Has there ever been a period in the history of the London Market when insurers were more jittery or uncertain of the road ahead? After the market-wide losses that will inevitably result from the shocking recent events in New York, few companies will be able to afford to suffer another major hit to their balance sheets. Apart from the enormity of the claims arising from this event, or any catastrophic event, many insurers will be worried about their ability to collect from reinsurers.

Many reinsurers will honour the terms and conditions of the reinsurance policy and respond accordingly. But it will be interesting to see if any try to avoid liability through allegations of misconduct, misrepresentation, negligence or, worse, fraudulent conduct against brokers, agents or other such third parties.

The onus is on the insurer to have taken the appropriate precautionary measures. If the insurer had not undertaken a vigorous due diligence of its trading partners prior to buying reinsurance, this could have devastating repercussions.

It is now more important than ever that insurers do everything to protect themselves against the threat of avoidance of liability through major frauds or incompetence that could put their solvency at risk.

Underwriters are facing increasing pressure from their finance directors to generate sustainable premium income. As a result, the signs of a fraudulent or failing business are often missed or willfully overlooked in a bid to increase market share. Today, the stakes are even higher, as the recent collapse of Independent Insurance has focused attention on the issues of effective audits and inspection procedures.

But how does a London Market organisation or insurer detect the danger signals of a fraudulent or mismanaged company? And how much significance can insurers place on the importance of effective due diligence procedures, particularly if underwriters enter into binding authority agreements with overseas partners?

Before the failure of Independent, it was presumed insurance companies were under the effective scrutiny of the ratings agencies, auditors and regulators. Those who took this for granted were in for a nasty surprise. The demise of Independent threw the spotlight on the issue of security. If it could happen to Indie, it could happen to anyone.

However, as with most disasters, there is an up-side. A positive outcome may emerge if more companies come to appreciate the benefits of conducting effective due diligence assessments before entering into commercial relations with potential business partners.

Go external
Most London Market operations insurers are unlikely to possess the internal resources or skills to conduct a proper audit and investigation of another organisation. External audits and investigation teams can provide a valuable service, particularly for underwriters who enter into binding authority agreements with Managing General Agents (MGAs) or Managing General Underwriters (MGUs). Last year, 13,500 binding authorities were issued at Lloyd's and it is unlikely that more than a small number were subject to pre-contractual review.

Under the terms of a full binding authority, policyholders have the power to negotiate, sign and issue policies, pay claims, collect recoveries and appoint lawyers. In these circumstances, underwriters really need to know what kind of organisation they are dealing with and whether they employ the right people to manage the business.

An audit and investigation team will look into the company's systems and procedures, including their accounting functions, computer systems, underwriting and claims procedures. Other questions will include who manages the company and who is really behind it.

It is vital that the underwriter looks at the shareholding – are they the real shareholders or are they holding the shares for someone who wishes to remain anonymous? If you don't know, then find out.

An external audit and investigation team can draw on its contacts with law enforcement and regulatory bodies around the world and ask whether this company is bona fide or whether the owners have any other hidden business interests.

Doing your homework is important when dealing with people who effectively hold your cheque book and, where there is a claims fund provided for in the agreement, actually hold your cash. Naturally you want to be sure they are the right people to be doing business with.

One big fraud that caught everyone out in the London Market was the North American Fidelity Guarantee case. Major insurance players dealt with this company, which supposedly controlled $100m (£67.8m) in assets. In reality, the company, which had no money at all, was actually a holding company in Delaware.

Some serious players in the insurance industry got their fingers burned on that occasion. What is particularly unfortunate about this case is that, if they had committed a relatively small amount of time and money to a proper audit, the fraud would have been spotted almost immediately.

Take your time
Investigating fraud or mismanagement within an organisation requires time and patience. The team that conducts the audit will need a wide range of underwriting skills and expertise.

Claims experts should also be employed to ensure settlements have been handled properly. A qualified accountant will need to look at the company's accounting systems and the way it manages its bank accounts. Has the company established the right internal controls and procedures?

For example, it should be standard procedure to separate the money belonging to the underwriters from the operation of the company's own funds. There should also be appropriate security controls – the cheque books should be locked away, the correct signatures must be on the mandate and payment authorisation procedures must be in place, so money that is not validly approved does not leave the company.

The signs are that attitudes are changing, especially in the aftermath of the Independent episode and the recent changes to the Lloyd's Code of Practice for managing and controlling binding authority arrangements. Organisations are beginning to recognise the value of instigating proper due diligence inquiries and audits and investigations of their partners.

When insurers and brokers discuss renewals or new programmes at events such as the Baden-Baden conference, let us hope they take a more diligent view of their prospective trading partners before entering into commercial relationships. At the very least, they should insist the contract provides for the inspection of records and audit of the agent's files. Insurers should also insist on regular audits of agents that include this procedure within their best practice management and ensure they seek out the appropriate professionals to assist them in this task.

The vast majority of those operating in the London Market insurance industry are honest and upstanding people, but there are, unfortunately, a small but significant number of bandits out there. Ignoring insurance fraud or adopting the attitude of “it won't happen to us” may be easier in the short term, but leaves companies perilously vulnerable to bankruptcy in the long run. The industry must tighten up its audits and inspections procedures, otherwise it won't be long before the next major insolvency hits the front page of Insurance Times.

  • Bob Floate is director of Axiom Claims Consulting.