Selecting Limits of Liability
We are often asked what limits of liability are appropriate for a practice. As underwriters, we always recommend that you select the highest limit of liability the underwriter will offer and that you can afford.
Here are a few questions that may help you to understand how limits of liability work in the insurance policy and whether your practices falls on the higher or lower end of the exposure spectrum.
1. What is your insurance objective and how risk averse are you? Do you want to have a low deductible on your E & O so that you transfer more financial risk to the insurance company in the event of claim? Are you more interested in having the E & O for the unforeseen catastrophic claims? If you are not worried about the smaller claims and are willing to assume more financial risk and transfer less risk to the insurer by electing a higher deductible, you receive a premium credit. Make sure to check the premium savings between deductibles to see if the credit you receive for taking a higher deductible really compensates you for the additional risk you assume. In the event of a claim, you will be asked to write a check in the amount of the deductible to the insurance carrier.
2. In what state are you located and in what states are your clients located? How litigious are these states? Ask your attorney.
3. Know that whatever limit you choose, it is REDUCED by the amounts spent by the insurance company in defending you. It’s not unusual that 50% or more of all loss dollar spent can be used up on defense costs.
4. What services do you render? Fee only financial planning presents a lower exposure than discretionary asset management. Discretionary asset management using no loads presents a lower exposure than that using listed stocks. Do you sell commissioned products – are they mainstream products or alternative products?
5. Who are your clients and where do they come from? High net worth or middle income? Known or referred to you or cold calls? For practices concentrated in retired clients, do the potential heirs agree with the client’s objectives or will they have a different opinion of your services after the client’s death?
6. If you are managing assets, do you have a common security running across portfolios that might lead to multiple claims from different clients if the security gets in trouble? Clients rarely sue for the entire amount of the portfolio. Claims generally center around one type of investment. Another type of claim is “peak to trough”. The client calculates the demand as the difference between the portfolio value at the height of the bull market less the current low of the bear market.
7. Select your clients carefully. Do you have clients that do not elect to follow the recommendations you have made which are necessary steps to achieving their goals? If so, and you elect to continue to serve as advisor, you have a much higher exposure to loss. Are you considering a prospective client that walks in the door with a preset, and often unrealistic, return expectation that can only be achieved by very aggressive portfolio techniques? If so, you may wish to consider declining such a client.
8. If you personally have a high net worth, are you concerned about whether the veil can be pierced placing your personal assets at risk? Check with your attorney for the laws in your state. If you are a registered representative you have a much greater risk of being personally liable for the loss regardless of whether you have formed a corporate entity.
9. Do you act in multiple capacities to the client? Are you doing accounting work as a CPA and investment advisory work as an RIA for the same client? If so, the client will regard you with a higher degree of trust and will have high expectations for the standard of care. Do you have ERISA clients? If so the standard of care required is higher and the Department of Labor regulations are far reaching. These clients present a higher degree of exposure.
10. Are you in regulatory compliance with the state and federal requirements? Is your ADV up to date? Are your fees correctly stated? Is your practice accurately disclosed in your Form ADV and client contracts? If not, you have a higher degree of exposure since misunderstandings over these issues can lead to suits for misrepresentation.
11. Have you checked your marketing materials carefully to determine what standard of care you are establishing in the client’s mind? Are you holding forth as “experts”? Do you use words of totality like “always” or “never”? If you do, you have created an impression in the client’s mind of an increased standard of care that can be used against you in a claim.
12. How does your fee structure compare to the marketplace? If you are higher than the norm-can you demonstrate why to the client? How many fee disputes have you had and how are they resolved? Unresolved fee disputes often lead to lawsuits because the client is so upset over the unresolved or poorly resolved fee dispute they go looking for “errors” the advisor has made in the rendering of services. This can lead to allegations of breach of fiduciary duty.
13. Talk to your insurance broker – what insight can they give you in their experience in your state or in the professional liability line of insurance?
14. At this time, approximately 60% of our policyholders carry limits of $1,000,000 per claim and $2,000,000 in the aggregate.
15. Are you worried about one big claim or a series of interrelated claims that would result in one per claim limit being applied to the loss? Severity (the largeness of one claim) argues to a higher per claim limit. If are you concerned about several unrelated claims made and reported during an annual policy period (frequency) this would argue to a higher aggregate limit.
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Are There Differences Among Policies?
We have been managing the same E&O professional ility program for RIA’s for more than ten years. That’s ten years of phone calls, letters, requests for clarification and, in general, a significant amount of misunderstanding and confusion about what E&O insurance is all about. We also speak a lot, and will typically field a wide variety of questions from the audience. Whether by phone, in person, through correspondence, or from an audience, the questions don’t vary a lot — they underscore just how broad the level of misunderstanding really is. Lacking understanding, many advisors will rely upon the “school yard” as their primary source of information. In short, there is a crying need to shine light into the darkness.
The E&O professional liability polices available for financial advisors are not commodities, unlike other policies such as private passenger automobile, homeowners insurance and many commercial policies. The professional trying to evaluate various policies, therefore, needs a working understanding of their terms and conditions.
An insurance product is complex and technical – even the shortest policy will take 15 or more pages and thousands of words to define the conditions under which coverage may, or may not, apply. While it is unlikely that the layman will be able to understand all of the nuances of coverage, it is possible to evaluate the appropriateness of different policies and insurance programs. This article will attempt to do precisely that — wish us luck, as it is a tall order. Please note that this article addresses basic concepts of E&O policies, and the law in a particular state may be applied differently.
We all know one of life’s unwritten rules — for every benefit there is an offsetting price to be paid. In other words, there really and truly is “no free lunch”, also known as “The NFL Rule”.
As the NFL Rule applies in this case, all or nearly all E&O policies available for Financial Advisors are written in an unregulated market. This is the market of choice because the profession is highly fractured and complex. Accordingly, any insurance product must meet the needs of a variety of different types of practices. Only in the unregulated market can coverage terms be tailored as circumstances dictate.
Equally this also means that an E&O insurer can legitimately offer policy terms and conditions which simply would not pass muster in the regulated markets. For that matter, it can also change policy terms and conditions from one renewal to the next without having to disclose to policyholders what has changed.
Defense Provisions
Although it is not generally recognized outside of the insurance industry, it is typical for an insurer to pay, on average, at least as much for the defense of claims as is paid in damages to claimants. In other words, the defense provisions of the policy are a critical part of the overall insurance policy.
There are two clauses commonly used in E&O policies. Under the first, the insurer has ?the right and duty to defend?. Under the second, the insurer has only ?the right but not the duty to defend?. What is the difference between these innocent sounding words “right and duty” as compared with “right but not the duty”? (Right about now might be a good time to ?get smart? about ?duty to defend?. Type in the phrase ?duty to defend?, quotes included, into any of the general internet search engines and browse through what pops up ? it will be a real eye-opener when you see the body of case law defining the extent of the duty to defend.) Here’s where we go “techie” on you.
Under a right and duty to defend policy, the carrier is required to provide a defense if only a single allegation potentially brings the case within the scope of coverage. Alternatively, if a claim alleges only acts that are excluded, the carrier will deny coverage for the entire claim.
Nonetheless, in nearly all complaints, a count of some form of ordinary negligence will be included, if only to trigger coverage for the defendant. Failing to include at least one complaint of a covered act would result in a coverage denial of the claim by the defendant’s insurer. As a result, the defendant would have no available funds, other than his or her personal assets, with which to defend the claim and / or to pay damages. Surely the defendant’s lack of a “war chest” takes all the fun out of the game for the plaintiff and his or her attorney.
But if the insurer has no such duty to defend in the first place — that is, if its policy is a ?right, but not a duty to defend? contract — the carrier may simply elect not to provide a defense. Thus, if a plaintiff alleges wrongdoing that is covered, the insurer under a ?right but not the duty to defend? policy may elect not to provide a defense, leaving the policyholder to shoulder the considerable expense of a defense lawyer. While it may be appropriate in certain types of policies (e.g. excess or ?umbrella? policies, and commercial reinsurance contracts) for the carrier not to assume the duty to defend, the advisor?s primary E&O policy should always include the insurer?s duty to defend. Anything less is simply unacceptable.
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Surviving in the Liability Jungle
In response to the question “What is it about your practice that keeps you awake at night?,” a CFP I spoke with recently replied, ”Nothing. That’s what I have insurance for.” A more accurate answer — for this particular professional — would probably have been, “That’s what I have expensive insurance for.” The better answer is, “I don’t stay awake at night because my firm scrupulously avoids high-risk situations.”
Certainly insurance offers security. But it’s no substitute for practicing defensively. And using insurance as your only safety net misses the point — dealing with a claim is typically a major drain on both emotional and financial resources to any practitioner.
Unfortunately, ways of doing business that professionals regarded as “safe” 15 years ago are, in many cases, no longer safe. Society has changed the nature of the practice. The rate of litigation, the willingness to sue and the size of awards have grown exponentially, causing insurance companies to withdraw from the professional liability markets or raise rates exponentially. Indeed, in 1986, the shrinkage of available financial capacity to provide insurance for several of the professions created the “liability crisis” we have heard so much about. Extraordinary increases in the cost of insurance, in turn, caused those who could not pass on cost increases of this magnitude to practice without insurance.
Increased regulation of the financial planning profession, imposed from within or from without, is often cited as the solution for stemming the erosion of confidence in the financial planning profession. With the infamy surrounding the more well publicized breaches of professional conduct, all professionals feel the reverberations. It is no accident that the ICFP has, for the first time in its history, actively supported the promulgation of professional standards. Yet the number of voices supporting self-regulation as an alternative to government regulation continues to grow. Self-regulation is a vastly preferable alternative to government regulation. But if self-regulation is to work, it means not only adherence to the growing number of professional standards, it also means that each practitioner must manage his or her practice with the utmost degree of professional care and follow procedures that have been proven to avoid losses. This is true because, once the profession has adopted a set of standards of professional conduct, plaintiffs will now possess established standards of professional care against which to litigate.
It is more critical today than ever before that the operating fundamentals that contribute to running a safe practice be part of your mindset as you go about managing a business. We call this concept “loss revention” or “risk management” in the insurance business. And we believe that, by looking at the nature of past claims against accountants, we can come up with increasingly better ways for practitioners to protect themselves.
Who’s Suing? Not surprisingly there are certain types of activities that attract more claims than
others. In general, these are the types of activities that have the potential to cost the client a large percentage of his or her resources. For example, a sizable corporation that looses $5,000 in its investment accounts is unlikely to sue the financial planner for not identifying the problem. An individual client who losses $5,000 very well may.
As the leading carrier providing E&O coverage for financial planners, our loss information spans some ten years of coverage. It is highly informative about the types of losses that practitioners experience, as well as those that are potentially severe.
Claims Experience. Our claims experience, which spans two carriers, is highly informative, but must be viewed with at least two caveats. These are that the experience is not statistically credible, both because of the number of claims and because of their lack of maturity; and, that the experience of carrier may not be the same as the policyholders’ experience because of contractually imposed limitations on coverage. Nevertheless, the claims experience is a very strong indicator of where the land mines are.
Message # 1 – Defense Costs Are The
Hidden Cost Of Settling Claims. Nearly all professional liability insurance policies will cover the costs of both defending and settling a claim. We therefore need to look at the costs of defending the professional, across all claims.
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Standards & the CFP Practitioner’s Exposure to Liability
As we stand at the edge of the implementation of CFP Practice standards, much concern has been expressed about the impact of these newly drafted standards. At its most extreme, the opponents of standards have asserted, sometimes in strident tones, that these very standards will result in drastic changes in the liability climate in which the profession practices. The purpose of this article is to critically examine the issue of how these standards are likely to affect the profession, as well as to examine the validity of the views of the opponents of standards.
As we look at the draft standards, the drafters, the CFP Board of Practice Standards itself, appear to acknowledge the concerns of the practitioner that the standards implemented may result in a change in the liability climate. In Standard 1, the Board of Standards notes:
Conduct inconsistent with a standard in and of itself is not intended to give rise to a cause of action nor to create any presumption that a legal duty has been breached. The standards are designed to provide CFP designees a structure for identifying and implying expectations regarding the professional practice of personal financial planning. They are not designated to be a basis for legal liability.
The Planner’s Difference. We currently represent, as National Program Manager, a program which provides E&O Insurance for financial planners and RIA’s. A number of years ago we also underwrote group E&O programs for broker / dealers. Consistently, and for several years, our claims experience for broker /dealers was considerably worse than that for financial planners.
The reasons for the differences in experience from these two similarly situated professions became clear to us with a series of claims reported in 1993. A NYSE company had filed for bankruptcy resulting from the misappropriation of funds by the officers of the Company. Within the first two weeks following the bankruptcy filing, four claims involving investments in the company were filed against four different registered reps of the same broker / dealer alleging lack of investment suitability. In no case was there a defensible assessment of the client’s investment objectives or tolerance for risk. The claims could not be easily defended because there was little apparent justification of the choice of the investment in the first place.
Three years later, long after this series of four claims had been settled, we were having a discussion with a financial planner who had also recommended this same investment to his client. He patiently explained to us the efforts to document the client’s objectives at the time that the investment had been made. He also pointed out that the client had, in the engaging documents, explicitly acknowledged the inherent risk that the client could not assume away, no matter how well or poorly an investment performed. As a result, the policyholder asserted that it was highly unlikely that a claim would be filed. No claim was ever filed. In later years we came to learn that several of our other policyholders had had a similar exposure to this same security. No other claim involving this investment was ever filed by those of our policyholders who were financial planners.
This series of claims, as well as the lack of any claims reported by those financial planners who had placed the identical investment, lead us to an important conclusion — the difference between financial planners and other similarly situated financial advisory professionals was the process of financial planning itself, together with the resultant documents identifying the client’s investment objectives, tolerance for risk and, most importantly, the meeting of the minds between professional and client. These three elements of documentation are all important when something goes wrong, as it surely always will. These same elements are the very subject of the standards soon to be implemented.
In defending a claim, the documents crucial to the providing of a defense include:
- Assessment of investment objectives;
- Assessment of client tolerance for risk; and
- File notes made contemporaneous to the alleged wrongful act
The existence of these documents, and in fact the financial planning process itself, already distinguish the financial planning professional from other financial advisory professionals. These standards serve to reflect practices already widely applied by many practitioners.
While the debate surrounding standards is far from over, we can at least hold it up to the light of day. In other words, when rational discourse breaks down, we can at least look at the facts.
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The Perils of Group Sponsored BD E&O Programs
Many broker / dealers enter into contractual arrangements with a property / casualty insurer to provide insurance protection against their negligence or that of their registered representatives. Our experience has been, however, that neither the broker / dealer itself nor its registered representatives understand the implications of the insurance decisions made by the broker / dealer. The purpose of this article is to explore those ramifications more fully.
THE RELATIONSHIP
The relationship between the broker / dealer and its registered representatives is that of principal and agent. Accordingly, it is widely held that the principal may be called upon and be held legally responsible for the acts of its agent(s). The insurance mechanism by which the principal obtains insurance for the negligent acts of its agent, however, is quite different for broker / dealers than it is for almost any of the professions. It differs in the sense that the broker / dealer will sponsor a “group” insurance program, typically requiring that all of its registered representatives purchase insurance as a condition of appointment. In many other professional arrangements of this nature including property / casualty insurers and their agents, hospitals and doctors as well as other principal / agent relationships, the principal only requires that insurance be in place, but does not require that the “agent”, broadly defined, participate in an insurance program bearing the approval of and endorsement by of the principal.
The motivation of the broker dealer to sponsor a group errors and omissions (“E&O”) insurance program is completely understandable – the broker / dealer needs assurance that its registered representatives can demonstrate financial responsibility if their mutual client presents a claim. What is typically less clear to the broker / dealer, however, is that through the act of sponsorship of the insurance program, the broker / dealer may in essence be assuming the role of the insurer of last resort if the program turns out to be inadequate to meet the needs of its registered representatives – in essence, the broker / dealer may be implicitly warranting that its sponsored insurance program is adequate.
The mechanism by which these programs are marketed only compounds the problem – the insurance broker will typically inform the insured registered representatives through an insurance brochure which, at a minimum, cannot be thought of as full disclosure; and, may turn out to be quite misleading to the registered representative.
It is typically clearly stated in the insurance contract that the broker / dealer is the “First Named Insured”. As such, the broker / dealer is responsible for payment of premium, receipt of various notices under the policy and negotiation of the very terms of the contract itself. In essence, the very wording of the contract itself as well as the relationships defined within the contract will assign responsibilities to the broker / dealer which it may well be ill equipped to satisfy.
The very design of the insurance program itself may turn out to be inadequate, principally because of the relationship between the broker / dealer and its registered representatives. Let’s examine some of these structural problems.
“Marketing” to the registered representatives
Scope of coverage
Prior acts and tail coverage
Aggregate limits
Conflicts of interest
“MARKETING” TO THE REGISTERED REPRESENTATIVES
The annual renewal of the group policy is typically marked by the mailing of an announcement to the registered representatives of the features of the current program. The mailing may include a letter identifying how inexpensive this year’s program is, together with a summary of its salient features. While these mailings are made by the insurance broker, they prominently feature the tacit and implicit approval of, and the endorsement by, the broker / dealer. Further, the registered representative will typically receive no further explanatory information, although he or she may receive a certificate of insurance.
Apart from leaving the registered representative with no choice, such documents fall far short of representing complete disclosure – they are analogous to the registered representative supplying only a summary, rather than the full prospectus, to an investor interested in a particular security.
In the brochure itself it is typically stated that the brochure does not represent all of the relevant terms and conditions of the policy; and that the terms and conditions and the policy shall govern in determining the extent of coverage. Those who ignore this or similar warnings do so at their peril.
From time to time, the registered representative may wish to obtain additional information about the terms and conditions of the insurance program under which he or she is provided with coverage. Quite logically, the registered representative will turn to the compliance department of the broker / dealer. A registered representative making such an inquiry may find that the compliance department suddenly becomes uncooperative, or perhaps even hostile, apparently assuming that the mere act of inquiry masks some tip-of-the-iceberg like potential claim.
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Loss Prevention & the Greening of the FP Profession
Standardization — the Two Edged Sword. The financial planning profession is at a cross roads — on the one hand, an ever growing number of voices clamor in support of increased levels of government regulation. As is nearly always the case, the cry for increased levels of government regulation has arisen because of highly publicized abuses. Government regulation, however, has a sledge hammer like quality to it.
The response by the profession, appropriately and predictably, has been to launch efforts at self regulation with renewed vigor — who better, after all, to promulgate and enforce appropriate standards of professional behavior than those knowledgeable of the profession itself. Any corrective action, whether imposed from within or from without, will also have the effect of reducing risk to the client base of the financial planning profession, while simultaneously stemming the erosion of confidence felt by the public in general and by would be regulators in particular.
But there’s a fly in the ointment, as those of other professions have come to realize over long periods of time — the standardization of the “rules” of professional conduct and practice has eased the burden of proof that must be sustained by the plaintiff’s bar. To be convinced of the validity of this premise we need only look at changes in the accounting profession over the last decade. Rates for professional liability coverage for CPAs are some 400% higher than they were in 1985. Rates increased because the insurance industry grossly underestimated the number and severity of claims which might reasonably be expected against members of the profession. Claims increased, in turn, not only because of inroads made by the plaintiff’s bar, but also because of the rather sharp increase in the level of self policing activities undertaken by the accounting profession. One need only look at the number of FASB and SAS opinions published in the last decade.
In any professional negligence case, the plaintiff must be able to credibly demonstrate that there existed a generally accepted standard of professional conduct which the defendant failed to meet, resulting in harm to the plaintiff. As with all other professions, the financial planning profession has eased the burden of proof to the plaintiff by taking the necessary step of promulgating standards of professional conduct and practice. But with published standards, the plaintiff will no longer have to demonstrate that a standard exists. A standard will exist, de facto.
Will this result in increased claims activity and therefore increased hazard to the profession? It’s inevitable.
The Implications. With increased levels of litigiousness, and the resultant increase in the level of risk associated with being a financial planner, the obvious question is what can be done to manage and / or control that risk. Before answering this question, however, we need to know something about what risks the practitioner faces.
Claims Experience. Our claims experience, which spans two carriers, is highly informative, but must be viewed with at least two caveats. These are that the experience is not statistically credible, both because of the number of claims and because of their lack of maturity; and, that the experience of carrier may not be the same as the policyholders’ experience because of contractually imposed limitations on coverage.
Nevertheless, the claims experience is a good indicator of where the land mines are.
Message # 1 — Expenses Are The Exposure.
Nearly all professional liability insurance policies will cover the costs of both defending and settling a claim. It is therefore illustrative to examine the split between the cost of defending a claim, and the cost of settling a claim, across all claims. Here’s our data:
Briefly stated, this data demonstrates that a very significant exposure against which the practitioner purchases insurance is to cover the expense of mounting a defense against what in many cases are non-meritorious claims.
This proposition runs somewhat counter to conventional wisdom. The insurance buying public tends to believe that it purchases insurance to protect accumulated assets against the erosion of some unanticipated adverse judgment. The data suggests otherwise – an equally valid reason for buying professional liability insurance is to protect against the expense of providing a defense for a claim that never should have been brought in the first place. While as a professional you may well assume that the quality of your practice is above reproach, you need not have been negligent to be named as a defendant in a lawsuit.
Insuring Your Financial Planning Practice
E&O professional liability insurance for financial planners and RIAs is sold by insurers operating is the excess and surplus lines market, or the E&S market as it is known in the insurance industry. Its characteristics differ from the more established market in which insurance is marketed, which is known as the admitted market. This article, in addition to addressing what policies are available to the planning professional will also address what the professional needs to know about E&O insurance with particular emphasis on the E&S market.
The Issues
Because of the characteristics of the E&S market, insurance products sold within in it, unlike other policies such as private passenger automobile, homeowners insurance as well as many commercial coverages, are not commodities. The professional facing the decision of how to evaluate various policies, therefore, needs answers to the following questions:
What is the E&S market?
How do the two markets differ?
How important is the carriers financial strength, as well as other considerations, in the E&S market?
Given regulatory controls, what other program characteristics are important to the professional?
The E&S Market
Many types of widely available insurance policies are sold in the so called admitted market. In this market, the policy’s language and key provisions, as well as the way in which premium is calculated and the underwriting rules, are approved in advance by the state insurance department in each state. In fact, the coverage provisions are highly standardized precisely because the market includes thousands or even millions of potential customers with similar insurance needs – faced with such a large number of potential insureds the industry actually works cooperatively in developing a common policy and coverage provisions.
While the admitted market is used when there are large numbers of potential insureds with similar risk characteristics, the E&S market is used when the insured group is relatively small or the risk characteristics are not similar. Indeed both characteristics are true of the financial planning profession – the number of potential insureds is relatively small and the risk characteristics are nonuniform.
Just look at the numbers – the American Bar Association has over 600 thousand members and the AICPA some 300 thousand members. The largest of the associations for financial planners has less than 30 thousand members. Further, the profession itself is highly diverse and encompasses life insurance agents, registered representatives of broker I dealers, financial planners, asset managers, investment management consultants, mutual fund managers, registered investment advisors and several professional designations. These characteristics strongly suggest that a high degree of tailoring of coverage is required to meet the diverse insurance needs of the profession. It is possible to provide such a tailored approach only in the E&S market.
How Do the Two Markets Differ
The E&S market has two characteristics of which the professional should be aware:
With the exception of New Jersey, insureds cannot access the State’s Guaranty fund in the event of a carrier insolvency; and
While coverage can be tailored, it is equally true that the policy form is unregulated and may contain provisions that would not be acceptable to the State Insurance Department in the admitted market.
These characteristics have some important implications for the professional.
The Carrier’s Financial Strength
Carrier insolvencies are relatively rare events. In such an event the insured or the claimant may look to the state’s insurance guaranty fund to provide limited relief. In the E&S market, however, no such assurance exists except in the State of New Jersey where the insurance department has set up a separate guaranty fund for the E&S market.
Most states require that a surplus lines policy bear a warning which appears on the policy jacket. In some states, the warning must be printed in large print, while in others it must be printed using red ink.
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