Société Générale, rogue trading, and a little solution called insurance

The news last week that Société Générale was defrauded by an employee resulting in a loss of €4.9billion (£3.7 billion) was a big shock - and not just because of the scale of the fraud. The incident demonstrated that large, well-established banks with rigorous risk management procedures face serious risks of internal fraud - and that risk management procedures can, and do, fail. The Société Générale revelations raise major questions about the nature of risks that financial institutions are facing and how companies can mitigate those risks.

According to Mark Johnson, Underwriting Risk Officer at Talbot Underwriting Ltd. and an expert in financial institutions cover, rogue traders are one of the largest operational risks financial institutions face. Johnson points out that insurance provides one solution to deal with that threat.

According to Daniel Butler, executive director of Aon's financial institutions team: "Financial institutions will have fidelity bonds that cover fraud for personal gain but other motives can leave banks without protection. For example, Nick Leeson left Barings exposed because his illegal actions were found to be in support of the company balance sheet.”

Most banks buy bankers blanket bonds which cover employee dishonesty but again coverage is only triggered in the event that an employee is motivated by personal gain. Banks could typically purchase as much as £500 million cover in the London market for this type of cover. However, motives other than personal gain, as may prove to be the case with Société Générale, can leave banks liable. A second product called professional indemnity cover with a dishonesty extension, covers a bank in the event of a claim by a client where an employee trades the client’s funds dishonestly. However, crucially, neither of these covers offers protection in the event that an employee trades the bank’s own funds unlawfully.

After the incident with Nick Leeson, the Lloyd’s market was the first to develop and launch a product called Unauthorised Trading cover. The coverage protects banks in the event of unauthorised trading by an employee in relation to the bank’s own funds, filling the gap that existed.

According to Butler: "Employee fraud, and in particular unauthorised trading, is insurable but the challenge is persuading banks to admit such exposure exists.” Underwriters at Lloyd’s confirm that it’s a hard sell, with many companies believing that their internal controls are sufficient, although the Société Générale case may start to overturn those assumptions. “Many companies are left exposed because they assume that their internal controls are strong enough to protect them,” says Johnson. “Lloyd’s underwriters would normally send in value-added independent surveyors to recommend the best control practices.”

Though the scale of the fraud with Société Générale was so staggering that an insurance policy wouldn’t have made a dent in covering it, Richard Norris, underwriter at Novae points out that most cases of unauthorised trading would fall within the limits of a policy. A typical policy would give up to £200 million capacity, offering not only financial redress, but also some reputational cushioning for a company when the story hits the press.

So will the case of Société Générale change the way companies deal with the latent risk of rogue traders? Johnson says: “underwriters will expect to see an increased number of enquiries to purchase cover in the coming weeks and months.” At the very least, it will raise awareness that risks are real and internal processes can fail.