The Financial Conduct Authority (FCA) is looking to reform the UK regulatory framework for Alternative Investment Fund Managers (AIFMs) and the businesses that service or represent them. The aim is a clearer set of rules that better reflects each firm’s size, activities and risk profile, including how it reports and is monitored. As part of the proposals, CP26/28 makes the following point about professional indemnity insurance (PII):
“PII can mitigate losses arising from negligence claims, but reliance on PII has limitations. Coverage may be subject to exclusions, caps or conditions, and claims may not be settled promptly. The availability and cost of insurance can also vary. PII does not therefore replace the need for adequate capital, liquidity and effective governance.”
I’m not going to question the FCA’s reasoning here. But, when insurance no longer offsets capital requirements, the conversation can become very cost-focused and overlook the wider benefits of maintaining cover. We saw this after the Investment Firms Prudential Regime in 2022, when several clients spoke to us about not renewing their PII. So, it is worth looking at PII as a practical risk management tool, not simply a regulatory requirement. Valuers should also take note, given the proposed changes.
Mitigation and circumstance costs – most PII policies allow an AIFM to step in before an issue becomes a claim. That gives the firm room to respond quickly when a situation could become serious. Broad policies can also address trade errors by applying mitigation cover regardless of any hold-harmless agreement between the fund and manager. This is an important detail because those agreements will often apply to negligent acts, which trade errors are by their nature.
Vicarious liability – this cover is less common, but it can be valuable where a claim is made against the AIFM and the loss was caused by a third-party service provider. One example we have seen is a prime broker processing an order outside the manager’s trading parameters. Affirmative cover can help ensure that insurers meet the initial legal costs and expenses, rather than first debating the AIFM’s liability under traditional PII clauses and the contracts between the parties.
Allegations of wrongdoing – PII does not wait for a final judgment. It can respond when wrongdoing is alleged against an AIFM. That matters because the allegation itself can make contractual protections harder to rely on. Gross negligence or wilful misconduct, for example, will typically sit outside the liability limits in a services contract. Subject to the policy terms, PII can provide cover while the allegation is being determined.
Other business risks – PII can do more than respond to portfolio management issues. Depending on the policy, it may also cover intellectual property liability, public relations costs to limit reputational damage, and claims involving libel, slander or defamation.
Regulatory investigation costs – the FCA’s proposals may reduce some of the requirements around risk management, liquidity and valuations, particularly for small AIFMs. But the regulatory risk does not disappear. A firm crossing from one threshold to another may need to make significant changes, such as appointing a depositary when it moves from small to medium scope. Even with a six-month implementation period, there is an underlying risk in not meeting the new standards. Depending on the breadth of cover, PII can meet the legal costs and expenses of an informal or formal regulatory inquiry. These matters are rarely resolved overnight, and the legal costs can become significant.
While we are on the subject; there are two other important areas of insurance to consider alongside PII:
Directors’ & Officers’ Liability (D&O) – where claims arise against individuals in their roles for the firm, this is the coverage that responds. Importantly again, it can operate from the ground up in the event no indemnity is available to an individual, meaning that accusations of gross negligence that fall outside of a directors’ contractual provisions with regard company reimbursement, can still be covered by the insurance up the point of final and non-appealable judgement. With many AIFMs needing to establish segregated risk management functions (unless managing close-ended, unleveraged AIFs) independent from the portfolio management functions, the importance in ensuring the definition of an insured person under your D&O policy incorporates all such roles will be key.
Cyber Liability – providing cover for a vast number of universal threats (including but not limited to forensic costs, data restoration, system repairs, extortion and ransomware costs & business interruption), we are recommending all our clients to obtain Cyber Liability alongside their traditional financial risk insurances.
A less complicated regulatory framework is welcome. Changes that help firms market and launch funds more quickly could also give the asset management sector an important boost. My hope is that, amid those changes, firms keep a balanced view of risk management. Cost matters, but it should not be the only consideration.
