E & Oh, No: The Coverage Is Expensive And Often Inadequate, But It’s Good To Have In A Bleak Market.

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May 1, 2008

1916 words

E & Oh, No: The Coverage Is Expensive And Often Inadequate, But It's Good To Have In A Bleak Market.

Dave Lindorff

IT'S YOUR WORST NIGHTMARE: You've been invited to dinner at the home of a client who has become a friend over the years. You are -sitting in the living room having after-dinner drinks and the client says, "By the way, you'll be getting served with a lawsuit on Monday, but don't worry. You're insured." Sound improbable? Perhaps. But this actually happened to an advisor who was a client of Bud Bigelow, president of Cambridge Alliance, an insurer in Burlington, Vt., that sells errors and omissions insurance.

Errors and omissions (E&O) insurance is the must-have policy for financial professionals. But many planners don't have it because of a combination of cost and coverage problems. Even those who do have insurance often find that E&O covers a lot less than they thought. If you have a policy, you might want to check it; and if you don't, perhaps you should reconsider. But you may need help with shopping.

GOING BARE

Industry participants estimate that anywhere between 40% and 80% of financial advisors, mostly in small or solo practices, lack coverage. One reason may be that the cost of E&O has risen along with the increase in regulation. Basic coverage for up to $1 million in claims and defense costs for an individual planner can run anywhere from $1,500 to more than $7,000 per year, depending on the terms and exclusions of the policy. Deductibles start at as much as $30,000.

"The battle everyone faces is that E&O insurance seems awfully expensive. The insurance seems like something you'll never need-and seems as if it won't cover what you really need," says Nancy Hradsky, director for special projects at the National Association of Personal Financial Advisors (NAPFA).

Lisa Roth, president and CEO of ComplianceMAX, a San Diego-based compliance firm that supplies consulting and technology services to the financial advisory industry, says that today, smaller independent firms face more than $10,000 a year in premiums for bare-minimum coverage. "The industry just hasn't found a policy it can embrace," she says. "I don't know if I'll renew next year."

Indeed, a primary reason that -advisors do get the insurance is for the sake of their clients. Broker--dealers and larger firms consider E&O a cost of doing business. "We feel very strongly that E&O -coverage is critical, both for the rep and for the client," says Karl Lindberg, president and CEO of broker- dealer ING Financial Partners, one of ING's four broker-dealer -operations. "You wouldn't want a doctor -operating on you who didn't have malpractice insurance. You'd wonder whether he or she couldn't qualify." Besides, he adds, "even a frivolous claim can cost upward of $40,000 to defend, and a large claim could wipe you out."

Larger financial advisory firms such as Mosaic Financial Partners in San Francisco, with its 16-member staff, or Pinnacle Advisory Group, in Columbia, Md., with 24 people, generally provide or require coverage for their employees.

"We wouldn't dream of running a multimillion dollar management shop without E&O in place," says Pinnacle Director of Financial Planning Michael Kitces. "We have never had to file a claim, so it feels very expensive. But if nothing else, we have some clients who require us to have it."

Mosaic's Norman Boone admits that "it's highly unlikely we'd ever need it, and I suppose we could consider going bare, but it's like fire insurance. It's for unanticipated problems."

E&O insurance is so named because the policies specifically do not include claims that are based on fraud. This can be a nail-biter, since when clients do bring a claim against their advisor, they typically allege fraud, whether or not it actually took place. Only when a fraud charge is tossed out in a settlement or is rejected by arbitrators will an insurance carrier make good on the claim.

Mark Brumley, E&O program manager at Raymond James, reports that the majority of claims he sees involve allegations of misrepresentation or suitability issues. Claims are most commonly filed over mutual funds and stocks, although he says variable annuities are increasingly a source of claims. Trading errors are another common cause.

But when markets are down, the number of claims rises. "You can actually graph it," says John E. Iannotti, executive vice president of AIG's financial institutions group's liability unit.

HOLEY COVERAGE

And when advisors need their E&O most, they may find that the insurance itself is problematic. "The real issue is not cost," Lindberg says. "It's coverage, because a lot of E&O plans have a lot of exclusions. Many financial advisors don't find out about the holes in their coverage until they have a claim filed against them." Compliance Max's Roth concurs. "The typical E&O policy will be a couple of pages long, with another 10 pages of definitions and exclusions," she says.

Norman Arnoff, an attorney with Registered Representatives Arbitration Defense Association (RRADA) in Garden City, N.Y., relates the case of an advisor whom he represents. In 2005, clients brought a case to arbitration, charging him with churning, unsuitability of investments and unauthorized activity in their retirement accounts. Luckily, the advisor had purchased E&O insurance for $2,500 a year earlier. Not so lucky, the carrier claimed that some of the disputed problems dated to a prior financial advisor the clients had worked with.

The insurer wouldn't let its house lawyer defend on those issues. But when the advisor hired his own counsel, as his policy allowed, the carrier said it wouldn't cover that attorney's higher hourly rate, Arnoff says. In addition, the carrier limited payments to the actual time an expert witness was on the stand, and did not cover prep time or time spent listening to the plaintiff's counter-expert.

Ultimately, the arbitrator awarded the plaintiffs $88,000. The carrier is refusing to cover the advisor's $100,000 defense bill. That case is currently in court.

With coverage like this, who needs enemies? "The reality of the marketplace is that the insurance company is not your friend, nor is it on your side," says Pinnacle's Kitces. "It's a business that has to cover your problem. People need to bear that in mind. Classically, the complaint about E&O insurance is that the companies are willing to settle claims when the financial advisor wants to fight and be vindicated. Settling can be cost-effective for the insurer, but it can ruin an advisor's career.

BE FOREWARNED

So what are the typical exclusions advisors should know about? Start with fraud. Financial advisors who are mired in arbitration can also find themselves engaged in a legal battle with their insurance carrier over whether there was fraud. "If clients lose money, some of them will throw everything against the wall and see what sticks, including a charge of fraud against the advisor," Arnoff says. "Fraud is always excluded from E&O policies."

Since the terms of arbitration awards tend to be somewhat vague and ambiguous, carriers themselves will often claim a finding of fraud to avoid having to cover the award, Arnoff asserts. Even without such disputes, he says, a typical arbitration will cost about $30,000 to $75,000 in litigation expenses.

A MATTER OF TIMING

Then there is the problem of when the claim is filed, explains Andrew Fotopulos, executive vice president of Theodore Liftman Insurance, an independent insurance broker based in Boston. Ideally, advisors would correct any mistakes before they even come to the client's attention, if possible, and turn to their E&O carrier to compensate them in case of a serious expense.

"Usually advisors discover a trading error or some other error-say too few shares traded or perhaps a trade that was done later than the client ordered-before the client knows about it, and they like to take care of such problems before the client finds out," says Fotopulos. "But with most carriers, you have to have a written claim from the client first, which means they have to be told about it."

Then too, in a kind of Catch-22, it could be deemed inappropriate for a financial advisor to get involved in urging the client to file a written claim or in discussing the amount of such a claim.

"You need to look at the policies carefully," AIG's Iannotti warns. "Many are claims-based. It's much better to have a policy that kicks in when you discover a mistake."

And most E&O policies exclude all but the most plain-vanilla investments. Options, futures, commodities, hedge funds, private equity, collectibles and real estate are excluded. "We won't write alternative investment policies," says Cambridge Alliance's Bigelow. "We only cover investments that are liquid, regulated and followed by the financial community."

Fotopulos advises planners to pay attention to a policy's definition of "professional services," because some services, such as divorce planning, are often left out. Iannotti says that AIG's E&O policies will sometimes cover alternative investments-for a price. "It's a subject for negotiation," he says. "Of course if we agree to cover a certain product, it will affect the premium."

"Hammer clauses" are another potential trap in many E&O policies. These state that if the insured refuses a settlement offer, and the arbitration judgment later exceeds the settlement offer, the insurer will not be liable for the difference.

GET GOOD ADVICE

Because E&O insurance is so rife with potential problems, experts say you should find an advocate to help you purchase it, such as a knowledgeable lawyer or an independent insurance broker. "There is a lot of room for negotiation regarding the exclusions in E&O policies," says Fotopulos, himself an independent broker, who is recommended by NAPFA. "Financial advisors need to pay special attention to the 'definitions.'"

RRADA's Arnoff goes much further, calling for a cleanup of the industry, so that ambiguity and denial of coverage doesn't occur so often. "E&O insurance could serve a great purpose," he says. "Just as homeowner insurers have helped to keep homes safe by insisting on safety standards in houses they insure, E&O insurers could improve financial management by doing risk management, reviewing procedures and practices and so on." RRADA is a professional organization that, for $125 per month, offers members legal assistance in negotiating their E&O policy terms and full legal coverage with no deductible for arbitration cases-and for cases involving disputes with the insurer about coverage.

The best solution to dealing with E&O insurance may well be to work carefully to avoid claims-particularly as several claims in a year could lead to cancellation of a policy.

The key to that, says Chris Meecham of Cornerstone Capital, based in San Diego and Mesa, Ariz., is to be open and direct in dealing with clients. "If you make some kind of a mistake, you need to tell your client right away," he advises. "In our business we are involved with every aspect of the financial affairs of our clients. There is a relationship of trust. That means when there's a problem, the client doesn't just come after you. It's not like we're just a broker."

Dave Lindorff is an award-winning investigative reporter, who has written for Business Week, Rolling Stone, The Nation, The New York Times, Village Voice and other major publications. He is the author of several books on politics. He lives in New York City. (c) 2007 Financial Planning and SourceMedia, Inc. All Rights Reserved. http://www.Financial-Planning.com http://www.sourcemedia.com

May 1, 2008