How much E&O should I buy?

By Brian Francetich
The question above and the subject of this month’s ia360 Risk Tip stands as one of the toughest questions to answer amongst the RIA’s decision and selection of appropriate professional liability (E&O) insurance.  Yet, the particular question also stands as one of the most frequent and consistent queries posed to our staff by the RIA community.

How much insurance (limit of liability) should the RIA purchase?  Tough to answer; fiduciary risk is severe in nature, not frequent.  Challenging, because how can one predict the future level of litigation or the overnight, unsuspected credit worthiness of our financial world?  While there are no absolutes, let us strive to, at least, get close to a target (hopefully the right target!).  Here are several helpful points to consider:

  • Client make-up?  Is your clientele high net-worth, middle-income, or institutional?  What is the largest account under management and how many do you have?
  • Client selection?  Client selection is a risk topic unto itself, but it is important to note that if you maintain clientele with unrealistic expectations or who do not heed your advice, then you are assuming an enhanced exposure.
  • Concentrated or Alternative investment positions?  These variables could be within any one account or across several accounts.  Are we are using less traditional asset types?  A concentration in one large account could lead to a substantial loss and concentrations across several accounts may lead to multiple smaller losses.  One or both of these variables could be present.  An advisor could have a concentration (percentage of AUM either by client or in total) of an alternative investment class (hedge fund)
  • Largest trades typically made?  This one is obvious; the more assets transferred at any one time the greater the exposure.
  • Know that Defense Costs reduce the Limit.  Most underwriters issue defense language stating limits will be reduced by defense costs.  The cost to defend a claim can often be 50% of a total loss.
  • What can I afford?  At times it may actually be somewhat surprising that doubling your limit may not greatly increase the premium.  This is a business decision and requires careful consideration.
  • What limits are offered by the underwriter?  Insurers often restrict the limits they are willing to offer to an RIA.  This is especially true if you are a young firm or possess certain fiduciary risk-variables that are of underwriting concern.
  • What is the main objective in having E&O?  The exposure is one of severity not frequency.  Are you willing to maintain a higher deductible and only rely on the coverage for a catastrophic event?  If so, buy higher limits for less.

Again, it is a very difficult question.  Take peace in knowing that all we can do is try to determine a practical target.  And, remember, the exposure is one of severity not frequency; doubling your E&O limits almost never doubles your premium charge.  And at the time of loss, you will forget the additional premium!

Tread carefully when selecting limits and consult experienced professionals.