SHARP RISE IN SECURITIES LITIGATION MAKES E&O UNDERWRITERS JITTERY

Both fee-for-service and commission-based advisors pay more for less coverage

In the 18 years that Joseph J. Janiczek of Greenwood Village, Colorado, has been an independent fee-for-service financial advisor, he has never had a claim against his errors or omissions policy. Nevertheless, last year the premium on his errors & omissions (E&O) insurance doubled.

Janiczek and thousands of other financial professionals who advise individuals and institutions on how to invest their assets have been caught in a "perfect storm" with respect to E&O. The worst bear market in decades, an economic recession, a "hard market" insurance cycle and a plethora of headline risks converged to raise premiums and deductibles, lower policy limits and make coverage more restrictive.

Although the stock market rebounded last year and the economy has begun to recover, headline risk remains a concern. "For a while it looked like [the market] would calm down and level out, but because of recent corporate governance and mutual fund scandals it now appears that it's not going to soften," says Erica Martinson, a major account risk manager with The Rollins Agency, Inc., a Tuckahoe, New York-based insurance broker.

In addition to higher prices, financial firms and their insurance brokers must contend with lower coverage limits and higher deductibles, she points out. Whereas before she could purchase a $10 million policy for an investment advisor client, on renewal she had to layer the coverage, buying a $5 million primary policy and $5 million of excess coverage.

E&O is "probably one of the hardest lines left," says Christopher Winans, senior property/casualty insurance analyst with Lehman Brothers. Rates continue to rise, albeit at a slowing pace, and terms and conditions remain tight, he notes.

Lou Stanasolovich, president and CEO of Pittsburgh-based Legend Financial Advisors, says he was able to obtain only a $1 million aggregate limit on renewal while the firm's prior policy provided $3 million of aggregate liability coverage. Legend had to find a new carrier after Shand Morahan withdrew from the market. "The new coverage came in higher and it's not as good for the premium paid," he says.

Squeezing the little guy

"Many of the markets that previously offered affordable premiums have raised rates to where they are no longer affordable for small advisors," says Bayard "Bud" Bigelow, president of Cambridge Alliance, a Burlington, Vermont, E&O managing general agency that underwrites policies on behalf of First Specialty Insurance Corp. "It's a signal that they only want large advisors."

For example, in the broker/dealer category, AIG, the predominant underwriter, no longer writes policies that generate less than $75,000 in annual premium. It would take too long-75 years of premium payments-to recoup payout in a $1 million award against a small policyholder, explains John Iannotti, executive vice president of AIG's National Union unit, a financial services E&O underwriter.

Underwriters like Iannotti have reason for alarm. Since the stock market peaked in March 2000, claims against broker-dealers have risen sharply. According to NASD Dispute Resolution, a unit of the National Association of Securities Dealers that handles arbitrations and mediations in cases against broker-dealers, cases presented for arbitration rose from 5,558 in 2000 to 8,945 in 2003, a 61% increase. The amounts paid out rose 113% during that time, from $76 million in 2000 to $162 million in 2003.

"A bear market means more claims," says Andrew Fotopulos, executive vice president of Theodore Liftman Insurance, Inc., a Bostonbased insurance broker and E&O managing general agent. In a rising market, trading errors could be corrected with the investor never knowing what happened, he explains. But when the market goes down these things get uncovered.

Costly mistakes

E&O claims generally fall into three categories: execution errors, suitability, and fraud, according to Bigelow. Execution errors, which typically result from trading mistakes, are the most prevalent kind, he adds. "They settle quickly, with minimal defense cost, usually for the amount of the loss."

However, cost of correction coverage is no longer universally available, Fotopulos points out. Some carriers now make this a separate endorsement while others have eliminated it altogether. "Most carriers work closely with clients on these claims because it's cheaper to fix them than to fight them," he says. "But, those who have pulled back on the endorsement say they want to prevent it from being misused."

At the other extreme are fraudderived claims, which insurers won't cover, except for defense costs if the policy includes a "duty to defend" provision. "These claims are scarce, but they're costly," says Bigelow.

However, suitability claims, e.g., "putting the little old lady in tennis shoes in Internet stocks," are increasing at an "alarming pace," he notes. "It's hard to make a [suitability] claim, but it's also hard to defend and expensive to defend. They tend to drag on and usually settle at around 50 cents on the dollar."

Suitability claims often trigger other kinds of complaints, including breach of fiduciary duty, failure to supervise, and misrepresentation. At NASD Dispute Resolution, which tracks 10 different causes cited in complaints against brokers, the ratio of the number of causes cited to the number of arbitration cases filed has risen from 1.78 in 2000 to 2.51 in 2003. Over this period, unsuitability complaints rose by 255%.

Fee vs. commission

While the NASD statistics measure activity among broker-dealers, are the trends they measure applicable to other kinds of financial professionals? Fee-for-service advisors like Janiczek and Stanasolovich, both of whose practices target high net worth individuals, i.e., $1 million or more in assets, contend they are being unfairly lumped in with insurance agents, stock brokers and other advisors whose earnings are commission based.

"Firms like ours, fee-only Registered Investment Advisors, have less potential for conflicts of interest," argues Janiczek. Stockbrokers and insurance agents are more likely to be conflicted because of sales practices rather than advisory practices, he says.

To reduce exposure to suitability claims, Stanasolovich's Legend Financial two years ago began writing investment policy statements for each client. The document specifies what kinds of investment will be made, what kinds of underlying securities would be bought, and what the investment objectives would be over a specific timeframe.

"While we had an investment policy statement in our contract, this is one more area of documentation that explains what we were doing in case a problem occurs," he says.

"Client engagement agreements with very strict wording we believe will help us avoid frivolous lawsuits," adds Janiczek of Janiczek & Co., Ltd. "If we do the proper financial analysis with proper guidelines and strategies, we can control much of our risk."

Document everything

"Everything in the client relationship should be documented," recommends Bigelow of Cambridge Alliance. Other steps he suggests to avoid litigation include confirming every trade, avoiding trouble-maker clients and staying away from alternative investments including hedge funds, limited partnerships, derivatives and private placements.

"Be careful who you do business with," he says. "If you don't like what you hear from a client, don't take thorn on." He specifically recommends avoiding people looking to invest the proceeds of a large lawsuit settlement, "high maintenance" clients and people going through a major life change such as a divorce, loss of job or closing of a business.

As for alternative investments, "They're poison," he says. "They're illiquid, unregulated and they provide minimal information." Cambridge's policies exclude these products because most of its clients cannot do the necessary due diligence on them.

Erica Martinson's clients recently conducted risk analyses to measure their exposure to issues identified in the mutual fund scandals. She is including the findings of these studies in submissions to E&O underwriters. "We want to position clients in the best possible light and proactively address concerns that underwriters might have up front," she says. Whether a client does only what is necessary to pass regulatory muster or is truly committed to risk management and loss control can "truly make a difference in how an underwriter looks at a company."

Copyright Rough Notes Co., Inc. Apr 2004
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