The Cost of (Financial) Malpractice Insurance
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There were a number of reasons why Melinda Stephens, a nine-year veteran of the securities industry based in Los Angeles, switched broker/dealers last year. But one of them was because she was worried about her own security — namely, the level of insurance her previous b/d carried.
In the end, she moved to AFP Group, a unit of Royal Alliance, partially because of the firm's reputation — and because AFP offered more comprehensive insurance coverage. It may seem odd to switch b/ds because of insurance, but in this environment, the level of insurance — specifically called errors and omissions insurance — has become more important.
“I just could not afford the risk,” Stephens says. “Even as insurance gets more and more expensive, because more and more people sue, it's something you still have to have.”
Stephens isn't alone. The cost of premiums is up dramatically over the last five years — by 300 percent by some estimates. Annual premiums per rep average between $1,500 to $2,500, compared with $800 to $1,000 about four to five years ago, according to Perry Even, senior vice president with insurance broker Arthur J. Gallagher in Aliso Viejo, Calif.
That hurts every b/d and advisor, but it especially hurts smaller firms, which, in the worst-case scenario, contemplate canceling their coverage, potentially exposing themselves to major liability because firms generally don't have the reserves to handle paying massive arbitration awards.
Think of errors and omissions insurance as financial planning malpractice insurance. In a bear market, it's especially necessary: Arbitration claims filed with the NASD reached a record 8,945 in 2003.
It's no wonder that deductibles have risen as well. A mere five years or so ago, the deductible per rep was around $5,000, which Even says is now around $25,000. In the case of a damage award (often split between firm and rep), the rep has to shoulder a lot more. The per-firm deductible has jumped as well. Even says that the largest b/ds need more than a $1 million policy for individual claims — and premiums cost more for that.
In some cases, b/ds were basically self-insuring themselves (read: paying for small judgements themselves). Says Rich Hunter, CFO of Commonwealth in Waltham, Mass.: “Our policy had evolved to a point where we had a $100,000 deductible for the firm and a $1 million cap on individual claims. Therefore, while it may have appeared that we were backed by our insurance company, the reality was that most claims were uncovered because they were under $100,000.”
To hold down costs, some providers have restricted coverage by not including certain non-core products, such as limited partnerships, certain types of annuities, hedge funds and other alternative investments.
A Break in the Storm?
Yet, some observers say rates could finally be leveling off, with annual premiums dropping back to the $800 to $1,200 range per rep. A number of new insurers are underwriting coverage for the smaller b/ds to compete with the likes of AIG and Chubb, two of the larger players in this area. (Neither company was available for comment at press time.)
“What was a situation that could cause broker/dealers to go out of business is now one where there's a more competitive environment to buy insurance,” says Sheri Pontolillo of CalSurance.
That said, there are still some issues. Whereas insurance companies used to more routinely provide what's known as “selling away” insurance — protecting firms against reps who willfully defraud their customers and their own firm — insurance companies no longer want to offer that coverage, seeing it as too big a risk. It means smaller b/ds have to be more vigilant in terms of who they hire. “It seems like a communicable disease,” says Gerry Burchard, president of Round Hill Securities, an independent b/d based in Alamo, Calif. “When you take a broker on, you get his history going back six years or whatever.”
Burchard says he considered self-insuring for a time. He says, though, that rates may start to become more favorable for those with extensive compliance procedures. If supervisory complaints drop sharply as a result of vigilance by compliance officers and improved technology (they're on pace to drop 11 percent this year), insurance costs should see a marked decline.
For now, though, higher costs are likely to persist, especially as investigations continue and arbitrations work through the system.
“Self insuring, at least in the current environment, is a much more cost-effective way for us to manage the overall program as well as the claims-handling process,” Hunter says. “I think you will see more and more firms come to the same logical conclusion in the near future.”
