RIA E&O Pitfalls: Who do you know? What do you know?

In life, we learn that success is not necessarily based on “What you know” but also on “Who you know”.  For this article, we will include within the definition of success “the avoidance of or protection from unnecessary risk”.

When investors select an investment advisor, the “The Who v. The What” maxim is critical.  All advisors are not the same.  To the investing client, one advisor may seem appropriate, yet in truth may have very little or only cursory awareness of an investor’s needs, strategies or investment vehicles that may be essential to the client’s success.  An advisor may appear adequately equipped, yet, in truth, maybe woefully uneducated or inexperienced to properly implement and manage certain tactics essential to a client’s goals.

Shifting to the subject of Investment Advisor Professional Liability Insurance (E&O), this truth and maxim– what we can call “The Who vs. The What” – holds as well; the “Who”, being the agent/broker selected for the placement of the “What”, being the particular insurance company and policy contract form insuring the advisory operation.

In total, our insurance brokerage team represents approximately 1,200 RIA firms throughout the U.S. and participates and speaks at several industry events.  Advisors may not recollect (or care to recollect!) the vast array of insurance terminology shared, but there are three key points – “Three Little Known Truths” we call them – concerning Asset Management E&O that investment managers should wish to understand:

1. There are No Standards to the “What” (Insurance Contract).
2. E&O Underwriters have Limited Knowledge of the investment world.
3. Agents/Brokers have Limited Knowledge of the investment world.

Investment Managers may feel they have adequate E&O insurance coverage placed by their respective “Who” (agent) with their respective “What” (insurance company/contract), yet that may not be the case. How crucial is this concern?  Breach of one’s Fiduciary Duty, or, more commonly, someone alleging such against an advisor, may not be a frequent occurrence – but it is typically severe.  While no industry body collects and publishes IA claim/mediation data, as the primary agent (measured by policyholder count) representing the largest national E&O underwriter of RIAs with total currently insured RIA policyholders of approximately 3,200 – the data from that underwriting “pool” reflects the average claim to be $245,000 ($155,000 for settlement and $90,000 in legal defense expenses).  Claims, essentially, fall into two basic “camps”: (1) Transactional (such as trade error), or (2) Suitability.

A Severity Transactional Claim.  Recently, our team helped to complete a Transactional correction for a trade error loss in excess of $3,000,000 in which, during the model rebalancing of client portfolios, certain cash that should have remained as such was invested into the market via the advisory firm’s rebalancing software.  Once the error was realized, the market had moved against them.  The E&O carrier paid full policy limits of $3MM and the firm co-insured on the loss by contributing additional funds out-of-pocket for the remainder.  Separately, we are also assisting one of our advisory clients to, hopefully, avoid participation in a $12,850,000 class action Suitability settlement surrounding proportionate liabilities from complex derivatives of the VIX volatility index that lost hundreds of millions and brought legal implications to multiple asset management organizations.

Understanding the importance of the “Who” and the “What”, let’s break down the “Three Little Known Truths”…

1. No Standards – Caution:  Most common forms of commercial insurance (property, auto, product liability, etc.) are issued under the control of the insurance industry’s “associated governing body”, the Insurance Services Office (ISO), with commoditized language.  Unfortunately, that is not the case for Investment Advisor E&O.  ISO asserts that the exposures presented by the investment marketplace are ever-changing and too unique for them to address.  Therefore, all insurance companies participating in the asset management world are free to issue their own, independent, unique policy/contract with differing terms, conditions, definitions, limitations, exclusions, etc.  Additionally, much of the RIA insurance marketplace issues their “paper” on what is called a “Non-Admitted” basis; meaning, they are free to modify terms and conditions with little regulatory oversight.  Should they foresee or notice a fiduciary risk, they adapt.  An underwriter’s asset management contract form is fluid; changing and modifying continuously.
2. E&O Underwriter Limitations:  Underwriters speak insurance.  They have limited knowledge of the investment world and its many facets and vocabulary.  Discretionary advisors have come to us presently insured on Non-Discretionary insurance E&O forms.  The respective underwriter had simply no knowledge of the difference.  Other advisors are found insured with murky definitions of excluded securities.  Etc., etc.  Asset categories and their terminology can be a foreign language to an insurance underwriter or underwriting company who are “generalists” insuring a multitude of different commercial risks.
3. Agent/Broker Limitations:  Ditto point 2!  Most insurance agencies are generalists insuring several different industries with limitations such as (1) knowledge of the investment world, (2) how coverage must be structured to meet the respective fiduciary profile of the asset manager, (3) how to effectively explain the individual risk profile and asset exposure to the underwriter, and (4) insurance marketplace relationship depth and carrier placement authority.  Starting with an inexperienced agent who then submits their account to an equally inexperienced underwriter can only compound the issuance of a problematic and “swiss cheese” insurance contract upon the RIA.

With that knowledge, how should an IA approach securing solid and effective Professional Liability (E&O) Insurance?

Foremost, know your “Who” (agent/broker) by determining:

• How long has the agent and agency been insuring advisors?  How many advisors do they insure?
• What is the depth of their underwriting market appointment authority?
• Do they have a process for analyzing your individual fiduciary exposures and presenting how the insurance contract is structured to meet those exposures?
• To what degree have they asked you questions that demonstrate their knowledge of IA exposures and the investment world that confirms their abilities?

Through that important “Who” confirmation, an advisor should be able to then move confidently to the selection of the “What” (the insurance company).  Get the “Who” right, and the “What”, correctly administered by the “Who”, should follow.

Just as I would tell my three boys when they were young and learning how to cross the street, “Stop, Look and Listen” – so too is it wise for the advisor to do the same concerning their E&O.  One minor “i” not dotted or “t” not crossed can be the difference between a covered claim and a self-insured event.

Golsan Scruggs is an insurance brokerage firm operating throughout the United States specializing in investment advisor E&O errors & omissions insurance (aka professional liability insurance) for RIA registered investment advisors. As one of the largest insurers of RIA firms in the U.S., we have a dedicated staff that understands the risks of the financial services industry and delivers superior results.  We make the underwriting process painless.

At Golsan Scruggs, we believe it is incumbent upon us to earn the right to be appointed as your insurance and risk-management agent. Our RIASURE process exists to serve that purpose.

Our RIASURE Review will analyze your fiduciary exposures, provide rate details and comparisons, and provide a contract comparison. No application required.

To obtain your complimentary RIASURE Review, please provide the following information or contact us at (800)273-5883. Fields marked with * are required.