The market may be up, but there are challenges aplenty facing advisors in the current regulatory climate. The Securities & Exchange Commission, National Association of Securities Dealers, and New York Attorney General Eliot Spitzer are on the lookout for fresh opportunities to supervise, correct, and regulate the financial services industry. And clients hurt by losses are looking at ways to restore their former financial well-being. The result: Advisors are being squeezed in more ways than one. Yet no matter how hard advisors may try to walk the straight and narrow, there are pitfalls. Just trying to protect oneself can be dangerous these days.
Errors and omissions insurance, which was designed to protect advisors against claims from clients with portfolios gone awry, has become a veritable minefield for those seeking protection in today's litigious climate. It used to be available cheaply, from a variety of carriers. But insurers once eager to offer coverage at low rates to most comers have either gone out of the business or gone out of business altogether, thanks in part to spiraling claims. Add to that poor underwriting and underpricing of premiums, notes Bud Bigelow, president of Cambridge Alliance, a managing general agent for E&O insurance. Whatever the reasons, the current turbulence in the E&O market has led to some broker/dealers and advisors "going bare," forgoing increasingly more expensive coverage, while others struggle to keep their policies in effect lest they be caught up in expensive legal action to defend their decisions.
According to Bigelow, whose Web site (www.cambridgealliance.com) offers several articles he has written on E&O, many of the insurers offering coverage during the 1990s were willing to offer policies at bargain rates to grow their business. They didn't set aside enough to pay claims, he maintains, relying instead on the booming stock market to pump up their reserves.
Avalanche of Claims
As long as the market was soaring and claims were few, this strategy worked. But when the market tanked, the jig was up. And then came an avalanche of claims from clients who lost bundles in the bear market. Suddenly, insurers found themselves settling or defending claims from an ever-dwindling store of reserves. In this crisis environment, says Bigelow, the E&O market went through a shakeout. The loss of many carriers from the field has left the main remaining carrier, Pittsburgh-based American International Group Inc.'s National Union Fire Insurance Group, holding a full hand. "They've taken the rates up dramatically," Bigelow says, adding that with annual premiums for B/Ds going from $4,000-$5,000 to $75,000, "they've priced themselves out of the small B/D market." National Union's reasoning, says Bigelow, is the increase of actions against financial advisory professionals, with arbitrations up some 20%.
John Iannotti, an executive VP at National Union, says that rates are actually returning to where they had been in the early 1990s. While he acknowledges that advisors' E&O rates jumped 50% to 60% in 2002 and again last year, he adds that "rates are now returning to what insurance companies were traditionally charging between 1993 and '95." Rate decreases since that time, he says, mean that the rate increases in 2002 and 2003 have simply brought rates back to where they were. "There is some talk in the market of rates leveling off," he adds, "but in my opinion it's not warranted." Iannotti says that B/D rates increased "well over 100% in 2002, and well over 50% in 2003. It was one of the most underpriced books in the E&O area. There's very little capacity right now in the B/D world for a very good reason: It's a volatile area, and if not done correctly, can lead to significant losses for the carrier."
No Coverage? Who, Me?
While many RIAs and B/Ds have struggled to keep their E&O policies in effect, braving higher premiums and even changing the way they do business, others have let policies lapse or never even sought coverage. And they have lots of good reasons for doing so. Among them:
High premiums. For small companies, coverage has become prohibitive. Some have seen premiums increase by hundreds of percent, and B/Ds that do provide insurance often are passing on the added cost of coverage to reps. Some B/Ds even use coverage as a profit center, charging reps more than their share for policies and driving up the reps' expenses even further. Moreover, notes Gary Diffendaffer, executive VP of the Certified Financial Planner Board of Standards, "if you want coverage for certain specific areas, it will cost more. If you do tax preparation, that would cost an extra premium."
High deductibles. On many policies, deductibles can run as high as $10,000. Between premium costs and the deductible applied at the time of a claim, out-of-pocket costs can be hefty.
Limited coverage. E&O insurance, if obtained through a B/D, will only cover actions taken under the blanket of that firm. Advisors who engage in other business outside the B/D, say, managing investments, creating financial plans, or administering third-party pension plans, will not be protected for that other business. Nor may they be protected for any actions at the B/D if they leave that firm. Exclusions in policies may also preclude advisors conducting some activities, such as offering alternative investments to clients. Coverage for "selling away," or selling products not approved by a rep's B/D, has been "carved out of the industry," says Iannotti, and is "very rarely given."
Exclusions may also mean that advisors who think they're covered for some actions may not be. An E&O policy does not protect against deliberate wrongdoing, for instance, and can leave an advisor who exhibits questionable judgment being left out to dry if he ignored a client's risk tolerance or other circumstances to pursue a questionable investment.
Experience as an arbitrator helped to convince one advisor, who asked to remain anonymous, that E&O insurance was not worth the cost. Says the advisor, "If there have been misdeeds or fraud or purposeful neglect, E&O will not cover you. If you typed in the wrong number and made an order for 2,000 shares instead of 200, E&O will cover some of the costs but not the total amount of the error." That, coupled with the rising costs of coverage, convinced this advisor not only to drop E&O insurance but also to move more toward a fee-based business. Those who function more as advisors and less as product sellers, said the advisor, need the coverage less.
Another limitation in coverage arises out of aggregate limits of liability. A B/D's policy will have a limit of how much will be paid out on any single claim. It will also limit how much will be paid out in total. Trouble can arise when the aggregate limit is reached on a relatively small number of claims. Any additional claims will simply not be paid, leaving a B/D or advisor to foot the bill. If a company's compliance department has been slow to get rid of reps with spotty records, they could eat up all the coverage, leaving the conscientious ones unprotected.
Conflict of interest. Policies bought by B/Ds protect the B/D and the rep. But reps may wonder whether the insurance company's attorneys will spend more time defending them or defending the B/D, which pays the premiums. Bigelow explains the potential for conflict: "This is the only profession I know where both principal and agent are under the same policy." He compares the scenario to that of medical malpractice insurance, in which a doctor is an agent of a hospital; the doctor and the hospital can each be named in a suit, but each entity has separate coverage. Each defends its own case and will also defend the other.
With an E&O policy, both insureds are under the same policy. However, says Bigelow, from there on it's different. "The very first thing that happens when a claim comes in is that the rep will be asked to sign a waiver of conflict of interest letter-'I accept this lawyer as my advocate,'" he paraphrases, "'but know that he's a tainted advocate and will try to represent two people who may have a claim against each other.'" The insurance company, he says, will try to keep the B/D happy, and "the reps pay the freight."
Playing Hard to Get
Even with all the exclusions and provisos, policies still aren't that easy to get. E&O insurers offer coverage to the "excess and surplus lines" market rather than to the "admitted" market. Excess and surplus lines are not subject to the same kinds of regulatory controls as "admitted" policies, such as consumer insurance policies (say, homeowner's or auto insurance) or even other commercial policies. Insurers do not have to go through state insurance departments, according to Bigelow, and the coverage need not be widely offered due to its diverse risks. It also can change each year. Indeed, Iannotti says that 80% to 90% of B/Ds applying to National Union are not bound "because they are unwilling to pay the price." Investment advisors have a higher "bind to quote" ratio--around 50%.
Additional restrictions to coverage can arise. According to Andrew Fotopulous, executive VP at Theodore Liftman Insurance, some carriers want higher deductibles before they'll take on more risk themselves. "Before, it might have been $5,000 to $10,000. Maybe they want $25,000 now," he says. Another problem, he points out, is that some carriers who formerly offered coverage for sales of insurance products may no longer offer that coverage--sending advisors who sell insurance back on the trail of a policy that will cover the business they do.
B/Ds that have reps with less-than-stellar records may find that it's harder to get, or keep, a policy, regardless of rates. And adversarial firms, he adds, will probably be denied coverage, as will firms with too many trading errors. Fotopulous says that B/Ds themselves have cut down on their coverage as rates have risen. "They may be self-insuring, and not letting their reps know that they are self-insuring," he warns. Finally, if you work for a B/D that has no coverage, tough luck. Individual registered reps can't get E&O coverage.
You're Covered. I'll Sue.
Curiously, the very way that claims are handled by many E&O insurers may promote a greater number of blemishes on reps' records. It comes down to a matter of money. If you ask Randy Cooper of Life Transition Planning in Tampa, Florida, about E&O, he'll tell you that insurance can be an invitation to sue. "It's a deep pocket," he says. "It creates quick out-of-court settlements because the insurance company doesn't want to go to court, and assumes you're guilty anyway." He cites the experiences of a couple of friends. "I knew them and looked at their circumstances," he says, "and what I saw looked just slightly sloppy--their customers were not hurt, but it was sloppy enough to allow an attorney to do something." Without E&O insurance, he says, the attorneys would have to pursue a case through arbitration or in court. Taking either route is costly. But with E&O insurance, he says, actions are brought and settled quickly to save money.
Ken Fonte, of Fonte Financial Planning in Houston, concurs. "If there were a dispute," he says, "the insurance company would be looking to settle whether right or wrong, and I didn't like that aspect of it. I knew if anything came up they'd probably settle and, even though I knew I was right, I wouldn't have the option [to fight a claim]."
Michael K. McMahan, a planner with Raymond James Financial Services in Gastonia, North Carolina, has E&O through the firm's self-insurance plan. But he agrees that settlement is a much more likely scenario, depending on the cost to the insurance carrier. McMahan was the subject of an action in 1999 by a client who claimed a loss of $300,000 in an option transaction. The client and her attorneys pursued the case all the way to the Chicago Board Options Exchange, where three arbitrators, says McMahan, "found in my favor. They awarded her nothing and entered an order that the matter be expunged from my record.
"That's the good news," he adds. "The bad news is that I spent three years in this matter and spent $65,000 in legal fees. My E&O insurance paid 90% of these expenses. Had I agreed to settle with her, it is likely that my E&O would have paid 90% of the settlement." Nonetheless, McMahan believes that E&O can work against an advisor because of the likelihood of settlement.
The cost of defending cases like this, he points out, is "probably $25,000 to $50,000; it may be $75,000, depending on the complexity. So what the E&O insurance managers do is [consider whether] the person involved has done anything inappropriate." But there's still the consideration of cost, and they will ask themselves, he says, whether they are better off spending $50,000 to win or settling for $35,000. And bear in mind that the advisor may have a deductible of $10,000 or more.
The negative for the rep, says McMahan, is the damage to his reputation. "That's what I was fighting," he says. "On everything you sign [Form ADV, U4, and other paperwork], you have to say, 'I settled this case.' What is the value of your reputation, and what is the value of having that black mark on your record?" he asks.
McMahan is involved in another case at the moment. "I am 100% certain that I will win, but what they're asking for is a relatively small amount of money." He expects that E&O will push for settlement, but says he won't accept that. "I'll pay the money out of my pocket just to not have this black mark on my record. On this case, I may not get any recovery from E&O."
In fact, if an E&O carrier wants to settle and the advisor pushes for a fight instead, he may not have any recourse for the expense incurred. E&O policies can be written with "the right and duty to defend," or may be written instead giving the company the option of defending or settling a case. That means that if the company doesn't want to fight and you do, you'd better be prepared to pay the costs incurred. National Union B/D policies, for example, follow the rule of "right and duty to defend;" their investment advisor policies are "right but not duty to defend."
Not all reps are pressured to settle, McMahan says. Some companies have a more liberal policy than others, and he feels a rep's track record will have much to do with the E&O company's final decision. However, "in the smallest cases, even if there's no legitimacy [to the claim], the E&O carrier has an economic incentive to settle quickly to save money. It depends on clout. Often it depends on the reputation that the reps have within the organization. If they have a good reputation, E&O is more inclined to stick with them and do what the rep wants to do." If the rep hasn't been there long or doesn't have a solid reputation there, he says, E&O will be "inclined to settle quickly and move on." E&O premiums at McMahan's office, by the way, have increased "by a factor of four over the last three years," he says, from $30 per month per rep to $125 per month per rep. With 16 reps in the office, that's a big sum. However, McMahan notes that premiums had been at the $30 level for "a long time."
The settlement question brings up a comment voiced by those who eschew E&O: Having it is like tattooing on your forehead an invitation to sue. Indeed, Fort Lauderdale-based attorney David Weintraub indicates that there is some truth to this. While a high percentage of cases that he sees are meritorious, he says, "they have to be of a certain size to be worth pursuing." Weintraub's firm (www.stockbrokerlitigation.com) specializes in securities litigation and arbitration. He sees "substantially more [cases] in arbitration than in court," with more cases against NASD member firms than against any other entity, and far fewer cases against independent investment advisors who are not employed by an NASD firm. "I don't see a lot of them. And my colleagues don't see a lot of them." When asked why, he theorizes that independents don't have as deep pockets as those of the NASD firms.
It may be, he says, "that with fee-based people there is less potential for abuse," but it's more likely that they are a "much smaller player in the grand market." Moreover, Weintraub says he has to "give those cases a much closer look. They have to be bigger. If I have to go to court to resolve a case, it involves more time on my part and a lot more expenses. There will be depositions, frequent hearings. Those expenses are substantial and somebody has to pay them." He also cites cases in which judgments are awarded but, owing to a lack of insurance, cannot be collected. So why bother?
Settlements are far more common, he says, than cases that go all the way through arbitration. The NASD Web site (www.nasdadr.com) shows a predominance of settlements rather than cases that make it through the entire arbitration process.
So you don't want to pay high premiums. Or your B/D doesn't have insurance, so you can't get covered. Or you don't want to take chances on that aggregate limit. What can you do to protect your assets?
Alternatives to E&O
One advisor, who asked not to be identified, says that many "planners use the riders on their homeowner's insurance. Quite a few lawyers suggest that." This advisor also mentioned structuring a practice as a limited liability company as an option to protect personal assets. "More and more are going for limited liability companies, particularly if they're not solo practitioners."
William Wixon, a Plymouth, Minnesota, planner, says that, despite not having any claims, his B/D's E&O coverage "was dumped. I went out looking for E&O, but it was so expensive even for a bare-bones policy that a few of us working under a B/D signed up with Lincoln Benefit. If you're licensed as a Lincoln Benefit agent, they offer an E&O policy, but it's pretty slim." Wixon also set up a 401(k) for his business, and funded it with his IRA and SEP money, "because it's ERISA-protected; I'm trying to make myself less of a target." He also moved his home into his wife's name, "because I figured if somebody goes after me, [I'll] make myself appear not to have many assets in my name. When their attorney is looking for a deep pocket, hopefully I won't have one."
The industry E&O situation has become such a big issue that it's rumored that several B/Ds are banding together, to form a captive insurance company. Under the Liability Risk Retention Act of 1986, companies can organize and pool capital and file a plan to provide insurance. Essentially, says Bigelow, those forming the group assume the risk, and don't have to adhere to whatever strictures an insurer might require.
However, Bigelow questions whether a B/D-formed captive insurance company would be effective. "With a standard insurance company, what you have to do to write a line of business is file rates and forms and get a license in the state. With a risk retention group, all you have to do is show up and announce [your intentions]. The only requirement is that the pool of potential insurers has to be uniform with the potential of risk." But just showing up is far from enough. He stresses that B/Ds have to be committed for the long term, and have to be willing to fund the company in the first place. "Entry into the game is about $5 million," he says. For small B/Ds, it's the same old problem--several would have to pool their resources to reach that amount.
Whether you have E&O or not, Houston planner Fonte offers this advice: Be careful. "There are some prospects you just get a bad feeling about. If you don't need the business, you'd be better off moving on." Attorney Weintraub agrees: "If your client doesn't pass the smell test, don't do business with him." Wixon concurs: "Try to identify those clients who may give you trouble, or expect you're going to beat the indexes. I walk away. If they say they're involved in a complaint with a previous advisor, run away. It's preventive medicine." As E&O becomes more of a hassle, many advisors should consider this thoughtful remedy, no matter what their current coverage is.
Marlene Y. Satter is a freelance business journalist who can be reached at msatter @erols.com.