When journalists asked Bernard Madoff how he managed to pay investors a 10% return each year, he said that he used a ’proprietary strategy‘.
He didn’t want to go into details.
Back then, when the money was rolling in, that probably seemed like a perfectly reasonable answer to investors: if you have the Midas touch, why let everyone in on the secret?
Now it appears that the wonder of Wall Street had no secret formula. Instead, for nearly ten years, Madoff had allegedly been using money provided by new investors to pay off existing ones.
Madoff has been charged with fraud in one of the biggest-ever such cases and since his arrest investors, banks and charities across the world fear they may have lost billions of dollars.
The total amount that may have gone to what one banker called ’money heaven‘ is put at US$50bn and the losers range from the world’s biggest banks to private individuals.
Impact on financial institution insurance marketThe alleged fraud committed by Madoff highlights the need for financial institutions and, in particular, hedge funds, to purchase appropriate professional liability limits, according Paul Towler, head of the financial and professional practice at Lloyd’s broker Jardine Lloyd Thompson Limited (JLT).
But the fraud could have a huge impact on the financial institutions insurance market, he believes.
“The litigious environment that prevails means that it’s inevitable that financial institutions who invested clients' assets in Madoff's funds will face actions from disgruntled clients seeking to recover lost monies,” Towler says.
“Investors will be seeking redress from fund managers on the basis that they failed in their duty of care and failed to carry out adequate due diligence. People have lost so much money, the lawyers will have a field day. Not only are fund management firms exposed but so potentially are their directors,” Towler said.
As a result, he believes that the sheer scale of the fallout from Madoff could seriously affect the financial institutions insurance market’s dynamics, affecting the availability and cost of both professional indemnity and directors & officers insurance.
Challenging environmentThe worry now is whether investment businesses will be able to obtain sufficient limits and the right type of insurance to protect themselves and their clients, Towler says.
“This reinsurance renewal season was already proving very challenging for financial institutions business because of existing concerns about the health of the financial sector. Madoff could be the last straw for some reinsurers and if they withdraw, that has a big impact on primary insurers,” says Towler.
In Towler’s view “prices are going to increase and cover will be restricted.”
Towler also believes that some underwriters may want to spread the risk more widely. He says that insurers may be less inclined to write policies that typically provide up to £20m of cover on a 100% basis.
“Insurers may be looking to write 25% instead, which points to a return to the subscription market,” he predicts.
There are undoubtedly also wider risk management lessons to learn from the affair.
Risk management practicesJérôme de Lavenère Lussan, managing partner of investment management consultancy Laven Partners said the affair reveals the possibility of serious shortcomings in risk management practices.
“Madoff’s collapse is an expensive lesson in the importance of investors and their advisors carrying out thorough due diligence. Investors have for years purported to carry out due diligence that is detailed and focused on risk,” he says. “However, it has become clear that many rely on ‘word of mouth’ endorsement and the false premise that it necessitates only a cursory analysis of the fund concerned.”
Avoiding the traps So what steps can businesses take to avoid falling into the same trap in the future? de Lavenère Lussan says it is crucial that due diligence covers operational risks, valuation processes, investment strategy, offshore structures and independent risk monitoring processes.
Given the current economic outlook, these lessons could be timely. The UK’s Serious Fraud Office (SFO) has warned that as financial institutions and financial instruments come under pressure, it is possible that more and more instances of fraud will emerge and employees, directors, investors, and the companies themselves may become victims.
As a result the SFO has initiated a whistleblowing campaign to get individuals involved in revealing irregularities. To facilitate whistleblowing the SFO says it is to publish an online referral form so individual workers, ex-employees, shareholders and anyone with information can tell them about suspected City fraud.
