Louis Stanasolovich, a financial planner with Pittsburgh-based Legend Financial Advisors, recently had to scramble to find errors-and-omission insurance when his former carrier, Evanston Insurance, pulled out of the E&O market entirely.
He eventually found some, but it didn't come easy — or cheap.
Evanston is hardly the only company to make it harder for advisors to get E&O, and if Stanasolovich wanted to form a support group for advisors with E&O troubles, he'd likely find tons of takers.
Since 2001, advisors nationwide have been rocked with increases in professional liability insurance premiums — a direct result of the drain on insurance reserves created by a perfect storm of capital calamities, beginning with the Sept. 11 terrorist attacks.
“They had an effect on everyone, because the reinsurance pool dried up,” leaving insurance companies competing for the backing of a suddenly limited pool of capital, says Bayard “Bud” Bigelow III, CEO of Cambridge Alliance, an insurance company specializing in E&O coverage for financial services professionals.
Sept. 11 “was the biggest property and casualty event, the biggest medical insurance event, the biggest life insurance event, in the history of the world up to that point,” he says. When this calamity is combined with a market decline that inspired a huge spike in malfeasance suits against brokers, it's easy to see why insurance companies got more selective and raised rates on E&O policies. (E&O pays the legal costs and damages an advisor might incur when sued over a mistake that cost a client money.)
But that doesn't make it any easier on advisors, who depend on E&O to protect their practices.
As claims ramped up and capital shrunk, Charles Darwin went to work on the weaker carriers. Insurance companies jacked up their premiums and pulled in their horns, or — as was the case with Stanasolovich's carrier — pulled out of the market altogether.
The result: Two straight years of 20 percent-plus insurance premium hikes, as liability insurance was rationed out to the safest bets. For instance, reps with NEXT Financial Group, a 500-broker firm out of Houston, saw their premiums increase from $85 per month to $110 per month last year, and then saw them inflate again, to $125 a month this year.
Even plain-vanilla, fee-only planners — considered the safest liability bets in the financial services industry — had to shell out substantial additional premiums to keep existing coverage in place, as David Bergmann found out, when levies on his own Marina Del Rey practice soared, to a monthly premium of $2,675 from $1,475 — an 81 percent increase in just one year
The worst may be over. “We're not getting 20 percent-plus premium increases anymore,” says Andrew Fotopulos, executive vice president of Theodore Liftman insurance, a third-party broker between financial advisors and insurance underwriters. “The market's been good, and a good market covers a multitude of sins.”
But, many have learned the hard way that market fortunes turn on a dime — and with them E&O trends.
Shopping for E&O Coverage
Not all E&O policies are created equal, say industry insiders. Because almost all are written as excess and surplus lines, state insurance regulators take a more hands-off approach to regulation. Unlike with, say, auto insurance policies, state officials do not insist on approving underwriting policies and procedures in advance.
As a result, the E&O market is not commoditized, and policies and procedures can vary widely from company to company.
When shopping for a policy, look carefully for the phrase “right and duty to defend,” which means that if any single one of the charges or complaints levied against you are actions causing liability covered under the policy, then the insurance company must spring for your defense. The alternative clause is “the right but not the duty to defend,” which means the insurance company has the option of simply not providing you with a defense. This, of course, would leave the advisor with a nasty lawyer's bill. That's acceptable in certain limited circumstances, says Cambridge Alliance's Bigelow — in a rider on an existing duty-to-defend base policy, for instance. But otherwise, such policies are best avoided. The primary policy should always contain the duty-to-defend clause.
If the policy contains the duty-to-defend clause, the insurance company will generally retain for itself the right to select the defense attorney, which actually works in an advisor's favor. Most advisors have limited experience in dealing with suits and official complaints. The insurance company, by contrast, deals with these every day and know who the best and most experienced attorneys are.
Moreover, a duty-to-defend policy requires the insurer to provide an adequate defense. An incompetent attorney hired by the insurer gives an advisor some recourse should he lose his suit. But if the advisor chooses an inadequate attorney, he's on his own. Here are some other considerations:
Scope
Another important thing to keep in mind while E&O shopping: Make sure your policy is designed to cover a practice with your characteristics. For instance, if your broker clears deals through a third-party clearinghouse, make sure your policy allows for that. Many will only cover transactions traded through the broker/dealer.
If you deal in limited partnerships, you're going to want a policy that covers alternative investments. Check the exclusions, and for those with complex practices, be prepared for difficulties.
“If a broker's out there selling alternative investments, it's going to be harder for me to find him an underwriter,” warns Theodore Liftman Insurance's Fotopulos.
Premiums
Most companies set premiums based on some combination of the following factors:
Assets under management. Types of investments. As mentioned, alternative investments and options strategies (with the exception of covered calls) are considered risky, and are more difficult to find coverage for).
Discretionary vs. nondiscretionary authority. Discretionary accounts — in which the broker is allowed to effect transactions without the express consent of the client — are more vulnerable to churning and other abuses, and are more difficult to underwrite.
Percentage of ERISA vs. non-ERISA money. A plain-vanilla, fee-only planner or registered investment advisor, with $30 million in assets under management, a $1 million policy limit and a $10,000 deductible can expect to pay upwards of $4,000 per year in premiums. If the advisor is compensated on commissions from transactions, is in a sales-oriented practice or if he uses alternative investments, premiums go up rapidly from there.
Exclusions
Make sure you understand the coverage your policy does and does not provide. For example, some states prohibit insurance companies from covering punitive damages because that defeats the deterrent purpose of punitive damages for willful misconduct.
Even if states allow for coverage of punitive damages, though, look closely at the language of the policy. Most policies exclude coverage for damages arising out of willful misconduct and for damages arising out of any harm that the broker expected or intended to cause.
So what's left? Everything else is considered ordinary negligence. And these claims do not generate punitive damages. So even if punitive damages are not expressly excluded, either by statute or within the exclusions paragraph on the policy, they may be effectively excluded by the two clauses mentioned above.
Ideally, advisors should get an all-risk policy, as opposed to a named-peril policy. The former covers everything except those events specifically excluded, while the named-peril policy covers only those items specifically cited in the policy, excluding everything else. Appearances can be deceiving: an all-risk policy will have a longer list of exclusions than a named-peril policy. But the all-risk policy is actually less restrictive than the named-peril.
Recognition of Claims
The date at which a policy recognizes a possible claim is crucial. Some policies will cover claims as of the date that incident is reported to the insurance company. Other insurance companies will not take ownership of an incident until the customer actually presents a demand for damages.
Why is this important? Consider what happens when a brokerage changes carriers. Suppose Acme Investments carried a policy that did not recognize claims until they were presented to the insurance company as a demand for damages — which may not happen for months or even years after the actual event itself. When a company changes E&O carriers, no carrier will insure them against incidents already known to be in existence at the time the new policy is written. This could leave the brokerage firm with weeks, months or years worth of potential incidents which could explode into a claim.
The remedy: insist on a policy that provides coverage as of the date on which the incident was first reported.
Unless you are just starting out in the business, you'll need to invest in a retroactive policy. Check to see if the continuing date, or retroactive date (the terms are used interchangeably), is for “claims made or acts occurred,” counsels Fotopulos.
“It costs more to get a retroactive policy — a good deal more,” he says. But it's worth it.
The Premium
Again, this isn't auto insurance, with a large number of drivers with similar risk characteristics. The number of financial services professionals looking for E&O coverage is relatively low and their risk profiles are extremely diverse. E&O coverage is not a commodity, so the premium should not be the primary consideration. An incautious b/d, in an effort to save a few bucks in premiums, could easily find itself forgoing crucial coverage in a decision that costs him or his firm tens or even hundreds of thousands of dollars in claims down the road.
Tail Coverage
You and your employees won't be hawking investment products for the same company forever. You and your people will retire, leave the firm or leave the industry altogether. But the need for coverage from actions that took place while they were working there doesn't go away. Look for language that allows you to file claims even after the policy has expired. It's called an “extended reporting period endorsement.” If there's no such language, assume there's no such coverage. Ask about it.
Caps
Insurance companies don't write blank checks. Policies will come with some combination of deductibles, per-claim limits on compensation or annual caps on individuals or firms. You should also know the difference between an “aggregate cap” and a “claim limit.” A claim limit is the most the insurance company will pay out on a given incident or claim; an aggregate cap is the cumulative upper limit on all claims, firmwide, within a certain amount of time.
Aggregate caps can be tricky. Unless they're updated continuously to account for the growth of the firm and its business, coverage among dozens or hundreds of reps can quickly become diluted. Jokes NEXT Financial President Jeff Auld, “If you're in a firm with an annual cap, you'd better be one of the first guys to get in trouble!”
Other Factors
Consider a ham-and-eggs breakfast. The chicken was involved. But the pig was committed.
Likewise, you should consider whether your insurance carrier is planning to be committed to the E&O market.
Consider: a brand new brokerage firm initiates coverage with Joe's Insurance, Inc. Because the business is brand new, there's no need for expensive retroactive coverage. But if Joe's underwriters are inexperienced or naïve about the risks, he may pull out of the market altogether, and leave our fledgling b/d flapping about in search of a new insurer. But because they're not a new b/d anymore, they'll have to pay through the nose for a retroactive policy, and eventually cost themselves more money in premiums that they originally thought they were saving.
How much more? Remember our plain-vanilla RIA with $30 million under management, and a $4,000 annual premium? Prior acts coverage would jack up his premium to around $10,000 a year — a 250 percent annual increase, according to Fotopulos.
Even if they renew your policy, if they stop writing new business, you may well see a drop-off in responsiveness as the company focuses on other lines of work.
“An uncommitted carrier that no longer writes the coverage you purchased from them is hardly likely to be responsive in handling a claim on your behalf,” warns Bigelow, who's been underwriting financial advisors (primarily in fee-only practices) for a dozen years.
Look for a carrier or underwriter who has served your business for several years and understands the unique risks of your specific business model.
Don't settle for involved. Look for someone who's committed.
E&O Glossary
Aggregate Cap: The upper limit on total payouts within a given firm's policy during a given amount of time. Also called the program limit or the account limit.
Alternative Investments: Many insurance providers will not cover claims arising out of such vehicles as hedge funds, commodities, limited partnerships and options other than covered calls.
Claim Limit: The maximum the insurance company will payout based upon a single claim. (Remember, legal costs can also count against the claim limit.)
Discretionary vs. Nondiscretionary Authority: Premiums for advisors with discretionary authority are more expensive.
Duty to Defend: Normally written as “a right and duty to defend,” this clause obligates the insurance company to mount a vigorous defense of the advisor if any one of the claims against him are for acts covered under the policy. Contrast with right but not the duty to defend. Your primary policy should always contain a “right and duty to defend” clause.
ERISA: Stands for Employee Retirement Income Security Act. Think pension and 401(k) money. The Department of Labor extends another blanket of regulation. Financial pros who handle this money are expected to provide an elevated standard of care. As a result, they come under more scrutiny and premiums tend to be higher.
E&O: Short for errors and omissions; a term used to describe professional liability insurance programs for a wide variety of fields.
Excess and Surplus Lines: Lines of insurance characterized by smaller risk pools of highly diverse clients. These lines are typically not closely regulated by state insurance commissions. Opposite of “admitted lines.”
Extended Reporting Period Endorsement: Allows claims to be made after the expiration of the original policy.
Prior Acts Coverage: Coverage of events that took place prior to the start date of a policy.