Managing operational risks at growing advisory firms

Despite the onslaught of unforeseen challenges brought by the Covid-19 pandemic, independent registered investment advisers achieved remarkable growth in 2020. As demonstrated by Schwab’s most recent RIA Benchmarking Study, strategic innovation paired with adaptive resilience resulted in financial and operational gains for many firms, with assets under management up 14.5%, revenue up 7.5%, and client growth up 4.7%, at the median among those with more than $25 million in assets.

Along with this growth and success, advisory firms are also facing a multitude of changes – some bringing new challenges and others driving innovation. The demands of clients are increasing in complexity alongside the emergence of novel investment approaches, while shifting demographics are bringing new planning needs and IT infrastructure looks nothing like it used to. And now advice can come from significantly larger, and certainly more geographically dispersed teams than ever before.

As encouraging and exciting as these developments are on one level, there is no escaping the fact that growth and maturity also result in increased operational risks. These risks can come in several forms – from errors and fraud, to cyberattacks or breaches of fiduciary duty. Given the rapid pace of growth, continued change and heightened complexity, preventive operational measures may have their limitations when it comes to protecting firms.

Now more than ever, RIAs need to recognize insurance as a vital component of their risk management strategy. Lacking adequate coverage in the event of an unexpected risk event could prove devastating to your clients, your firm’s reputation and even your long-term viability.

In fact, having strong insurance coverage may be the only financial backstop available to your firm in a scenario that can’t be prevented by purely operational safeguards. For example, incidents resulting in lawsuits can quickly result in significant legal costs or settlement obligations that can easily topple a firm that lacks adequate coverage.

Insurance allows advisory firms to transfer risk away from the company’s balance sheet and creates a safety net that most firms can't afford to be without – particularly smaller firms with relatively modest access to capital. 

Advisers should take a holistic planning approach to best protect themselves, their employees, and their clients. We recommend that firms:

1. Employ annual strategic planning to better understand their priorities, goals, and risk tolerance.
2. Research insurance options that suit your business model today while also anticipating new coverage requirements that are emerging as a result of changes occurring in the industry.
3. Determine the appropriate insurance coverage and levels, considering the scope of your operations, investment strategy and trade volumes, investor base, AUM and costs to cover legal expenses if such expenses were needed.
4. Routinely review options and coverage with your insurance broker/agent to confirm you have the necessary coverage and make changes as needed.

As advisers develop or review their risk management programs, understanding the range of insurance solutions available, as well as the benefits of each, will help them implement coverage that makes sense for their specific business.

Among the types of insurance typically considered for advisory firms:

• Professional liability or errors & omissions. This coverage is intended to address claims made by clients who believe the firm breached their fiduciary duty or was negligent in managing their assets.
• Directors and officers liability. This coverage is intended to protect directors, officers and other employees from shareholder claims resulting from the decisions they make on behalf of the business.
• Fidelity bond. Intended to mitigate losses caused by dishonest employees or fraudsters impersonating clients or firm employees.
• Cybersecurity. Can provide first-party and third-party coverage for the insured. First-party provisions are intended to cover the costs associated with responding to a cyberbreach and rectifying the issues. Third-party provisions are intended to cover liabilities that arise from lawsuits brought by clients or other third parties who allege that they have suffered losses because of the breach.

While some growth implications for independent advisers might be obvious – for example, increased staffing needs or investments in technology – advisers also need to be careful not to create vulnerabilities by overlooking less obvious implications, such as increased operational risks.

Ian Muir is managing director of advisor controls and trading at Schwab Advisor Services.