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Fund Manager Fraud Insurance

posted by Adam Levitin

The Bernard Madoff scandal in which perhaps $50 billion of investor funds were lost due to fraud has left me perplexed.  In addition to market risk, against which investors can hedge, we also see that investors (even, or perhaps especially investors in exclusive investment funds) can face catastrophic fraud risk.  Why haven't some of the insurance companies responded with fund manager fraud insurance?  Insurance, after all, is the proper response to rare, unpredictable, and catastrophic events.  


If you're going to put millions into a single fund, you're trusting the fund manager not only to make good investment decisions, but also not to steal your money.  These are different types of risks.  The first is easier to monitor than the second, and generally less catastrophic.  The second seems more suitable for insurance than the first, yet we have all kinds of specialized credit derivative products that function like insurance, but we don't (at least to my knowledge) have insurance for the later (maybe Lloyd's does?). 

Perhaps investors eager for higher yield don't want to lose a few bp on insurance, and perhaps the insurance companies can't work out the actuarial risk of something as unpredictable as fraud. Still, I would think that at least institutional investors, like pension plans and charitable trusts, would have, as part of a prudent investment duty, to purchase insurance against fund manager fraud.  This seems like a market niche that really should be filled.   

Comments

This is all about human nature;there is no need for insurance if there is trust,but human beings have become so greedy making profits to the detriment of their fellow brothers and sisters that they forget that all of us are mere mortals,that we have a limited life and the only satisfactory objective is to live through it by being helpful to less fortunate ones!

I think it's quite simple: greed. Madoff claimed to be able to outperform markets year after year, yet nobody quite understood how he did it. And of course, he wasn;t going to tell, or everybody could replicate his tric, and the pot of gold at the end of the rainbow would disappear. So nobody asked awkward questions.

There is "fund manager insurance" of the sort you describe, in the form of Errors and Omissions (E&O) and Directors & Officers Liability (D&O) insurance.

E&O is concerned with a company's performance failures and negligence with respect to its products and services. D&O covers management's performance and duties of management. Think of these two lines as malpractice insurance for those who are not doctors, lawyers, accountants and the like.

E&O/D&O premiums have in fact increased recently, reflecting in part all of the trouble that the financial sector and its managers are now in.

A problem with a Bernard Madoff sort of situation is that to the extent that his money management operated in the shadow financial system, there may have been few if any market forces that required him to purchase this insurance. It is generally a good idea to carry both lines. Without persuasion from vendors, customers, creditors and regulators, that good idea may not be put into action. The more of a black box this investment scheme was, the less he may have felt the power of this persuasion. Then again, he may have this insurance in place, in which case, some insurance executives had quite a bad weekend.

Yes, this insurance exists, and moreover, it's required that he carry it.

When I worked at a mutual fund company I arranged each year for the D&O, E&O and a fidelity bond. The fidelity bond was the policy that protected the shareholders in the event of my stealing their money. It was required for mutual funds.

Bernard Madoff was a principal in the broker/dealer Cohmad Securities Corp., which is regulated by FINRA and the SEC. It appears that most if not all of the fraud involved the broker/dealer entity. The broker/dealer rules are less familiar to me, but I'm certain that there was a fidelity bond requirement and I believe also membership in the SIPC (Securities Investor Protection Corporation). Of course there were capital requirements too, but I would expect the fraud included fraudulent representations of capital reserves.

Incidentally, at least for the mutual fund company I was involved with, the fidelity bond was pretty cheap, about $8000 per $100 million of assets -- reflecting exactly what you're saying, that this is a very rare but catastrophic occurrence. D&O/E&O was quite a bit more expensive, maybe 5 or 6 times that, reflecting that people are negligent a great deal more often than they are out-and-out fraudulent.

SIPC is basically fraud insurance.

Madoff problems are difficult for the private sector: a catastrophic risk (very low frequency; very high exposure) is impossible to insure.

Brilliant! In order to protect ourselves from a crooked fund manager, we can buy anti-fraud insurance!

But . . . what if the insurance company turns out to be just handing the premiums over as executive bonuses, and when a big event like this happens, they can't pay out? Kinda like a CDS situation?

It's okay! We can buy insurance on the insurance company's solvency! And furthermore, we can buy insurance on the insurance on the insurance companies solvency!

Maybe this insurance gets overpriced! That's okay, because some investor will just go on the sell side, creating a policy out of the air! Gosh, hope he has the reserves to cover it? But that's cool too, nothing another level of insurance won't protect against!

And . . . I got an even better idea! Let's take a bunch of these insurance policies, antifraud and antifraud-antifraud and antifraud-to-the-power-of-N, and put them together into one big fund, right? And we can sell shares in that fund! For investors who don't want a whole lot of risk, we can create a preferred class of shares that gets all the insurance payouts before the other shares do! Why, that'll be one solid investment, won't it?

I have read a couple stories since my last post and it sounds like in 2006 as a result of an SEC investigation (which failed to uncover the fraud, but still) he was made to register as an investment adviser. So he was both an RIA and a B/D. There was at least one other broker/dealer entity, too.

Therefore, he had multiple entities that each had to satisfy a regulatory framework. Could he really have gotten through the filing of all those forms without purchasing any of the required fraud insurance? I'd find it more plausible that he hid the true financial condition from the insurance companies but did purchase insurance. It would be harder to get by with no insurance without the regulators or his custodian bank noticing.

(trollumination: that is some great satire -- but just to be clear, the investors are not the ones buying this insurance. I'm saying that Madoff had to have bought some. And Joe S.: $50B is a huge loss, no doubt, but of course it is possible to insure it. How could any legit broker or investment adviser be that big if you couldn't insure it?)

This niche has been filled. There are multiple carriers on the Lloyds marketplace underwriting fraud protection insurance for investors in hedge funds and alternative investments. This coverage is a niche part of the professional liability insurance marketplace and is picking up steam as a result of the highly publicized Madoff mess. We've been brokering the products to individual investors, Fund of Funds, charitable organizations, endowments, pension funds and now even to Fund managers themselves. If anyone cares to speak in greater detail about the coverage I can be reached at [email protected]. Cheers!

This niche has been filled. There are multiple carriers on the Lloyds marketplace underwriting fraud protection insurance for investors in hedge funds and alternative investments. This coverage is a niche part of the professional liability insurance marketplace and is picking up steam as a result of the highly publicized Madoff mess. We've been brokering the products to individual investors, Fund of Funds, charitable organizations, endowments, pension funds and now even to Fund managers themselves. If anyone cares to speak in greater detail about the coverage I can be reached at [email protected]. Cheers!

There is another problem. SIPC insures financial customers up to $500,000, but it only has about $1.6 billion itself, which will be quickly depleted. (Also, SIPC insures against theft, but not investment losses). Does Lloyd's, etc., have enough cash on hand to handle something like this? I don't think anyone imagined that a Ponzi scheme could get this big.

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