Navigating Operational Risks and Insurance Solutions for Alternative Investments: Insights from Claims Experience
As alternative investments continue to rise providing diversification and potentially higher risk and return, it is inevitable that non-traditional assets come with a variety of operational risks that most of the time are complicated to identify, analyze, quantify and manage. The aim of this article is to highlight the main non-traditional investments’ operational risks, based on actual claims trends, and provide a quick overview of the available risk hedging solutions through insurance.
Alternative investments offer a wide range of assets, including real estate, private equity, shipping, energy, venture capital, among others. Unlike traditional investments, alternative investments require a deeper understanding of the operational complexities involved in managing and administering these assets. The following section provides a brief description of risks linked to alternative investment funds and managements as well as available insurance solutions.
Operational risks in alternative investments and claims trends:
1. Negligence / errors / omissions: Human error has been one of the major causes of financial losses resulting in investor claims or other losses. Even though it is an area where increased risk management and ensuring adequate controls are in place can make a big impact on prevention, it is evident that it remains as one of the main causes of professional indemnity claims.
2. Representations / documentation risk: Noting the nature of the alternative portfolio, there is an increased risk of lack of transparency relating to the underlying assets; valuation methods; and performance metrics; making it harder for investors to assess the true risk and return potential. This has been a common area where claims arise alleging misrepresentations on prospectus, disclosures, in particular in an M&A context, or marketing material on which an investment decision is based on.
3. Valuation risk: Complex, inaccurate, or biased valuations, especially for illiquid assets such as private equity or real estate, introduce greater risks for the investment manager in the accurate assessment of the investment value. Typically, this is a cause of complaints by investors and relates to disturbance of the relationship between counterparties i.e. the fund manager’s sub-contractors.
4. Counterparty risk: The involvement of various parties such as investment manager, custodians, administrators, brokers etc. may cause increased risk of failure or misconduct which can lead to financial losses or operational disruptions. Insurance claims resolution may protect the professional relationships with counterparties or, on the contrary, if the scope of service between counterparties is not clearly identified, a further disturbance may be caused.
5. Operational infrastructure risk: Due to a diversified portfolio, investment managers may require specialized operational infrastructure to support their unique characteristics to ensure appropriate monitoring, trade execution, risk management, compliance, and reporting. Depending on the segment of the alternative investment there are different risks for operational inefficiencies, errors, or delays in processing transactions and reporting. This may become the cause of various financial losses including reduction of investment value, regulatory/compliance issues, increased cost to restore facilities or infrastructure.
6. Regulatory and compliance risk: Alternative investments are subject to various regulatory requirements, which can vary across jurisdictions. Failure to comply with these regulations can result in legal and reputational risks.
7. Cybersecurity risk: Vulnerability to cybersecurity threats may cause unauthorized access, theft of sensitive information, or disruption of operations. Depending on the type and exposure of the alternative investments such as technology start-ups, remotely monitored plants, online trading companies, or the like there is a range of claims and crisis management cases where insurance plays a role in an efficient resolution.
8. Liquidity risk: While liquidity risk is not considered an operational risk, it has operational implications for alternative investments due to the illiquid nature and the challenge in meeting redemption requests in a timely manner. This may cause claims due to delays or restrictions on investor withdrawals and potential losses if forced to sell assets at unfavorable prices.
9. Investments operational due diligence risk: Alternative portfolios require a thorough due diligence review by the investment manager, identifying possible operational failures and their existence so adequate insurance to protect the fund(s) from reduction in asset value due to unavailability of, or damages to, the underlying asset or business interruption / absence of income. In the context of an investment life cycle, these issues may have been caused, prior to, during or after the holding of an asset and can be realized or come to the awareness of relevant stakeholders at any point in time.
Insurance Solutions for Alternative Investments:
Below we have provided a general description of some of the most common types of insurance coverage applicable to alternative investments; the list is not exhaustive and the availability of the coverage as well as actual terms and conditions will vary by policy.
1. Professional Liability Insurance: Professional liability insurance is crucial for investment managers and advisors in the alternative investment space. This coverage protects against claims for losses caused due to negligence, errors, omissions, or failure to provide the service or managing investment portfolios. Drawing insights from claims experience, such programs can tailor their coverage to address specific risks and enhance their protection against potential liabilities.
2. Directors and Officers (D&O) Insurance: Undoubtedly the board of directors at both the AIF and AIFM level have the ultimate responsibility to protect the interests of the Fund and the Fund Manager respectively. D&O insurance protects such individuals from claims brought against these directors and officers for alleged wrongful acts, such as breach of fiduciary duty, mismanagement, or negligence as well as the costs of responding to regulatory investigations and in some cases fines and penalties.
3. Fraud and/or Crime Insurance: Alternative investments, particularly those involving private placements or complex structures, are susceptible to fraudulent actions from employees or external parties. Fraud/Crime insurance coverage can help protect the fund manager or the funds against losses resulting from fraudulent activities or misrepresentations by the investment managers or advisors.
4. Cyber, Property, and Casualty Insurance: Alternative investments often involve physical assets such as real estate, infrastructure, or commodities and technology. Depending on the segment, the insurance coverages can become essential to protect against damages or business interruption from natural disasters, accidents, liability arising from these assets, technology and cyber security breaches incidents.
5. Transactional Risk Insurance: In an M&A context Representations and Warranties insurances can provide exit solutions for sellers, whilst at the same time securing buyers against unknown operational risks, transferring the risks typically handled commercially between the parties in the share purchase agreement to the insurance market. Further, there are also solutions for known risks, both in an M&A context, as well as a going concern, based on certain criteria, that can be transferred to the insurance market through Contingent Risk insurance solutions.
In conclusion, alternative investments offer unique opportunities for diversification and at the same time are linked to non-traditional operational risks. By understanding, proactively managing and properly hedging those operational risks through comprehensive insurance coverage, investment managers will enhance their risk management strategies and protect their operations/portfolios. Review and assessment of the insurance program should form part of the operational risk reviews, engaging with experienced professionals and insurance advisors, providing feedback on coverage, benchmarking for best practices and sharing updated claims trends.