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Madoff: 'straw that breaks the camel's back'?

Adding the Madoff scandal to the list of litigation-spawning incidents which have caused a myriad of unprecedented dislocations in the financial system could be "the straw that breaks the camel's back" for the professional and managerial indemnity markets, according to Mike Alder, vice president of claims at Ironshore.

Speaking during an Advisen panel discussion on the impact of Madoff litigation on the directors' and officers' (D&O) and errors and omissions (E&O) markets, Alder said the combined impact of claims resulting from the sub-prime and credit crisis, shareholder suits filed against banks after government bail-outs and now the new wave of lawsuits that Madoff's alleged $50bn fraud is"really affecting the bottom line of the [professional and managerial liability] industry."

"It is important to realise that this [Madoff], with other scandals, is putting huge strain on the D&O and E&O markets. We have a new volume of losses that are now appearing and coverage is going to have to be cut back and prices are going to have to increase, otherwise we'll have more instability and maybe catastrophic consequences for the insurance market," he said.

As reported in The Insurance Insider, the US information firm Advisen estimates that global D&O and E&O losses resulting from the credit crisis could hit as much as $12.3bn, while researchers atAon Benfield have predicted that insured losses arising from the alleged Madoff Ponzi scheme could reach as high as $3.8bn.

Ray DeCarlo, senior managing director at New York-based brokerage Frank Crystal & Co and fellow panel member, described Madoff as "another anomaly creating exposure for financial institutions"

"The losses that arise are just enormous. Other highly publicised hedge fund losses have been in the range of $300mn, and now suddenly we have this huge loss."

Experts on the panel, which also included David Bradford, EVP & editor-in-chief at Advisen and Karen Mariscal, counsel at US law-firm Edwards Angell Palmer & Dodge, were agreed that the types of allegations that have been made in the class actions filed against investment managers, auditors, funds and feeder funds involved in funnelling money to Madoff's accounts so far - including lack of due diligence, failure to diversify, negligence and breach of fiduciary duty - would typically trigger D&O and E&O policies.

"They are class actions allegations on behalf of investors and derivative allegations on behalf of the funds. That implicates D&O and E&O cover," said Bradford.

Investors attempting to claw back losses will also be scrutinising general partners liability, a similar type of coverage typically bought by financial institutions such venture capital firms which responds on a claims-made basis in the same way that D&O and E&O policies do.

"I would certainly encourage anyone who has first party coverage on a crime policy to pursue a claim," Mariscal said.

The triggers on D&O and E&O policies are however fairly broad, so in terms of defences there are various arguments that the insurance companies will be looking at.

Mariscal highlighted policy rescission as an outside possibility, based on the fact that material representations were made in the underwriting process and underwriters relied on the representations when issuing the policy.

"The policy is much more likely to be rescinded if you can demonstrate that the insurer was in on it," Mariscal added, explaining that it rescission has historically proved a very unlikely remedy to such a claim.

"Of course with all coverage the facts are key - and a lot is still unclear about what exactly happened here. But if you are an institution that invested in Madoff and its possible that someone in your shop knew more about what was going on and were getting money back… it won't be surprising if people start looking closely at management fees in the context of kick-backs - as a means of possibly triggering coverage under crime policies," Alder added.

By way of defence, insurers may be able argue disgorgement - taking the position that they do not have to pay claims where the insured has been ordered to pay back money that they should not have received in the first place. Since many D&O and E&O policies contain personal profit or advantage exclusions as well as dishonesty and fraud exclusions this could be a successful argument.

Speaking to The Insurance Insider, attorney and partner at US management liability specialists OakBridge Insurance Services, Kevin LaCroix agreed with Alder's general estimates for the feeder funds implicated in the law suits.

"But there are some huge limits out there. I know the Spanish bank Santander made losses through its private banking of as much as $3bn and it may well have a very significant amount of D&O and E&O cover."

Indeed, while Santander has apparently lost a mere EUR17mn, its clients face total losses of EUR2.3bn and anti-corruption investigators in Spain have already launched an investigation into how such a large exposure could have been built up without triggering Santander's risk controls.

According to reports, Santander's fund-management arm, Optimal, even praised Bernard Madoff for his impeccable timing just weeks before his arrest on 11 December last year for orchestrating the biggest fraud in corporate history.

Spanish legal firm Cremades & Calvo-Sotelo has teamed up with America's Labaton Sucharow to represent victims.

The London insurance market is also facing potential exposures. As reported in The Insurance Insider, the first Madoff-related notifications arrived on the desks of London market insurers earlier this month.

Fund management giant Man Group, which manages $61bn across a broad range of funds, has an estimated $360mn exposure to Madoff, according to a company statement, while RBS has also notified a possible claim spawned from its believed £400mn in exposure to Madoff, according to senior market sources.

Banking group Rothschild and UK-based asset manager Schroders - which controls £115bn of funds - have also notified potential claims, and Nicola Horlick-run Bramdean Asset Management is also believed to have notified London market insurers.

Lloyd's has established a major loss code - MADO - to collate all notifications to market practitioners from the alleged fraud.

"We place D&O and E&O risk in the London market and counsel investment management firms with business going through London. There certainly is significant exposure in London both to the credit crisis and subprime cases generally and with Madoff. A lot of these cases will run through London, whether directly insured or reinsured. The fact that Lloyd's have established the MADO does not surprise me because I suspect a lot of these insurance losses will find their way back to London," LaCroix concluded.

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