Stockbrokers E&O players have their own market issues

Investors are always thrilled when the stock market is on a tear. When it drops, however, they may not just be unhappy; they may get litigious. Regardless of whether their claims are legitimate, the sellers of their securities are going to need help, and that's where E&O insurance comes in.

At last fall's annual convention of the Professional Liability Underwriting Society, which was held in Chicago, a panel of speakers addressed some of the issues surrounding such coverage for securities broker/dealers. Taking part in the discussion were John Iannnotti, executive vice president of AIG's Financial Institutions Group; Perry Even, a broker with Arthur J. Gallagher & Co. Insurance Brokers of California; and Gerry Gunderson, senior vice president, general counsel and former chief e-compliance officer with Investment Centers of America, a wholly owned subsidiary of National Planning Holdings Inc., which is a broker/dealer holding company affiliated with Jackson National Life Insurance Co. The moderator was Martin Schexnayder, a partner in the Houston office of the law firm Wilson Elser Moskowitz Edelman & Dicker LLP. Following is an edited transcript of part of the discussion.
Martin Schexnayder: We're going to try to identify trends and issues affecting E&O insurance for stockbrokers. John, what have you been seeing as an underwriter?
John Iannotti: I think it's important to look at the securities broker/dealer industry from the year 2000 forward. Every carrier underwriting securities broker/dealers lost money from 2000 through 2003. Four main factors were behind these losses.
The first factor was that insurers decided to offer "selling away" coverage. Essentially, it covers the broker/dealer entity's liability when its independent registered reps sell products for which they have not obtained the broker/dealer's written approval. What happened was an E&O policy essentially was turned into a fidelity bond, because most "selling away" claims ended up involving products that were either Ponzi schemes or involved theft of some sort.
The second factor was insurers' decision to extend coverage for the selling of limited partnerships and promissory notes. It's what the broker/dealers decided that they needed to do, so we offered the coverage–without charging for it. Many of these limited partnerships and promissory notes became insolvent. So the E&O policy became a financial guarantee for the promissory notes and the limited partnerships.
The third factor, which made for a "perfect storm," was the collapse of the NASDAQ and many of the Internet stocks. We ended up having a huge number of claims that high-tech stocks and mutual funds sold to investors were "unsuitable" for them, in violation of Securities Exchange Commission regulations. I think it's important to note that between 2000 and 2004–although you won't find it in writing anywhere–the definition of "unsuitability" changed. It's now "any investment that loses money."
The last factor, which I think caught many carriers by surprise, was a sharp increase in defense costs. Typically, most broker/dealer E&O cases end up in arbitration. In 2000, the average defense cost in arbitration was $17,000. Somewhere between 2000 and 2002, the figure rose to $50,000, and the carriers failed to price for it.
These four factors led to substantial losses between 2000 and 2003. As we rolled into 2004, I think the market began to stabilize. We eliminated "selling away" coverage. We essentially eliminated the coverage for the limited partnerships and promissory notes. We raised the retention to $50,000 to cover the defense costs issue. The policy, I think, is back to where it needs to be–to providing E&O.
Perry Even: It might be helpful to review broker/dealers as a class. There are a couple thousand security broker/dealers across the country, but the particular segment that buys stockbrokers E&O typically has an independent contractor field force. Broker/dealers who are New York Stock Exchange firms with employed brokers, or regional firms that have an employee field force are not typically candidates for this kind of coverage. If they buy a policy, it's going to have high retentions and focus on a specific part of their operations. Nor are discount brokers–the Charles Schwabs, the e-trader platforms, etc.–probably candidates. The 150 to 190 firms around the country that buy this coverage represent about 200,000 registered reps who are independent contractors. That's the key distinction.
Martin Schexnayder: Perry, as a broker, did you see a significant withdrawal from the market after the stock market collapsed?
Perry Even: We did see some markets that abandoned this class, but most carriers stayed. They've obviously sharpened their pencils. Also, after the downturn in the stock market, the run-up in claims lasted about two-and-a-half years. Now the claims frequency is maybe a third of what we saw at the peak.
John Iannotti: I think that's important. The claims frequency tends to follow the market. And I think when you take a look at the spikes in claims, there's generally a two-year lag between the moment someone loses money to when a claim is actually filed. So I think carriers are going to watch the stock market's performance closely.
Martin Schexnayder: I think one of the other distinguishing characteristics of the market decline in 2000 was that most broker/dealers had not experienced a "bear" market. When we got a turn, a tremendous number of customers were unprepared for it because their stockbrokers had not discussed the subject with them. While we will continue to see market corrections, I don't think we're going to see the kind of run-up in claims we had–simply because those reps and their customers had to deal with that reaction in the market.
Gerry Gunderson: I agree. I think both the investing public, and broker/dealers and their reps learned a lesson. A lot of things have changed at broker/dealers since the bubble burst. The good firms are doing a better job of screening and hiring reps.
Broker/dealers are subject to the CRD system, which is a cooperative venture between the National Association of Securities Dealers (NASD) and the states that track arbitration, litigation and regulatory events that may have been filed against a rep. Even a complaint from a client who says he or she lost $5,000 goes on a rep's record and stays there for two years–even if that client makes no formal claim. Firms look at that information now when hiring. The amount of money that broker/dealers spend on compliance is probably two or three times what it was in 2000.
Martin Schexnayder: John, as an underwriter, what do you consider when evaluating a broker/dealer's submissions for stockbrokers E&O?
John Iannotti: When you're underwriting a broker/dealer that has 14,000 registered reps, you can't just look at the prior losses and say, "OK, I know exactly where the losses are." The key questions are, What was driving those losses? Was it a specific product, and do they continue to sell it?
We also look at how many claims were made against the broker/dealer's fidelity bond. That's a good indicator of the quality of the broker/dealer's compliance efforts. There may have been no E&O claim, but if there have been a significant number of fidelity-bond claims, that's a red flag.
We also consider where the registered reps are located. For example, carrier arbitration expenses are high in Florida and California. So if a broker/dealer has a significant concentration of registered reps in those states, that raises a flag for us.
The size of the compliance department is a key statistic for us. We like to see one person per 100 registered reps. Sometimes we see companies with one person per 1,000. There's no way one compliance person can oversee that many registered reps. Another important issue is how well the broker/dealers uses technology to uncover trades that may be unsuitable.
Gerry Gunderson: Technology is a huge part of compliance. We have an internal proprietary operating system that really was developed with the compliance function in mind, and we've modified it so it can do such things as assist compliance supervisors in checking the suitability of investments. The NASD has a pending amendment, Rule 2821, that will affect how variable annuities are sold and will require that a principal sign off on the trade within 48 hours after the client signs the application. There is no way to do that effectively without technology. We recognize that even with one compliance person per every 30 reps, you still need good electronics to look at everything.
Martin Schexnayder: Perry, this is a heavily regulated field and you have to deal with that in getting your clients the best available coverage while satisfying federal and state regulators. What challenges have you encountered in that respect?
Perry Even: In 2005, the State of New York Insurance Dept. surprised all of us with Circular Letter No. 6, which announced that in New York, a liability policy written for a broker/dealer that uses independent registered reps and that covers those reps as additional insureds is a group insurance policy, even if the broker/dealer pays the entire premium for it. Furthermore, the insurance department stated that such a group policy could be issued only to a purchasing group, and that the registered reps could not be required to participate in the group but could opt out with a showing that they had comparable coverage. The circular also stated that insureds in these group programs in New York could not be made subject to an aggregate policy limit. That caught the attention of a few people.
Martin Schexnayder: How do you address that issue?
Perry Even: All of our programs comply with New York's requirements. I think the saving grace is that so far no other states have taken their position. New York further modified its position regarding comparable coverage to acknowledge that if the group program extended coverage to the broker/dealer entity, then the rep who could opt out had to secure comparable coverage that also extended to the broker/dealer. So for practical purposes, the registered reps can't opt out, because they probably can't find that coverage individually. Even if they could, it probably would be more expensive than in a group program. I'll let John talk about the underwriting challenges created by Circular No. 6.
John Iannotti: New York says that you need a purchasing group. That's something we can all deal with. The second issue is the non-mandatory issue, so a carrier's first concern is the possibility of adverse selection. The third and most alarming issue is that each registered rep now has his or her own dedicated limits. And this line is simply not priced for that. The average annual premium for a broker/dealer's stockbrokers E&O policy is about $1,500 to $2,000 per registered rep. Some doctors are lucky if they can find E&O insurance at all, and lawyers E&O is one of the most expensive coverages out there. Yet we're offering $1 million of E&O coverage to securities broker/dealers for $1,500 per rep–which is less than auto insurance. There's something fundamentally wrong with that.
Carriers need to address this issue, probably with substantial rate increases. If other states join the New York bandwagon, I don't know if the product will even remain viable, because you'll have to have either a substantial rate increase or sharply reduced limits, maybe to $250,000.
I recently read about a company that sold about $25 million in various products to retirees of Exxon Mobil in Houston. About 25 registered reps from the same company were involved. Now if each had his or her own dedicated limit, a savvy plaintiff's attorney would conclude, "If I sue each rep individually, there are $25 million of policy limits available for a claim."
Martin Schexnayder: Perry, have you seen a change in the products or services your clients are offering? If so, how is that affecting coverage?
Perry Even: We see product changes all the time. Companies have come out with a variety of alternative products; everything from structured notes to hedge funds to 1031 exchanges. As an insurance broker, we need to keep an eye on what products come into the channel, to see whether they might trip an exclusion or create an exposure an insurer does not anticipate.
Martin Schexnayder: John, are claimants or plaintiffs counsels finding new ways to bring claims?
John Iannotti: I don't think we've seen anything unusual over the last two years. I have been surprised by what we're not seeing. I expected, for example, to receive claims with respect to equity-indexed annuities–which we haven't. I think the NASD did a great job of informing its members of potential pitfalls with that product.
Perry Even: When you get a huge market correction, everybody loses a lot of money. In some ways, I think we saw fewer claims than we actually expected. We bounced back from that. And I think we're now in a period where firms are looking at new products–how can they differentiate themselves, how can they stay ahead of other firms, and how can they stay ahead of market cycles?
Martin Schexnayder: Hedge funds seem to be one of those new products. Although they've been around a long time, they seem to be getting a lot more attention.
John Iannotti: The problem with hedge funds is on the retail side. If a lawsuit is filed, typically the registered rep will have to take the stand and explain the hedge fund strategy. Because of its complexity, there's no way he or she can do that. It's probably a "loser" case from Day No. 1. So that is going to be one of the keys for us: determining whether brokers actually understand what they're selling.
Martin Schexnayder: Perry, give me an example of the types of debates that you and John might have about what kind of coverage you're looking for, and what he will and won't provide.
Perry Even: Typical discussions between brokers and underwriters concern a client's claims history and what it tells us about that firm and its management structure. There was a time in the 1990s when a submission for a broker/dealer would show only two or three claims in five years. Those times are gone. We have to provide a claims history with the submission, and we have to put it in context. In some cases, that loss history indicates that a premium decrease is in order. In other cases, you see a history where the broker/dealer was behind the curve, in terms of its field-force recruitment or supervision.
Martin Schexnayder: John, what does Perry ask for that really "drives you nuts"?
John Iannotti: The typical argument you receive from brokers in regard to the loss history is: "This is the way it used to be. It's no longer that type of risk, so you need to either discount what you're seeing or ignore it altogether." That simply doesn't work in most circumstances, although it does in some. The broker/dealer may have a whole new compliance department, so maybe you can underwrite it, for example, without prior-acts coverage. The general issue concerns the limits you are going to make available for certain products it may sell, like limited partnerships, viatical settlements or hedge funds. The typical discussion takes place over what limits we're going to provide for such risks, and what those limits should cost.
Martin Schexnayder: Gerry, from your perspective as the insured, what are you're looking for?
Gerry Gunderson: A big issue is the exclusion on some of the products. I think with hedge funds we do have insurance coverage, but they have to be approved. I'm not a big fan of hedge funds. As part of our due diligence, we ask ourselves whether an average agent or rep can understand the product being sold. So we don't do a lot of hedge funds. We don't do a lot of limited partnerships either. Viaticals aren't covered under our insurance policy, so we have them as "prohibited activities" for reps. We'll terminate a rep if we find out he or she is involved in viatical sales.
Martin Schexnayder: Perry, what challenges do you see ahead for brokers and insurers?
Perry Even: I think they fall into two categories. One is that some particular product–probably a popular one–ultimately will be determined to not be very effective for clients. And we've seen this over the last 20 years, whether it was a universal life product or a vanishing premium product or, to some degree, variable annuities. There's going to be a product on which we'll see some sort of blow-up. The second issue is: What will regulators focus on, and will that lead to litigation?
Martin Schexnayder: John, does the fact that stockbrokers E&O claims typically go to arbitration–as opposed to maybe more protracted and expensive forms of litigation–affect underwriting?
John Iannotti: It does to the extent that the arbitration process typically takes 24 to 36 months. So you will be able to know relatively quickly if you made money in a particular accident year. That allows you to make changes quickly. If you're selling D&O insurance, it typically takes five to six years to close the claim, so it takes a long time to determine how you did in a particular accident year.
Going forward, the big challenge for us is not hedge funds, viaticals or other new products. We can underwrite and charge for a product. I think the last thing we want to do is just start excluding things because they're new. We have to take the time to understand them and price them appropriately. Our bigger challenge is really going to center around regulations like New York's Circular Letter No. 6. Another potential problem is to have a new carrier dip a toe in the market and undercut what we believe to be a fair price. When we know actuarially what the right price should be, yet someone else offers it for 30% to 40% cheaper, you have to have the backbone to walk away from that business.