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Industry Spotlight > Broker Dealers

Safety First

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Few prudent drivers would take to the road without having their cars adequately insured, even if it were legally permissible. In these days when a medical catastrophe has the potential to wipe out a lifetime of savings, no one who can avoid it goes without healthcare insurance. Most people grumble about the premiums paid for such protection and pray they never need the coverage but don’t feel they can afford to gamble on going without. Often the peace of mind that comes with coverage is well-worth the premium. Most financial planners and investment advisors have come to feel the same way about errors and omissions, or E&O, insurance.

“It’s a necessary evil,” says Lisa Kirchenbauer, CFP, only partly in jest. Kirchenbauer has a small practice ($32 million in AUM) in Arlington, Virginia, and purchases E&O coverage for herself as well as the firm’s other CFP.

Two years ago, after 17 years with a broker/dealer, Kirchenbauer went completely independent and launched Kirchenbauer Financial Management and Consulting. “For the first time I had to get my own coverage; that was a rude awakening,” she recalls.

Her first shock was that as a sole practitioner she didn’t have the size to make her an attractive risk for one of the major E&O insurers. She says that the staff at one major carrier politely explained that they didn’t offer coverage to advisors with less than $100 million in assets under management. Seeing she wasn’t getting what she needed as a small independent, Kirchenbauer decided to see if her membership in the FPA gave her any leverage, which it did with two insurers.

“I got two completely different quotes, and neither would cover my hedge fund of funds business,” she says. “And they still won’t.”

One of the quotes was twice as much as the other, and even the low one was twice what she had been paying through her broker/dealer. “Because I’m a smaller firm, it’s been a big challenge,” noted Kirchenbauer. “I’m getting about half as much coverage for twice the price.”

Other independent advisors with relatively small practices would be wise to take a page from Kirchenbauer’s book and investigate E&O policies that may be available to them as members of professional associations such as FPA or NAPFA.

A Changing Market

For advisors affiliated with broker/dealers, as Kirchenbauer belatedly discovered, E&O coverage under a massive policy has long been one of the cost benefits of that association. While that still remains the most viable route for many advisors, coverage under such policies is not as inexpensive as it once was, according to a comparison of data collected for the Investment Advisor independent broker/dealer directories in 2000 and again last year.

In 2000, some 83% of the broker/dealers listed in the directory offered E&O insurance to their reps. Five years later, with a greater number of firms participating, that figure had dropped to 73%. What’s probably more alarming to advisors is the increase in E&O premium costs (see “I’ll Get It From My B/D” sidebar ). Five years ago, there were two B/Ds in the directory offering their reps E&O coverage for less than $100/year. Last year one of those companies, Prospera, noted that the average cost per rep had gone from $88 to $2,160. While that was the greatest upward spike of the broker/dealers listed in both directories, triple-digit increases since 2000 have been the rule rather than the exception.

Surprisingly, perhaps as a “loss leader” strategy, the number of broker/dealers that offer the coverage to their reps without charging for it has increased at the same time that overall premiums have escalated. Only one of the B/Ds that offered E&O at no charge in 2000–SII Securities–still did so in 2005. Two other firms that didn’t pass along the cost of coverage in 2000 are now asking for more than $2,000/year from their reps for coverage.

Mark Connell is a CFP with Capital Advisory Group in Dallas, a firm that actively manages about $64 million and advises on another $70 million. Both he and the firm’s owner/president, who is also the firm’s other advisor, get E&O coverage as registered reps through their broker/dealer. In addition, Connell also has coverage as an investment advisor. The firm president, a 30-year industry veteran, chooses not to purchase any coverage, Connell notes. Contrary to the experience of some other advisors, when Connell made a survey of coverage available on the open market last year, he found that in a few cases he could actually purchase coverage for slightly less than he was currently paying.

He says about the only thing advisors can count on regarding E&O coverage is that every year it’s going to cost a little more than it did the year before. “I don’t know of anyone who’s had to file a claim on their policy, but every year when it’s coming up for renewal, you wonder what’s it going to be,” he says. “You’re just expecting it to go up.”

Connell has also found that advisors need to compare different policies very carefully to see that similar coverage is offered when assessing premium cost. For many advisors, a big issue is whether or not they are covered for errors and omissions in alternative investments. The answer can vary from policy to policy, but it appears that hedge funds are an area that many carriers want to scrupulously avoid.

Why No Discounts?

Todd L. Jones, a financial advisor and VP of Captrust Financial Advisors, headquartered in Raleigh, North Carolina, says his company, which specializes in retirement plans and manages more than $12 billion in assets, hasn’t had any problems getting E&O coverage. He suspects, however, that the dually registered firm may be paying too much for its coverage and wonders why E&O providers don’t offer the equivalent of a “safe-driver discount” for advisors who have systems and procedures in place to minimize errors and omissions and who have longstanding records with no “accidents.”

“It’s like taxes,” explains Johnson of how he views the insurance. “There’s no way around it, but in the same way you don’t want to pay more taxes than you have to, you don’t want to pay any more for insurance, either. If you’ve got systems and safeguards in place to ensure that you’re serving your clients to the best of your ability and you’ve minimized the likelihood of errors or omissions by your staff, you hate to overpay for the insurance or to be underwritten the same way as somebody who hasn’t gone to the same lengths.

“We’ve been fortunate: We’ve never had a complaint with any of our advisors, and we’re going on 16 years,” he adds.

Just how the underwriters arrive at their risk assessment is a mystery to Johnson and most other advisors. “To my knowledge there’s not a good system for identifying who is high risk and which firms are low risk in that regard,” says Johnson with frustration. “At least I’ve never had anyone knock on our door and say, ‘This year, because you’ve done such a good job, we’re going to reduce your premiums.’

“We’ve never had anyone ask questions about this stuff. We spent a great deal of money and other resources implementing a CRM system that helps to document client interactions, that ensures a workflow throughout our organization that delivers a consistent experience to all our clients. If someone has that, they’ve got clean U4s, a good track record without any complains, they’ve got adequate client safeguards in place, and then a systematic and consistent approach to handling client interactions, you’d think that would bode well for reducing risk.”

Connell agrees. “It seems that it’s a lot like other property and casualty insurance out there, everybody gets hit, no matter how many people are actually doing anything wrong,” he says. “If you get a life insurance policy and you’re young and physically fit you’ll get a lower rate than someone who’s 60 and been smoking four or five packs a day and has a history of heart disease. Those types of policies are individually underwritten, but it seems like E&O really isn’t. They basically look at the industry as a whole and it goes up for everyone.”

“How they do the underwriting is a real black box,” adds planner Kirchenbauer, who hasn’t had to make an E&O claim in her 19 years in the business, either with her previous broker/dealer or as an independent. “They ask you about your business and then sort of hold their thumb up in the air and go, ‘We think the premium’s X.’ This continues to not be the greatest situation, and I know there are advisors who are going without coverage, but I just wasn’t comfortable with that.”

To sum up the advisory community’s position on the insurance issue, Connell simply points to the name–errors and omissions. “At some point you have to ask, ‘Am I perfect?’ We’re all people and we all make mistakes some time,” he says. “We have a good relationship with our clients and we let them know we’re not infallible. We live in an imperfect world and mistakes happen. I’m glad we have [E&O insurance]. You have to recognize that it’s a good thing.”

Managing editor Robert F. Keane can be reached at [email protected].


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