Lloyd’s on ‘Rogue Traders’

July 1, 2008

It appears the “rogue” trading in the investment banking industry may not be an isolated problem. After Jerome Kerviel cost French bank Société Générale to book some $5 billion in losses, Morgan Stanley announced last week that it has lost £60 million ($120 million) due to a suspected rogue trader allegedly inflating profits.

An article on the Lloyd’s web site (www.lloyds.com) asks the question: “In a difficult economic environment when the reputations of financial firms are increasingly in the spotlight and even the most pristine brands seem vulnerable to rogue trading, are companies taking adequate steps to protect themselves and their trading systems? ”

Although the rapid advances in technology have generally bee a boon for financial firms, a recent Lloyd’s report shows that business leaders also think it could be the greatest source of new liabilities.

However, despite the concerns of senior executives, Daniel Butler, Executive Director at Aon told Lloyd’s that many companies are not insuring this particular type of risk. “We have had a handful of inquiries about coverage for unauthorized trading events but we haven’t seen a huge surge in demand since SocGen,” he noted. But he also indicated that there are a number of reasons why companies are not making the connection between the increasing risks (and costs) of unauthorized trading and purchasing the insurance.

“There is still not an entirely pure connection between some of the risk work and the insurance work in large organizations so it takes a while for things to filter through to the insurance side,” Butler explained. The reaction to SocGen and other recent rogue trading incidents has been for firms to focus on their control structures and carrying out audits and surveys to ensure their first defenses are in place, to make sure it couldn’t happen to them. Butler agreed that “this is the first thing they should think about, obviously;” however he added that “once that is done then ensuring adequate insurance cover is in place should be the next priority.”

Emotion is also a considerable obstacle to obtaining the correct level of protection. “There is still an understandable concern that if you buy rogue trading insurance then it suggests there could be something wrong,” he continued. “There is a pride issue at stake. Companies invest time and money in implementing the best controls so to spend money on the possibility of them breaking down is an emotional challenge. In other words, if you have 45 traders it’s a hard thing for a company to say, ‘We’re going to spend $10 million in case one of those people is a crook.’ Or, ‘Ok, we’ve just spent millions to make sure our systems will work, now we’re going to spend another $20 million in case they don’t work.’ That’s a tough sell to the board.”

Butler pointed out that for other areas of financial institutions coverage such as D&O and Professional Liability, which respond in instances when third parties are suing, companies are more able to see the risks and readily accept the need for insurance. Indeed, underwriters at Lloyd’s report that there has been an increase in demand for other types of Financial Institutions coverage in the last few months and that this demand may be being driven by BASEL II [The EU’s banking regulations].

“We have certainly seen increased interest recently in Financial Institutions cover,” stated Mark Johnson, underwriter at Talbot. He indicated most of his brokers report both increased demand for the products as well as bigger limits, though some of this could be linked to reduced premium prices.

“Following Enron, WorldCom and other major financial scandals, BASEL II set out recommendations for the reform of banking laws and regulations with the goal of establishing international standards and stricter regulation around the industry,” Lloyd’s explained. “In effect, it forces companies to set up much more rigorous risk and capital management practices to ensure they are adequately protecting themselves against financial and operational risks. The EU has already instituted BASEL II through the EU Capital Requirements directive and scores of other countries have already indicated that they intend to follow suit in the coming years.

“At the same time, there has been a general increase in the legal responsibilities that many senior employees of financial institutions can find themselves facing, such as exposure to loss of personal assets and legal fees to defend themselves. Meanwhile, in an increasingly litigious world, financial institutions can find themselves facing greater exposures to loss and related legal expenses. Consequently, Directors’ and Officers’ cover and Professional Indemnity cover are both in high demand and many financial services companies now believe they are essential.”

According to David Lewin, Managing Director and Continental Europe Casualty Specialty Leader at Guy Carpenter, “Companies need to be as proactive as possible in managing risks and researching for new and emerging risks.” As a reinsurer, he advises both his insurance company clients as well as their clients to put good risk management practices at the heart of what they do so as to prevent legal liability exposures.

Still, that leaves the risks associated with unauthorized trading largely uncovered. As Butler put it following Morgan Stanley’s announcement, “There are still some gremlins out there.” Recent incidents may seem like petty crime when compared to the losses caused by legendary rogue trader Nick Leeson who brought down Barings bank with £800 million [$1.6 billion at today’s exchange rates] in losses, but they prove that unauthorized trading continues to be an issue for financial institutions.

When part of an overall strategy to manage the risks, insurance for unauthorized trading contributes to peace of mind rather than constitutes an admission of failure. More generally, as technological development and innovation continues at a rapid pace, companies will undoubtedly need to get better at anticipating and responding to the liability implications of their technologies and processes, and building this thinking into their risk management strategy.

Source: Lloyd’s

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