Subprime loans lead to sublime times for the plaintiffs' bar. The credit crisis has spread beyond arcane financial instruments, such as credit default swaps and collateralized debt obligations. It is affecting all businesses, large and small.

Insurance professionals know the truism, “Bad times lead to increased claims.obCrLf We are in a bad time, as measured by an overall drop in equity markets, more bank failures than in the last 5 years combined and large-scale layoffs. Some types of claims already are on the rise, such as shareholder class-action and derivative lawsuits against corporate directors and officers of teetering and failed financial institutions. Like an earthquake at sea, the credit crisis hit the financial sector immediately and dramatically.
Our shared experience during the tech-driven equity meltdown beginning in mid-2000 tells us that although a ripple effect to Main Street on claims is likely, it's unclear how high that wave will be. Brokers and agents can act now to lessen the likelihood and severity of claims that may be coming their ways.
Another Fine Mess
Oliver Hardy's classic put-down of his comedy partner, Stan Laurel, should be the title of the eventual Congressional investigative report of the credit crisis. Today's “fine messobCrLf follows an oft-repeated pattern in the business world, one which we never seem to recognize until it's too late. Whenever somebody starts talking about a “new paradigm,obCrLf we should run for the hills, because “new paradigmobCrLf is code for “ignore the fundamentals.obCrLf
We saw it during the savings and loan (S&L) crisis of the late 1980s and early 1990s. More than 1,000 S&Ls failed, having loaned unregulated multiples of their actual assets. The resulting losses totaled $160 billion, of which you and I (meaning the United States) paid $125 billion. The loan-to-asset value ratio is one of the fundamentals.
We also saw it in the tech-driven stock climb up to mid-2000, the irrational exuberance as then-Federal Reserve Chairman Alan Greenspan called it, followed by the inevitable tech meltdown. The “irrationalobCrLf part was believing, just as some later did with collateralized mortgage obligations, that a company's stock value is whatever someone will pay for it, not the value of its earnings. The earnings-to-equity ratio is another fundamental.
The credit crisis resulted from another failure to recognize fundamentals. For years the lending industry relied on an ever-inflating housing market, rather than borrowers' actual incomes, to pay for jumbo mortgages with low teaser rates and big payments after the first 2 years or so.
These past crises were followed by investigations, token criminal prosecutions, floods of civil lawsuits and new regulations. That pattern is being repeated in the credit crisis. We are just seeing the first inning of what may be a long game.
For the insurance agent or broker, the fundamental principles of avoiding an E&O claim are the same as they always have been. When a broker has promised to review the policyholder's insurance needs, or where the law imposes on the broker a duty to do so because of a long-term relationship with a customer, three steps can mean the difference between winning and losing an E&O lawsuit: 1. Provide options to customers, even for lines or amounts of coverage that you're not certain they are interested in, but might need 2. Provide options in writing, or send a written follow-up to a discussion about the options
3. Confirm in writing any coverage or limits that the customer declines.
Stock Market Drop, Take Two
Because many insurance brokers are dual-licensed in securities, the 2000-2004 market drop directly affected them. Annuities, especially variable ones, in retirement plans came under close regulatory and legal scrutiny, but in a marketwide meltdown there is no safe place to hide, except for Treasury notes and other government-backed investments.
One reliable barometer of investor claims is the number of binding arbitrations filed against securities brokers in the Financial Industry Regulatory Authority (FINRA). In 2008, the rate of filings of FINRA arbitrations is projected to nearly double the reports from 2007. Through September, 3,469 FINRA arbitrations were filed, a 46 percent increase over 2007, and the number of FINRA cases closed decreased by 34 percent, indicating the system is becoming overloaded. The recent peak year for new FINRA filings was 2004, when nearly 9,000 arbitrations were filed.
Insurance agents and brokers who are dual-licensed in securities may find themselves in FINRA arbitrations or civil lawsuits. If they advise or are fiduciaries of any employee benefit plans they may face suits brought under ERISA, and if they place E&O coverage for securities brokers, they may see claims from their broker-customers if there are problems with that coverage.
This is an opportunity for us to perform our own risk analysis, to identify the accounts that may be problematic, and to make sure they have been thoroughly handled and documented.
Policy Limits
Mortgage borrowers often are contractually required to insure the residence with a sufficient policy limit to protect the lender's interest in the home. In a deflating housing market, some borrowers might be tempted to reduce their home insurance payments, but their agent must know what amount of coverage the borrower has agreed to maintain. Seeing is believing-don't accept at face value a request to reduce property coverage limits. Ask the real estate agent and confirm that response in writing.
Financial sector insureds aren't the only ones who might be exposed to credit crisis claims. A good answer to the “how muchobCrLf question will provide more than one option.
Where the gist of the claim against an insurance broker is that he failed to recommend sufficient limits, a plaintiff's lawyer can find an expert witness who will testify that higher limits were available, affordable and procurable. The best defense is the ability to show in writing that the policyholder chose not to buy a higher limit before the loss occurred.
Insurer Insolvency
So far, no major insurers have gone out of business due to the credit crisis. But if they do, what can agents do to protect themselves?
Most states follow the rule that a broker is not liable for placing insurance with a carrier that is, at the time, admitted in the state where the risk attaches. One seminal case is Wilson v. All Service Insurance Co. (91 Cal.App.3d 793 [1977]), in which a licensed broker had placed auto insurance for a customer with Transnational Insurance Company, a California admitted insurer. After an auto accident, Transnational was declared insolvent by the California DOI. Before Transnational was formally liquidated, the injured plaintiffs settled with Transnational for $10,000, though they claimed they were entitled to $30,000 in damages and $50,000 in punitive damages against the carrier for its pre-litigation handling of the claim. The Court of Appeal in Wilson held that a broker may rely upon the DOI finding that an admitted carrier is financially able to do business in the state, and dismissed all claims against the broker.
It's the insurance commissioner's responsibility to investigate and decide whether carriers are sufficiently solvent to merit admission. The broker has no legally imposed duty beyond that. The insured's recourse in the event of an admitted insurer insolvency, at least in consumer coverage like auto, is the state's insurance guaranty association, not the broker's E&O policy.
For non-admitted carriers, the broker's task is not so easy. Rating agencies may not act immediately to downgrade insurers' ratings amid rumors of financial trouble, so the broker has little hard evidence to rely upon.
Changing insurers can create risks for brokers, especially in non-standard lines of coverage. For example, no two miscellaneous E&O policies are identical. Once the decision is made to switch insurers, a careful comparison of alternative policies and coverage terms is needed. An insurer with better financial security won't do much good if the policy won't cover a typical loss because of an advancing retroactive date or a material new exclusion. If the insured decides to change carriers because of concerns about the financial health of the incumbent, the broker has done what is possible to make herself bullet-resistant, so long as the insured's informed choice is reflected in the broker's file, preferably in a written communication to the insured.
Unemployment and EPL
With hard times come layoffs and the temptation to characterize a legitimate downsizing as a personal vendetta by the employer. Insurance professionals are as exposed to the risk of employment practices liability (EPL) lawsuits as are their customers. EPL claims include unlawful discrimination, sexual harassment, retaliatory termination and wage/hour law violations.
Now is a good time to review your own EPL insurance policies and coverage limits, and suggest that your customers do likewise. The U.S. Bureau of Labor Statistics keeps track of extended mass layoffs, quarterly tallies of reductions of 50 or more employees by a private employer lasting at least 31 days. There were peaks in mass layoffs in late 2001 and in late 2005. A peak has been building through most of 2008, and if announced layoffs actually occur, 2008 will set the record for the past 10 years.
EPL complaints filed in the U.S. Equal Employment Opportunity Commission (EEOC) tend to increase in years that follow spikes in layoffs. The 2001 spike was followed in 2002 by an increase in EEOC filings (called “chargesobCrLf) of about 5,000 above the 10-year average. The short-lived 2005 spike did not lead to an increase in charges in 2006, though there were 7,000 more charges in 2007 than in 2006. Since most EPL civil lawsuits are not preceded by EEOC charges, the impact of mass layoffs on future EPL claims may be greater than these figures indicate.
Desperate times lead to desperate claims. The average cost of defense fees in an EPL case in California is $150,000 (not including settlements or verdicts), which means that the fees of going through trial are much higher, since more than 90 percent of such cases settle. Against that kind of exposure, a higher premium may seem reasonable.
A Stitch in Time
Ignoring the fundamentals led the economy into its past and current slumps. For the agent or broker, the market slump poses the challenge of not making the policyholder's problems your own problems.
Like a cleanly fielded ground ball or an alert runner stretching a single into a double, a confirming letter or e-mail can change the outcome. As usual, the fundamentals make all the difference.

Louie Castoria defends brokers and other professionals, and is a humorist in his spare time. He is a partner in Wilson Elser Moskowitz Edelman & Dicker LLP in the firm's San Francisco office. The views expressed herein are the author's and are not legal advice.

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Avoiding Errors & Omissions: Credit Crisis Fallout-Act Now

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