As disgraced New York financier Bernard Madoff faces the rest of his life in jail, Helen Yates looks at the impact of recent alleged frauds on the insurance and reinsurance industry.

A year ago the uncovering of multi-billion dollar frauds would have shaken the foundations of the global financial system. But they had already been shattered by the time investors got to hear about Bernard Madoff. It is testament to the magnitude of the $64.8bn and $8bn thought to be lost in the Madoff and alleged Stanford Ponzi schemes that the news shocked an already crisis-weary audience. “We’re not blinking at millions now,” says Paul Towler, business unit head of the financial and professional risks team at Jardine Lloyd Thompson. “It’s got to be in the billions to get everyone excited.”

The Madoff fraud has been called the largest-ever investor fraud committed by a single person. It is likely to have lasting implications for the insurance and reinsurance industry – particularly the select number of players that write financial institutions (FI) cover. Madoff and Ponzi exclusions are included in new professional liability policies, while some risks could simply become uninsurable. Prices are hardening, although there is some debate over whether capacity has contracted.

Madoff began the Ponzi scheme in the early 1990s as a way of delivering returns to institutional clients. (For an explanation of Ponzi schemes - see the box on the next page.)

In his testimony to a New York court, Madoff said he had never intended to continue the scheme long term. But concerns were raised as early as 1999, when financial analyst Harry Markopolos told the US Securities & Exchange Commission it was possible to prove Madoff was running a scam. “It should never have been able to happen,” says Towler. “People were obviously looking to see what they wanted to see.”

While another Madoff-scale loss seems unlikely, the allegations of an $8bn Ponzi fraud levelled against Sir Allen Stanford, the billionaire Texan and international cricket sponsor, suggests the shake-out by the investigating authorities is far from over. Stanford denies he was involved in a Ponzi scheme, and has vowed to fight allegations he was involved in a multi-billion dollar fraud. He claims he is the victim of government persecution.

An economic downturn is often the trigger that exposes long-term deception. Frauds against banks can start when traders try to cover up big losses in the short term, with every intention of making the money back. But, as Towler says, the market moves the wrong way. The prosecutors might argue this to have been the case in the $7.2bn fraud allegedly perpetrated by Jerome Kerviel, the former Société Générale trader whose losses were four times greater than those of Nick Leeson, the man who brought down Barings Bank in 1995. Kerviel claims his employers knew what he was doing and the losses he was taking on.

Fraud increase

Individuals are more likely to find themselves in financial difficulty during a recession, another prompt for fraud. This can range from claims fraud (cases of arson tend to go up during a recession) to billion dollar investment fraud. Last year there was a 16% increase in detected fraud in the UK, says CIFAS, the UK’s fraud prevention service.

Towler says many people tend to commit fraud when their circumstances change. “It might just be an intention to borrow money but then it becomes a bigger and bigger hole.” He thinks the recession will encourage more whistle blowing. Disgruntled employees are more likely to reveal shady practices when they have lost their job or had their salary cut. “If everything is going smoothly and someone has cut a few corners then you’re more likely to keep quiet. But if you’re on the other side of the fence then you might shout.”

The Madoff fraud could cost the insurance and reinsurance industry anything from $1bn to $6bn, according to estimates. While these figures are significant, they merely top up already sizeable claims (in excess of $12bn) expected from the collapse of the subprime market.

Dave Bradford, executive vice-president at Advisen, thinks it will cost up to £2bn. “I’m not sure the impact is going to be really noticeable over and beyond what was already taking place with the subprime and credit crisis, because the losses are being borne by the same group of insurers.

“There are a number of issues at play. Some of these funds didn’t carry insurance and others carried comparatively low levels of liability. Some defences will hold up for some of the defendants,” Bradford says.

An analysis from Aon Benfield expects losses from Madoff to be between $760m to $3.8bn. The high end represents less than 20 loss ratio points on global Directors’ & Officers’ (D&O), errors & omissions and fidelity premium. The broker warns that because most claims are in the financial institution sector, the loss ratio could reach 40 to 180 points.

Whatever the final costs, there is likely to be a long-term impact. Towler says the “big knock-on” is for claims for fiduciary duty or civil liability from investors. “They’re going to be looking at what due diligence the banks did when investing their funds,” he says.

Aon’s Financial Services Group says D&O insurance costs grew by 50% in the fourth quarter of last year, something it attributes to the Madoff fraud, securities class action lawsuits relating to the credit crisis as well as the overall downturn in the financial markets. Madoff and Ponzi exclusions have become common in policies issued for 2009, and there are signs that some FI underwriters are cutting back their line sizes and not putting out full capacity.

“We’re going back to more selective underwriting with higher retention levels,” says Towler. “Certain risks are going to be uninsurable. Once there was a price for nearly every risk – some insurers undoubtedly were writing for income. That has all changed and we’re going back to a subscription market. In the past few years everyone has wanted to write 100% of everything.” He thinks the Lloyd’s market will benefit from this change. “There’s a lot of capacity waiting to come in.”

Advisen’s Bradford sees no evidence that insurers are cutting back their exposure to the FI sector. “Major financial institution players are hanging tough. I’ve talked to several D&O underwriters in London recently who have said FI business is actually looking quite attractive. It’s the one segment of the market where rates are going up.”

Financial institutions D&O remains somewhat of a niche market. According to Advisen’s benchmark database of insurance programmes, the top three carriers in 2006 and 2007 – representing 50% of FI D&O premium – were AIG, Lloyd’s and XL. Whether bailed-out insurer AIG can maintain its position remains to be seen. Short-term dynamics will be strongly influenced by access to reinsurance, thinks Bradford.

“For some classes of D&O the amount of reinsurance capacity is concentrated within a handful of reinsurers,” he says. “If one or more ultimately decide that they’ve had enough or have a change in underwriting philosophy and risk appetite, it could have a profound effect on the primary D&O marketplace.”

Helen Yates is a freelance journalist