As E&O costs rise, advisers 'going bare'

Jun 19, 2006 @ 12:01 am

By Jeff Benjamin

DETROIT - After doing the math on the rising cost of errors and omissions liability insurance, a growing number of independent financial advisory firms are "going bare," shunning the coverage designed to protect advisers against client lawsuits.

"We got rid of it a year ago, because the premiums were just too high," said Scott Schultz, chairman and chief investment adviser at Schultz Investment Advisors Inc. in Williamston, Mich.

For Mr. Schultz, the final straw came when annual premiums reached nearly $75,000 with a $25,000 deductible for a firm that was overseeing $43 million worth of closed-end mutual funds for clients.

"The price of admission was too high, and nobody wants to write it," he said of the E&O insurance, which is the financial advisory business' version of malpractice insurance for medical doctors.

Although advisers affiliated with broker-dealer firms typically are offered E&O coverage at more affordable group rates, independent financial advisers have no such leverage and can face oversized premium payments.

Relying on consultants

Mr. Schultz, who instead has hired an outside consultant and independent auditor to help maintain business standards and avoid errors - which could lead to

lawsuits - is part of the growing divide among financial advisers.

One adviser, who manages more than $350 million in client assets, said, "There's no such thing as E&O insurance."

The adviser, who asked not to be identified because he didn't want it known that he doesn't carry the coverage, said his use of complex international and alternative investment strategies would make the insurance coverage expensive and difficult to find.

Other advisers have learned to grin and bear it, though the idea of going without E&O coverage can be tempting.

"There was a time a few years ago, when we got booted [from an insurance provider] after we started using alternatives, that we considered not covering that portion of our assets," said Thomas Orecchio, principal at Greenbaum and Orecchio Inc. of Old Tappan, N.J.

The firm oversees $300 million in client assets, $45 million of which is in alternative-class strategies.

Even though Mr. Orecchio has seen his E&O insurance premiums triple to $21,000 with a $100,000 deductible over the past three years, he thinks the risks of not carrying the coverage outweigh the costs.

"I think anyone who is [going bare] doesn't understand all the risks inherent in financial planning," he said. "The markets can do funny things, and people don't always remember things they were told."

E&O coverage isn't a requirement, and it offers protection only against client claims that arise from professional services rendered. But for some financial advisers, the biggest fear is the cost of defending even a bogus claim, which could add up to $40,000 or more in legal expenses.

As with all insurance, E&O premiums are calculated based on assumed levels of risk, and when it comes to the financial advice business, insurance providers tend to approach alternative strategies with caution.

"It is elective, but the most important thing is usually covering the defense cost associated with a claim," said Andrew Fotopulos, an insurance broker with Boston-based provider Theodore Liftman Insurance Inc.

He added that the typical E&O claim is related to client suitability, which is why alternative investments can send up a red flag.

"The minute the market starts going south, the claims start adding up," Mr. Fotopulos said. "Just like lawyers and doctors, investment advisers should have some kind of coverage."

He said premiums often will double when an adviser introduces the use of alternative investments, such as hedge funds or private equity, which is why some advisers will carve out the alternatives portion of their business and leave it uninsured.

"We've been doing alternative investments for about three years, and the need for E&O insurance has been there for a while," said Don Lutomski, an adviser at Charles D. Haines LLC in Birmingham, Ala.

Even though alternatives make up just 25% of the firm's $500 million under advisement, Mr. Lutomski said that the premiums doubled to $30,000 with a $500,000 deductible when the alternatives were added to the policy this year.

To help keep the E&O premiums as low as possible, Mr. Lutomski's firm uses external auditors and diversifies alternative strategies by investing in funds of hedge funds. But he still is flummoxed by the rate increase associated with the use of alternatives.

"There's not that much difference in terms of making recommendations and investments, and it's certainly not four-times the risk when you're using alternatives," he said. "It's not like we do anything wrong and have a reason to worry, but anybody can sue."

Scare tactics

For some advisers, the idea of frivolous lawsuits is part of the scare campaign perpetuated by insurance providers.

"I've never had a conflict, and I feel the kinds of relationships I have with clients are such that we're always going to work it out," said Jeff Broadhurst of Broadhurst Financial Advisors Inc. in Lansdale, Pa. He works primarily for retainer fees and has been in the business since 2003.

Mr. Broadhurst dropped his E&O coverage last year when the premium more than tripled to $1,000.

"Those rates are reflective of what the brokers are doing," he said. "I can see why the shysters in the brokerage industry would carry [E&O insurance] - because of all the crap they're jamming down their clients' throats."

One other argument against carrying the coverage is the notion that lawyers could see the insurance as a higher likelihood of a bigger settlement, industry observers say.

"If you have E&O, you run the risk of being a bigger target for lawsuits," Mr. Schultz said. "You can protect yourself by just setting up your practice as a limited liability corporation."


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