Mistakes When Purchasing E&O Insurance

Premiums and the Exclusion section of an E&O policy is typically the focus for buyers of E&O Insurance. The majority of financial advisors feel that they are never going to do anything wrong and the insurer will not pay if they do have a claim. The following are claims that are clients have experienced along with the payouts by their insurance company:

Example #1 - ABC Asset Management


Claimant’s alleged to have very little investment knowledge and sought the financial guidance of multiple parties including the insured. In one year’s time the claimant’s portfolio lost over $10,000,000.

Claimant’s allegation’s include negligent investment management and advice, negligent supervision, negligent misrepresentation and/or omission of material facts in violation of The Securities Act of Washington, negligent violation of California Securities Laws, unfair and deceptive acts in violation of the Washington Consumer Protection Act, breach of fiduciary duty, joint several vicarious and control personal liability. Claimant’s requested Arbitration award of no less than $15,000,000, pre-judgment interest, attorney’s fees and any other relief as the Arbitrator’s may deem just and equitable.

Result: Settlement (with $20,000 contribution from the insured)

Policy Limit of Liability: $5,000,000.00
Total Legal Fees: $25,114.15
Retention: $25,000.00
Net Payable from Carrier: $25,114.15
Damages: $687,000.00 (split between all parties)
Length of Time to Resolve: 1.5 years
Total contribution from insured: $20K

Example #2 - ABC Asset Management


Claimant is alleging the insured’s subsidiary purchased a security product which had a substantial decline in value.

Claimant needed to maintain very short term liquidity for its cash investments in order to fund an upcoming project. ABC Company purchased an investment for claimant that they felt addressed claimant’s need for liquidity. However the claimant alleged that the investment product purchased by ABC Company failed to meet the claimant’s liquidity requirements, violated claimant’s statement of investment policy, and has subsequently lost most of its value. Claimant alleges that they lost millions of dollars due to the investment decision.

The claimant alleges that ABC Company breached fiduciary duties and acted with gross negligence and recklessness. Claimant sought compensatory damages for out of pocket losses, consequential damages for additional losses and costs of arbitration and legal fees.

Claim resulted in settlement.

Result: Settlement

Policy Limit of Liability: $5,000,000.00
Total Legal Fees $47,333.54
Retention: $500,000.00
Net Payable from Carrier: $1,281,028.54
Damages: $1,733,695.00
Length of Time to Resolve: 2 Years

Example #3 - ABC Asset Management


ABC Company erroneously labeled client’s portfolio more conservatively than client requested. The error resulted in a lower performance on the portfolio than the client would have experienced had the assets been invested correctly. The client was unaware of the financial loss at the time of the first report of the claim. ABC Company sought relief through their cost of corrections coverage available on their professional liability policy. The policy responded and investigated the error, concluding that client did in fact sustain a financial loss. The carrier settled the claim with the client and the matter was paid and closed within 3 weeks of the discovery of the error.

Result: Settlement

Policy Limit of Liability: $500,000.00
Total Legal Fees: $0.00
Retention: $7,500.00
Net Payable from Carrier: $29,790.40
Damages: $37,290.40
Length of Time to Resolve: 3 weeks

From the above examples, you can see that claims have been made and paid.

Most financial advisory firms are trying to do their best when it comes to execution, being proactive with compliance and implementing policy and procedures but it doesn’t avoid the possibility of a claim. In the majority of cases, claims are settled whether among the applicable parties or through arbitration or mediation. The key is to have the broadest policy language possible to ensure defense cost coverage during that process.

There are five coverage issues that come to mind and often overlooked by most insurance brokers when explaining coverage and premium options to their clients. Here is a list of five of those issues.

  • Insurer or Broker may tell you the policy responds to the legal cost associated with a formal regulatory investigation. However, did you know that some E&O policies do not? Also, some policies require that the investigation be initiated by a client complaint? Ask yourself, what happens if the SEC during a routine inspection stumbles upon something that leads to a formal investigation or an event under the Whistleblower Act where it’s an employee or non-client initiated event? The solution is to ensure that there is coverage for a regulatory investigation or litigation that is not restricted by a client complaint. You must also ensure there is no Regulatory Exclusion listed within the exclusion section of your policy.

  • The Chief Compliance Officer (CCO) believes he/she is covered just because they’re an employee or the CCO title is included in the definition of an “Insured” or “Individual Insured.” An insured is typically covered for providing investment advisory services that may be tied-into the Investment Advisor Act of 1940 or limited to the “buying and selling of securities.” Remember, E&O policies are typically only triggered when a written demand from a client is received. The CCO concern is more with regulatory issues, not client demands. The solution, purchase Directors & Officers Liability Insurance that is designed to protect against claims arising out of business decisions instead of investment decisions. Again, make sure there is no regulatory exclusion found within the policy.

  • Quite often an insurance broker or insured may think that a trading error is covered automatically. This is not the case with the majority of policies. Typically, coverage needs to be added by endorsement and even then there are specific requirements you need to be familiar with in terms of reporting requirements, timing and whether the policy is “reimbursement” or “pay on behalf” of the named insured. Again, what triggers an E&O policy is a written demand from a client. The majority of trading errors are discovered by the financial advisor or custodian prior to the client learning of the mistake.

  • Purchasing a policy that is “Duty to Defend” is more favorable over the “Right and Duty to Defend” provision. The duty to defend language would normally be preferable if the insurer gave you the right to select your own claims attorney versus them appointing one to defend you. Quite often insured’s feel that the insurer wants to settle a claim to keep their expense down rather than fight to protect your firm’s reputation. There are pros and cons to the “Duty to Defend” language and your broker should make you aware of those issues based on their experience with each carrier. The second part of this issue involves the “Settlement Clause” or also known as the “hammer clause.” This clause states that the insurer’s defense ends at the amount they could’ve settled for with the claimant or the policy limit of liability and if you, the financial advisor, does not consent, any additional expenses above and beyond the suggested settlement amount are your own, and not reimbursed by the insurer. The solution is to remove the “hammer clause” from your policy or come up with a pre-determined negotiated compromise with the carrier prior to binding/securing coverage.

  • A misconception regarding 3(21) vs. 3(38) fiduciaries has been the buzz over the past two years. Various insurers have made a big issue regarding the fact that their definition of “Claim” includes breach of fiduciary duty for 3(21) and/or 3(38) fiduciaries. The broader policy forms issued by insurers who have been writing this line of coverage for over 20 years do not distinguish in their policy language between 3(21) or 3(38) fiduciaries. They merely state that they cover claims alleging a “breach of fiduciary duty.” The more a term is defined, the more restrictive the coverage will be interpreted. The key is not only the definition of a “claim” but even more important, the definition of "professional services”. This definition will vary among provider and may include not only direct investment in securities, selection and monitoring of third-party advisors, or selection of various mutual funds for participants to invest in but also acting as the plan administrator or trustee. Avoid those policies that only cover claims alleging a “breach of fiduciary duty” as it pertains to discretionary advice to ERISA plans. Remember, a financial advisor has a fiduciary obligation to all of their clients and every claim, whether involving an ERISA or Non-ERISA client, allege a breach of fiduciary duty.