Buyer Beware!
Brian Francetich of Golsan Scruggs (GS) in Portland, Oregon, has worked for more than a decade as a matchmaker between registered investment advisers (RIAs) and errors and omissions (E&O) insurance carriers.
GS works with nearly 1,000 RIA clients, many of them 401(k) plan specialists. Francetich, director of GS RIA and managing underwriter, stresses that his firm is not an insurance carrier, but an independent brokerage agent placing business with skilled providers in this space.
In a phrase, Francetich says RIAs’ understanding of the nuances of E&O policies is lacking. Likewise, he says, generalist risk experts at the major insurance companies do not necessarily know much about advisory firms or the provision of securities to retirement plans. As one would expect, this can cause confusion and the occasional point of friction for retirement plan advisers who are shopping for an E&O policy.
“The typical contract may be 60 pages or more of granular detail, so it’s always going to be challenging to shop for E&O policies—even for people with a lot of experience,” he says. “Even if you have read the whole contract, it’s going to be hard to understand everything that’s contained or implicated in the document.”
In basic terms, E&O coverage can be drawn upon to help defend a firm against: claims for actual or alleged mistakes or misconduct; claims or suits alleging staff imprudence or disloyalty during operations; claims alleging failures to accurately assess client suitability; claims related to not meeting client expectations; and claims relating to other potential liabilities imposed under the Investment Advisers Act of 1940.
According to Francetich, RIAs will be best served by contracting with one of the seven or eight leading providers of E&O insurance for advisers.
“More and more insurers have moved into this space,” he notes. “As a result, there are some providers with much less experience than others. We see some firms insuring RIAs in what we think are unsuitable ways, for example trying to do E&O-type coverage under miscellaneous professional liability forms. Some are using bankers’ professional liability forms, and some are even using tax preparer insurance forms.”
He says this is like trying to use a hammer when a screwdriver is the right tool.
“The core providers have built specific coverage forms designed around the Investment Advisers Act—that’s the center of the coverage and they build out from there,” Francetich explains. “This approach is the soundest legal basis for insuring RIAs, in our view.”
Be Ready to Shop for Insurance
Asked what simple tips or advice could help retirement plan advisers start the process of shopping for an E&O policy, Francetich says it will sound much like the common advice firms hear when looking to professionalize their practice.
“You need to be able to demonstrate that you have a culture of compliance that’s built around firmly established best practices,” he says. “You need to show that you have sound policies and procedures, and you also need to be able to show that you are actually effectuating these policies and procedures.
Also very important is demonstration of the scope and scale of service. Much of the time, this is in the advisory agreements, but it might not be very clear or intelligible from the perspective of the whole RIA business. You need a very clear outline of what services you will provide and won’t provide for clients.”
For firms that have had recent claims against their existing E&O policies, this will make the shopping experience more challenging—particularly if there are multiple claims and if any are still open.
“We occasionally see situations where a client with open claims goes to shop around and realizes the economics of a risk transfer aren’t going to make sense at this juncture,” Francetich observes. “Usually you can find someone that will offer you a policy, but it’s a question of cost and coverage quality.”
In this sense, Francetich says the E&O insurance market for RIAs is like the Wild West.
“Because the Insurance Services Office has not created a standard coverage form, you’ll see a huge amount of diversity in the policies offered,” he says. “You’ll see policies issued at very high premiums that, in the fine print, carve out some of the key coverage areas. There is a very open ability to do this.”
It is vital for advisers to understand that there are two sub-markets of providers. First are carriers that are “admitted,” meaning they have to adhere to oversight from the state insurance regulators. Then there are “non-admitted” insurers; this second group has essentially free rein to write whatever they want into their policies.
“In this non-admitted space, it is truly ‘buyer beware,’” Francetich says. “You could buy a policy that excludes 90% of what you do as a retirement plan adviser or wealth manager. I’ve actually run into those types of policies before.”
Steps to Analyze E&O Policies
According to commentary from RIA in a Box, which provides compliance solutions for investment advisers, RIA firms are not actually always required, from a regulatory standpoint, to secure errors and omissions insurance. But in its role as an RIA registration and compliance solutions provider, the firm strongly recommends that investment advisers secure adequate E&O insurance coverage.
In an introductory guide published on its website, the firm warns that any RIA firm that does not have proper E&O insurance coverage is exposing itself to serious business risk.
One of the first and most obvious areas to look at with any potential policy will be the annual premium, RIA in a Box writes.
“Just like other forms of insurance, higher levels of complexity, risk and coverage limits will lead to a higher annual premium cost,” says the guide. “In the investment adviser industry, you’ll often see higher premiums for advisory firms that utilize alternative investments, have past regulatory disclosure issues, or have relatively inexperienced principals who are the new to the industry.”
Next and just as important as considering cost is reviewing, in very fine detail, the real coverage limits coded into the potential contract.
“It is important to note that there may be separate limits for an alleged act, all acts combined (aggregate), or for the overall master policy,” the guide says. “There are a wide range of coverage limits. The higher the coverage limit, the greater the premium cost.”
The deductible also must be carefully considered. Just as in health insurance or automobile insurance, this is the amount of money the investment advisory firm will pay out of pocket before the E&O policy kicks in. Naturally, the lower the deductible, the greater the premium cost.
After the review, the adviser should consider the interplay of master policies vs. individual policies, the guide says.
“Often, an investment advisory firm can save money on errors and omissions coverage by joining a master policy,” RIA in a Box suggests. “A master policy combines multiple firms under one policy. Generally, these master policies will have a total master policy annual coverage limit. If the master policy coverage limit is reached, other pooled firms may not have access to protection.”
The firm recommends advisers perform “a high level of diligence to [clarify] whether a policy is for the individual firm or part of a larger risk-sharing pool.”
Finally, but far from exhaustively, the firm says RIAs should carefully review any contracted exclusions.
“Unfortunately, many professional liability insurance plans have a laundry list of exclusions. Be sure to review the full list when comparing plans to see what differences may exist,” the firm writes.
Art by Zack Rosebrugh