifically stated that legal liability cannot be avoided like this, the focus on avoiding conflicts of interest in the directive, together with the FSA's recent public comments relating to its concerns in this area, perhaps indicates that there will be concerns if parts of the directive relating to professional liability can be seemingly circumvented by the AIFM contracting out of its responsibilities for negligence.

This may indicate that contractual legal responsibilities toward the fund are likely to require review by alternative investment fund managers. The FSA's recent "Dear CEO" letter relating to conflicts of interest between asset managers and their customers demonstrates this. The document published in November 2012 noted concern that some firms, mostly hedge fund managers, relied on clauses to remove liability for the cost of errors and omissions other than in the case of 'gross negligence'. We have also noted an increased focus by investors relating to responsibility of the investment fund manager for 'negligent' trade errors in particular as well as similar interest from insured investment fund managers regarding their PII policy response.

What is the solution?

While we may need to wait for further developments and clarification, Willis has designed an insurance policy solution to make clear that liability for covered acts, errors or omissions of an AIFM is catered for by a Willis PII policy, notwithstanding that the clauses in the investment management agreement, offering memorandum or other contract between the investment manager and the fund may seek to avoid or limit such legal liability. This addresses the fundamental flaw inherent within PII policies, and in particular those issued to hedge funds, that require legal liability to be present to trigger the coverage when, in fact, such liability for negligence may not exist due to the contractual terms agreed with the investor. This solution not only provides a higher level of protection to our investment manager clients and their investors, but also provides an insurance policy that meets the Directive's negligence standard regardless of whether a higher 'gross negligence' standard has been agreed.

With the regulations including the use of PII for the first time as an alternative to capital for alternative investment managers, we believe this is an important and appropriate response to address the developing needs of our investment fund manager clients.

Originally published in HFMWeek's 2013 Guernsey Special Report, May 2013.

For more information about Guernsey's finance industry please visit www.guernseyfinance.com.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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