With the looming prospect of nearly $2 billion in professionalliability claim payments, fallout of an alleged Ponzi schemeorchestrated by Bernard Madoff, insurers will likely embark on morecareful underwriting of financial firms, one expert said.

“It's certainly going to have an impact on [insurers']underwriting procedures,” said Stephen Mildenhall, head of AonBenfield's Actuarial and Enterprise Risk Management practice, whichdeveloped a $1.8 billon best estimate of direct insurance lossesthat could be paid out on behalf of asset management firms, banksand other firms being sued in the aftermath of the Madoffscandal.

“It is astonishing that something of this size and scale managedto proceed…for a number of years without being detected,” Mr.Mildenhall said. As a result, “I would imagine that there would besome heightened underwriting within this class,” he added,referring to the financial institutions E&O/D&O class,already “pretty much under the microscope” as a result of thesubprime/credit crisis.

The price tag for professional liability (E&O) and directorsand officers liability insurance losses attributable to thesubprime and credit crisis could reach $9.6 billion, according tothe most recently published estimate, put forth by New York-basedAdvisen in November. The $9.6 billion forecast falls in a range of$6.8-to-$12.1 billion, Advisen said.

At Aon Benfield, Mr. Mildenhall noted that the maximum potentialinsurance limits exposed to the Madoff scandal are estimated atmore than $6 billion, but he said the range of direct insuredlosses will be a far smaller number–most likely somewhere between$760 million and $3.8 billion, with a best estimate of $1.8billion.

“The numbers all are derived from two dimensions ofuncertainty,” Mr. Mildenhall said. He highlighted the first elementas “uncertainty around the particular limits and attachment pointsthat insured parties would have purchased,” and questionssurrounding the degree of liability of different policyholders asthe second.

To develop its insurance loss estimates, Aon Benfield analyzedpossible exposure to four categories of potential defendants whichcould be protected by D&O and E&O insurance:

o Asset management firms that ran so-called “feeder funds”–fundsthat directed investor capital to Mr. Madoff or his firm, BernardMadoff Investment Securities.

o Foreign banks and insurers that placed investors' assets andtheir own assets under Mr. Madoff's management.

o Charitable organizations and public institutions, whose boardsmay be sued by disgruntled donors for performing insufficient duediligence on investments with Mr. Madoff.

o Bernard Madoff Investment Securities.

The Aon Benfield report notes that payouts by insurers ofBernard Madoff Investment Securities could be limited by policylanguage excluding fraudulent acts.

For the other three categories, the report summarizes estimatesof limits and attachments purchased, limits exposed, and directinsurance losses.

A summary setting forth typical low, medium and high levels oflimits purchased reveals wide ranges for financial firms inparticular. For foreign banks and insurers, for example, purchasedlimits range from a low of $10 million to a high limit of $750million, Mr. Mildenhall pointed out, noting that a medium limit forsuch firms comes in at around $100 million.

“There's a lot of uncertainty around what the limit would be,where the attachment would be, and whether there would beendorsements that mean certain layers wouldn't respond for certaincoverages,” he said. “That's driving a big range around the[estimate of] potential limits exposed.” He referred to a range ofmaximum losses payable under insurance policies calculated in thenext step of the analysis.

The range of limits exposed extends from a low of $1.3 billion(assuming only low-limit policies were purchased) to $6.4 billion(for high-limit policies).

Going on to explain the calculation of those figures, Mr.Mildenhall said Aon Benfield gathered information on investmentlosses associated for roughly 140 Madoff victims identified inarticles in the Wall Street Journal, Bloomberg News and other presssources. The reasoning was that for each announced victim therecould be a potential lawsuit against one of the three types ofentities analyzed–asset management firms, foreign banks andinsurers or charities.

The news sources cited actual dollar losses for about 100 of thevictims, he said, adding that Aon Benfield proceeded with itsanalysis by assigning a potential defendant category to each namedvictim.

“If the judgment that came down against [the defendant insured]was equal to the amount of economic loss [the victim] put forth,then how would the coverage respond in that case,” he asked,summarizing the question being answered by this part of theanalysis.

Depending on the type of insured, the broker selected thepotential limit that could be in play from the table of low, mediumor high range limits by category of defendant. The high-end $6.4billion figure assumes all defendants purchased high limitspolicies, he explained.

“For a lot of the big European banks, the potential economicloss would be in excess of the policy limits that they're likely tohave purchased. That would be a limits loss. In other cases, itwould be a smaller loss and it wouldn't exhaust coverage,” Mr.Mildenhall said.

According to the report, foreign banks and insurers account for$4.9 billion of the $6.4 billion high estimate of potential limitsexposed, with asset management firms accounting for $1.2 billionand charities only $222 million.

“We had some examples where we knew what people were buying, andsome examples where we knew at least a piece of the coverage,”filling in the rest. “So it's an informed judgment,” he said. “It'snot like we've got a bordereaux listing exact potential defendantsand their [insurance policy] limits.”

Moving from the estimate of potential limits exposed to thefinal calculation of direct insured losses, Mr. Mildenhall notedthat the exposed limits are only paid if every policyholder isfound 100 percent liable for their full exposure. “There's somechance here that suits are going to get dismissed,” he said,explaining that more likely scenarios assume varying degrees ofliability for different policyholders.

In the report, Aon Benfield applied a 60 percent factor to theexposed limit totals for asset management firms and for foreignbanks and insurers–developing insurance loss estimates ranging from$169 million to $738 million for the asset managers and $590million to $3 billion for the foreign banks and insurers.

The best estimates within the ranges are $371 million for theasset firms and $1.5 billion for the banks and insurers, withcharities contributing only $6 million to the overall best estimateof $1.8 billion.

For the analysis of charities, Aon Benfield assumed theinsurance losses would only be 5 percent of exposed limits, incontrast to 60 percent for the other categories of insured firmsthat are potential lawsuit defendants.

Brian Alvers, a senior vice president, explained that AonBenfield reviewed industry data on other events to analyzedismissal rates and also talked to other industry experts.Explaining the 95 percent dismissal rate assumption for charities,a foreseeable D&O suit might come from a large donor, but thedonor might be on the board of the charity. “They wouldn't be ableto sue themselves. So those things would probably go away,” hesaid.

Comparing the overall direct insurance loss best estimate of$1.8 billion to investment losses of $35 billion or more, Mr.Mildenhall noted that the result–about 5 percent of investmentlosses–is similar to the one that played out in the wake of theEnron debacle.

When Enron settlement figures are examined against estimatedpolicy limits, the resulting estimate of insurance losses for Enronis $3.7 billion, he said. This is 5-6 percent of the $60-$70billion total economic losses.

Mr. Mildenhall pointed out that the Aon Benfield estimate forMadoff litigation is an estimate of direct insurance losses, andtherefore does not include any provision for the next ring ofdefendants now being sued–third-parties like audit firms.

While the broker said many auditors tend to self-insure,potentially keeping a lid on private insurer payouts, experts agreethat auditors face significant exposure.

Gerard Silk, a partner with Bernstein Litowitz Berger &Grossmann LLP, representing investors in funds that had holdingswith Madoff, described opinions he has seen that are signed byauditors of funds.

“They make representations regarding the nature of investments,saying that those investments are in fact 'true and accurate,' andthat the investments were held by the fund as of year end,” hesaid. “Those are statements that could give rise to liability onbehalf of firms that made them.”

While Mr. Silk and Brad Friedman of Milberg LLP both identifiedaudit firms as potential deep pockets in Madoff litigation, on aWeb conference sponsored by NERA Economic Consulting earlier thismonth, the two plaintiffs' attorneys said they foresee manypotential hurdles for victims seeking to recover investmentlosses.

For example, Mr. Silk described legal hurdles facing limitedpartner investors in funds of funds, whose investments were putinto Madoff funds. Those LPs who file suits against generalpartners of the funds of funds “will have to demonstrate thatgeneral partners acted with a standard of conduct that is eithergrossly negligent or something beyond,” such as recklessly orfraudulently.

In addition, he said, in most partnership agreements, there islanguage governing litigation against the GP, there are provisionsfor indemnification of the GP, and provisions that allow the GP touse fund assets to defend itself from litigation.

“That presents an interesting twist because with limited assetsremaining, LPs could be suing the GP and, in fact, their own assetscould be going to defend the cases,” Mr. Silk noted.

Beyond that, he said, for cases being filed as class actions,there are added hurdles. For example, class actions alleging breachof fiduciary duty and other common law claims against GPs could besubject to preemption under the Securities Litigation UniformStandards Act of 1998–a law requiring certain securities classactions to be brought in federal court.

To make a federal claim, he continued, plaintiffs cannot pleadthat GPs or others were grossly negligent. “You would have todemonstrate that they acted with scienter–a state of mind ofrecklessness or greater than that,” he said. “You'd also have toprove that parties you're suing made false statements.”

Mr. Silk said private lawsuits that are not brought as classactions will face fewer hurdles–allowing claims that plead onlygross negligence and allowing plaintiffs to bring third partiesinto suits as defendants for aiding and abetting.

Fund-of-fund investors “have more avenues for recovery thandirector investors,” but “they are not easy avenues.”

Discussing the challenges facing direct investors, Mr. Friedmansaid there are only two real avenues of recovery–the SecuritiesInvestor Protection Corporation and as a creditor in the bankruptcyof Madoff Investment Securities.

SIPC, which maintains a special reserve fund authorized byCongress to help investors at failed brokerage firms, has alreadymailed out more than 8,000 customer claim forms to Madoffinvestors, SIPC announced in a Jan. 5 statement.

In a recent press advisory, Marshall Gilinsky, a policyholder'sattorney with Anderson Kill & Olick, suggested a thirdpotential avenue of recovery for investors. “Some blue-chiphomeowners policies…include limited coverage for losses like thosearising out of investments in Madoff's hedge funds.”

On the Webcast, Mr. Friedman explained that SIPC claimrecoveries are limited to $500,000 per customer. He also addressedconcerns of some investors, hesitant to file claims for recovery ofamounts invested with Madoff because they have redeemed money overthe years and fear that trustees will come after them to returnthat money.

Mr. Friedman said he believes too much attention has been givento this issue in the business press, suggesting that only thelargest investors would be subject to demands, often referred to asclawbacks.

Separately, Kevin LaCroix, an attorney who authors “The D&ODiary,” an Internet blog site with information on securitieslitigation trends and D&O insurance, is keeping track ofsecurities class-action lawsuits against Mr. Madoff, his firm, orthe feeder firms that invested their clients' funds with Madoff.Through Jan 12 he tallied 10 federal securities class actions andthree state actions.

Mr. LaCroix also counted a dozen additional cases againstrelated defendants. These include a recent case filed againstTremont International Insurance Limited. This case alleges that theinsurer, an entity owned by Tremont Capital Management, breachedits duties by offering Tremont-related funds as investment optionsfor the variable investment account component of the policies, andthat the Tremont-related funds were heavily invested with Madoff,Mr. LaCroix explained on a recent blog entry.

In a Jan. 12 blog entry at www.dandodiary.com, Mr. LaCroix–apartner for Oakbridge Insurance Services, a Beachwood, Ohio-basedinsurance brokerage–also discussed potential obstacles lawsuitdefendants might face in securing coverage from their D&O andE&O insurance policies.

Conduct exclusions, particularly personal profit and fraudexclusions, may be asserted as coverage defenses by insurers, hesaid, noting that while the fraud exclusions might only apply toinsurance for Mr. Madoff, the personal profit exclusion could comeinto play in other cases.

“Investors have already claimed that the feeder fundsinappropriately exacted management fees or other compensationwithout conducting appropriate due diligence or otherwise earningtheir fees. However, an adjudicated determination of theseallegations would be required for the profit exclusion to precludecoverage,” Mr. LaCroix wrote.

He said that based on his experience, he believes manyinvestment advisory firms and hedge funds buy relatively lowerlimits of insurance coverage. He pointed to a factor beyondexclusions that could restrict the total insurance losses.

“In many cases, the available insurance involved…could quicklybe exhausted by defense costs alone,” Mr. LaCroix said.

For more information:

o A copy of the Aon Benfield report is available upon request,the firm said. Aon Benfield will continue to update thispreliminary analysis and revise results as new information becomesavailable.

o The Web conference referenced in this article, presented bySecurities Docket and sponsored by NERA Economic Consulting, isavailable on both firm's Web sites: www.securitiesdocket.com andwww.nera.com.

NERA is a New York-based unit of the Oliver Wyman Group, an MMCcompany.

Securities Docket, the Global Securities Litigation andEnforcement Report, publishes news concerning securities classactions, enforcement and white-collar matters, and regularly holdsfree Webcasts featuring leading attorneys.