SHARP RISE IN SECURITIES LITIGATION MAKES E&O UNDERWRITERS JITTERY

Rough Notes, Apr 2004 by Simon, Ellis B

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."