The Real Cost of the Madoff Collapse to Insurance Companies Won’t be Known for Months

December 17, 2008

SOURCE: InsuranceNewsNet, Inc.

The impact of the collapse of Bernard L. Madoff Investment Securities (BMIS) on the insurance industry won’t be known for another six months, with even the exact scale of the losses difficult to calculate.

The Securities Investor Protection Corporation (SIPC), a quasi-governmental agency that serves as a trustee in a brokerage insolvency case, said Madoff’s records were falsified and unreliable, making the liquidation of BMIS assets more difficult than in most brokerage firm insolvencies.

Madoff, who is accused of operating a global Ponzi scheme losing $30 billion to $50 billion, maintained two different sets of books. One set of records tracked the actual losses at the brokerage firm’s investment advisory arm, while the second one was the version that was shown to investors, sad SIPC president Stephen Harbeck.

Companies, charities and individual investors who took a hit are starting to disclose their losses.

Among insurance carriers, Massachusetts Mutual Life Insurance Co. already issued a statement regarding the company’s exposure from Madoff’s alleged scheme. MassMutual said its client funds included in BMIS-managed funds is very limited – less than $10 million – although the company admitted that its review is still on going. With more than $500 billion in assets, the carrier is confident that the losses won't affect its overall financial standing.

By press reports put the loss at closer to $3 billion. MassMutual had indirect exposure to the scam through the hedge fund investment firm Tremont Group Holdings. Tremont Group Holdings Inc. is a subsidiary of Oppenheimer Acquisition Corporation, which is a subsidiary of MassMutual. The Associated Press reported The Tremont Group lost $3.3 billion, more than half of the company’s $6 billion total assets, including the pension funds of some institutions.

Experts believe more hedge funds may falter as the fallout settles, possibly revealing more insurance companies with various degrees of exposure.

Many hedge fund managers have had years of lucrative relationship with Madoff and have been advising wealthy clients to invest in his firm. This is largely due to the consistent but abnormally high short-term returns of 8 percent or higher on the investors’ money provided by BMIS  –  the typical strategy used in Ponzi schemes in order to lure new investors.

These high returns come from the money paid by subsequent investors rather than from real business profits. Ponzi schemes eventually collapse because there are little or no underlying earnings from the money received by the promoter. It requires an ever-increasing flow of money from investors to keep the scheme going. Madoff’s alleged scheme fell apart this month. Madoff told a senior employee he was struggling to pay back $7 billion to hedge fund clients who had requested their money back.

But the damage of latest fiasco to hit the financial world is only beginning. It not only compromised hedge funds' promises of expertise and trust in exchange for hefty investment management fees. Experts believe it would open a floodgate of lawsuits filed by disgruntled investors. Since Madoff's firm has been wiped out, legal experts say investors might have the best chance at recovering their losses by going after fund managers.

Jardine Lloyd Thompson (JLT) group of companies, a London-based reinsurance broker, believes this how the collapse will have a direct impact on insurers. 

“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,” said Paul Towler, a JLT partner. “The likely focus of clients will be the level of due diligence performed by the Financial Institutions.”

Firms can mitigate their financial loss to some degree if they have liability insurance policies such as  directors and officers (D&O) and errors and omissions (E&O), but Towler said the volume and value of claims would be hard to predict given the enormous amount of money involved.

Many insurers are bracing themselves for a series of claims against their D&O policies. They are also anticipating a sharp spike in professional indemnity policy claims by advisors who may be held liable for not having carried out sufficient research before advising clients to entrust their money to Madoff.

Lawyers representing hedge-fund firms are already preparing "mass-action" lawsuits where claimants are named individually rather than as a class. One law firm said it will file its case on behalf of several clients, individuals and groups, with funds caught up in the Madoff debacle within the week.

Experts predict the Madoff case will trigger increased regulatory oversight of the financial services industry, particularly on hedge funds, in the same fashion Enron influenced Sarbanes-Oxley's introduction to the market place. Not everyone thinks this would be necessarily good for the industry. This will set the stage for strict regulation that follows all-too-literal rules and all their unintended consequences.

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