While the financial services events of the past six months will bring with them a wave of E&O claims, they will also bring an increased demand for this type of E&O product. In particular, a market shift in the registered adviser model to small firms compensated through fees rather than commissions will create opportunities for insurers willing to mine smaller prospects and managing general agents who can assist in such efforts.

Since many people in the industry may not be familiar with all the details of this atypical insurance policy, we provide here an overview of a typical financial services E&O program.

The question then becomes, who needs financial services E&O insurance? Financial services E&O coverage is usually appropriate for the following groups:

o Security broker-dealers who buy and sell securities on behalf of clients.

o Registered investment advisers who more broadly manage investments.

o Life insurance agents who sell life, health and disability insurance as well as annuities.

Because security broker-dealers make recommendations regarding financial products to a client for a commission, their obligation is generally limited to the recommendation of suitable investments on a client's behalf. These suggestions are based on various risk factors, such as the client's financial situation, risk threshold, investment sophistication, investment objectives and other existing securities holdings.

The registered investment adviser, generally, has a higher duty than that of the broker-dealer as he/she has a fiduciary duty to more broadly advise clients regarding their financial situations.

A registered investment adviser may also engage in financial planning services and is compensated with a flat fee based on the amount of assets being managed. This can be a benefit as it reduces the appearance of a potential conflict of interest that may be present when a broker-dealer gets a commission on each trade transacted.

There are two kinds of business models in which registered investment advisers operate. The first kind is typically a small business that provides retail services to individuals, companies, institutional investors and trusts.

The advisers working in this scenario are frequently financial planners and may execute an investment strategy by buying financial and/or insurance products and performing asset allocation services according to the plan.

The second registered investment adviser business model involves the direct management of investment companies, such as mutual funds or hedge funds.

Advisers working in this scenario are on the front lines and are responsible for the development and execution of the individual fund's strategy. They may also be called money managers, portfolio managers, or fund managers. The “retail” registered investment adviser (discussed above) often researches the track record of these money managers when advising clients on mutual fund purchases, in order to steer the client toward the most appropriate fund in which to invest.

While the retail adviser's business is normally written out of an insurer's E&O department, given the more technical financial nature of its undertakings, a fund manager's business may be handled by the management liability department even though the exposure is E&O in nature. Other products typically written out of a carrier's management liability department are insurance company professional liability, bank professional liability, private equity, investment bank E&O (“wirehouses”) and general partnership E&O liability.

Many broker-dealer and registered investment adviser companies also have affiliated insurance agency units within their operations that sell life and health products.

The policies for all three of these professional groups do not vary substantially between insurance carriers, and a typical policy will provide coverage for standard financial products, including stocks, bonds, mutual funds, annuities (both fixed and variable) and life/health. Typical exclusions include commodities or futures contracts, options, mortgage-backed securities and unregistered securities/private placements (although these last two may be added by endorsement).

The broker-dealer business model includes a sales force of registered representatives who are affiliated with the broker-dealer as either independent contractors or employees, and who sell financial products that are vetted, approved and offered by the broker-dealer. The policy offered is a master policy, which covers both the registered representatives and the broker-dealer who share an aggregate limit.

A broker-dealer policy generally contains two insuring clauses. The first insuring clause covers the registered representative for direct negligence in selling or advising on a product. The second insuring agreement covers the broker-dealer for its legal duty–supervising the activities of its affiliated registered representative– and for any direct negligence it may commit (for instance, improperly vetting a product for distribution).

When underwriting a financial services E&O policy, some of the areas insurers focus on include the following:

o Experience and operational abilities of the broker-dealer.

o Power vested in the chief compliance officer to set and enforce supervisory and compliance standards.

o Hiring and firing attitudes of the broker-dealer.

The duty of the broker-dealer, in one large respect, is to ensure that its registered representatives are striking the right balance between production of business on the one hand and, on the other, professionalism in selling only what is appropriate for clients.

This duty is discharged via comprehensive promulgation and maintenance of compliance and other administrative procedures (and clear communication of these procedures), as well as the good-faith enforcement of these procedures through corporate culture and supervision. Of course, the company's record will be evident in the relative number of claims and regulatory issues it experiences.

With the market shift from commission-based business to fee income, the registered investment adviser model has started to gain popularity with many registered representatives moving away from commission-based business. Due to this market shift, along with the migration of the business to smaller registered investment adviser operations with five or fewer employees, there is a need for affordable policies for these small businesses.

Because insurance carriers have traditionally designed products for broker-dealers and affiliated advisers who have large premiums, insurers now wanting to mine these smaller opportunities will have to build out–or contract out via managing general agencies–the infrastructure to handle these small premium accounts.

Challenging times may be ahead for the financial services E&O marketplace.

Those companies that work with insurance carriers that understand the business, and that focus on the fundamentals of solid marketing/underwriting partnerships along with consistent claims service that underlie any good insurance operation, will be well positioned to protect their employees and their assets.