The E&O Crisis

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.