Consider this train of events: A producer tells a client that he will “shop the market” and “get the best deal” for a guaranteed universal life product. After comparing annual premiums for two policies, one from company ‘A’ priced at $98,000 and a second from company ‘B’ priced at $110,000, the producer recommends buying the first.
Weeks after signing the insurance contract, the client alleges the producer engaged in bid-rigging because company B’s policy could have been configured with a $94,000 annual premium using a term rider. A district court agrees, and then slaps the producer with a $50,000 fine–all of which has to be paid out of pocket because the producer’s errors and omissions policy excludes coverage for bid-rigging.
Sounds far-fetched? Think again. The chances of producers getting personally hit with stiff financial penalties or other sanctions stemming from securities violations are increasing, according to Larry Rybka, president of Valmark Securities, Akron, Ohio. Rybka detailed the threats facing independent producers and brokers during a session here of the Association for Advanced Life Underwriting’s annual conference.
“The stakes are high,” said Rybka. “Knowing what transactions are governed by securities regulations can mean the difference between earning a livelihood and loss of net worth because of NASD violations not protected by E&O policies.”
The minefield of uninsurable violations, he added, is growing because of a convergence of trends. Chief among these is heightened federal oversight of the insurance industry because of NASD notices and court rulings that now view certain arrangements–non-recourse financing of life insurance policies, life settlements and the sale of equity-indexed annuities–as securities transactions. Rybka also cited an expanding list of producer and broker actions that E&O policies will no longer cover and a failure among broker-dealers to keep pace with changes in securities laws.
The greatest “mortal sin” that a producer or broker can commit, said Rybka, is “selling away,” to wit: selling a product that one’s broker-dealer has not approved. Doing so can result in suspension or revocation of one’s securities license and/or life insurance license, an NASD investigation, public notice of penalty, and the advisor’s personal liability to investors.
The chances of producers running afoul of their broker-dealer have increased in the wake of NASD Notice 05-50, said Rybka. The ruling extends the association’s oversight to equity-indexed annuities as securities. The notice also makes binding on producers their broker-dealer’s policy with respect to such products.
Rybka added that Notice 05-50 has created a “catch-22.” He described a scenario in which a wholesaler tells a producer that non-NASD-compliant sales materials can be used for promoting a product that the Securities and Exchange Commission hasn’t yet declared a security. Later, the product’s buyer sues when the promised benefits don’t materialize due to poor disclosure on the absence of dividends, disclosure that would otherwise have been mandated by the NASD.
Recent court rulings have contributed to the extension of securities regulations governing insurance transactions. Rybka cited a landmark case in which the SEC brought suit against Life Partners, alleging the firm defrauded investors of more than $1 billion through the sale of life settlements that turned sour. Last year, the 11th Circuit Court of Appeals agreed, holding that “investments in viatical and [life] settlement contracts are investment contracts within the meaning of the Securities Acts of 1933 and 1934.”
Since then, government regulators have ratcheted up oversight of the arrangements, Rybka noted. In March 2006, New York Attorney General Eliot Spitzer issued subpoenas seeking information on life settlement practices. And the NASD gave notice in March that it is considering regulation of the transactions.
“The bottom line is that producers are almost always functioning as brokers in these transactions, as they’re seeking a party that will pay the highest price for the policy to be sold,” said Rybka. “This is a line of business where producers need to exercise extreme caution.”
To that end, Rybka suggested that producers seek the opinion of the client’s outside counsel when dealing with NASD-listed transactions. They should also disclose additional details respecting the proposed sale (e.g., the settlement companies with which the producer has established relationships and the reason for selecting a particular buyer). And they should determine whether their E&O policy covers the transaction.
Life settlements notwithstanding, E&O policies aren’t as attractive as they used to be, Rybka said, observing that policies from the four remaining E&O insurers carry lower coverage limits and higher premiums than in years past. Some broker-dealers and producers, he noted, are unable to get coverage. The policies also entail new exclusions.
For example, they won’t pay for “fines or penalties imposed by law or regulation or self-regulatory agencies,” such as the NASD and SEC. Nor will the policies cover “sums that are deemed uninsurable under state law,” such as penalties and punitive damages.
Additionally excluded from policies, Rybka observed, are claims “arising from or contributed to by activities through which the insured gained any profit or advantage” to which he or she wasn’t legally entitled. These activities include paying or receiving commissions without a license, insurance fraud, bid-rigging, ‘wet ink transactions’ and rebating.
The last may encompass non-recourse premium financing, an arrangement through which a bank finances a client’s premium payments for two years, after which the client can retain, transfer or sell the policy. Rybka said the arrangement’s key attractions for the client–the offer of free insurance for two years and the prospect of securing a portion of the cash value upon the sale of the policy to a settlement company–may constitute rebating.
Also now excluded from E&O policies are claims involving the use of confidential information not authorized by the insured. Rybka cited the example of a producer who learned about a client’s income through an accountant who failed to first get the client’s approval for the disclosure.
Likewise, producers may be without coverage if they fail to disclose to the client how they’re compensated or if they don’t make clear in what capacity they’re serving the client, be it as agent, broker or registered investment advisor.
Also in the fine print, exclusions: for actual or alleged price-fixing, price discrimination, unfair trade or anti-competitive conduct; claims arising from alleged tax advice, except where such advice is accompanied by a written disclaimer advising the client to seek counsel from a tax professional; and claims arising from placement of coverage with a multiple employer welfare benefit plan, such as a 419 plan.
How can advisors best deal with all the new pitfalls? The first course of action, said Rybka, should be obvious, if not altogether exciting.
“It’s boring, but it’s important that advisors carefully read through their E&O policy exclusions–all 10 or 15 pages worth. Their livelihood may depend on it. Also, they’ve got to review with clients their expectations, particularly as they relate to brochures, websites and letters.
“I also advise drafting an engagement agreement for every client,” he added. “Producers and brokers also need to carefully coordinate–in writing–with their broker-dealer on offerings.”