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Bankruptcy

: Credit Slips

Fund Manager Fraud Insurance

By Adam Levitin

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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.

Full post as published by Credit Slips on December 13, 2008 (boomark / email).