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Also available as podcast (Episode #83)
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How Much Errors & Omissions (“E&O”) Coverage Does My RIA Need?
Obtaining Errors & Omissions insurance for your Registered Investment Advisor (“RIA”) is not only a best practice, it is usually now a requirement for most RIAs. E&O is professional liability insurance that protects your RIA from risks ranging from the proverbial “fat-fingered” trade entry error, to defending yourself against meritless lawsuits. Most custodians now require RIAs using their clearing services to maintain a minimum level of E&O coverage. While typically in the $1 million range, there are nuances between custodial requirements and coverage types that are important to be aware of.
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Full Transcript:
How much E&O coverage does my RIA need? That is today’s question on the Transition To RIA Question & Answer series. It is episode #83.
Hi, I’m Brad Wales with Transition To RIA. I help you understand everything there is to know about why and how to transition to the RIA model.
If you are not already there, if you go to TransitionToRIA.com you can find all the resources I make available from this entire series in video format, podcast format, I have articles, I have whitepapers. All kinds of resources to help you better understand the RIA model.
Again, TransitionToRIA.com.
On today’s episode, we’re going to talk about if you have your own RIA, how much E&O coverage do I need to have for it?
A quick reminder or primer for some of you, E&O stands for Errors and Omissions insurance. We typically refer to it just as E&O. Think of it as professional liability insurance. It protects you from several potential risks.
By definition of E&O, errors and omissions, part of it is if an error is made. If you place a trade, and did the proverbial fat finger where you were supposed to buy or sell 100 shares and you accidentally bought or sold 1000 shares, and by the time it was corrected the market moved against the position.
In addition to errors, it is also to protect you from, among other things, perhaps lawsuits from clients, particularly that have no merit but which could result in significant legal costs for you to defend. So again, it’s professional liability insurance to protect you in that manner. It is something very important to an RIA practice.
We’re going to talk about how much E&O coverage you will want to have or need to have.
If you want to learn more about the process of how to obtain E&O coverage, I did a separate episode on that. It is episode #46. So check that out if interested.
Before considering how much E&O coverage you should have, you might be wondering, “Do I even need E&O coverage?” There are three main prongs to that which I want to touch on to start with here.
First, there’s generally no across the board regulatory requirement, at least as of today, that requires an RIA to have E&O coverage.
Now that said, if you are state registered, there in theory are 50 different regulatory bodies in 50 different states that could decide to implement rules or not. Perhaps there is a state that has since implemented an E&O requirement that I’m not aware of yet, but generally speaking there’s not a broad regulatory requirement that RIA’s obtain coverage.
I wouldn’t be surprised if, at some point, that does come along. If I had to guess, it would start at the state level. Maybe a couple of states start doing it.
Would the SEC ever look at it? To be determined. But at the moment, it’s generally not a regulatory requirement that an RIA have E&O insurance.
The second prong, and this is relatively new, is that most custodians now require that RIAs that use that custodian for clearing services have E&O coverage.
This is relatively new. It was about two years ago that the large custodians all made this a mandate. If you’re using the custodian as your sole custodian, or just one of your custodians – I’ve made separate episodes on being multi-custodial – the custodian requires that you demonstrate proof that you have E&O coverage.
There are still some smaller custodians that have not formally implemented a requirement. If I had to guess, it is only a matter of time before they all do.
The third prong of should you have E&O coverage is it’s a best practice.
Like physicians, it’s a best practice to have professional liability insurance. Unfortunately, there are people that are willing to sue even when there’s no merit. You’ll want to protect yourself from that.
Even before the custodial mandate, most RIAs, particularly of size, have E&O coverage. Over the years I’ve encountered several smaller RIAs that chose to not have it, but it’s a best practice regardless of whether you are formally required to have it or not.
I’ll give an example, a horror story if you will, of an RIA without E&O where it went bad.
This was several years ago. There was a midsized RIA, maybe around $80M, where the main principal/owner chose to not have E&O coverage. I don’t recall his main motivations for this, though it was likely to save money.
One contributing factor I recall though was his belief that none of his current clients would ever sue him. He felt he knew them so well that would never be an issue.
Which for starters, that is shortsighted. Yes, you might know your clients well, and feel they would never do something like that, but it only takes one for you to misread and for it to create an issue.
In this advisor’s case, it was not one of his clients. His client passed away, and the beneficiary of the account was that client’s adult children, who the advisor did not have a relationship with.
The children took issue with how the advisor had traded the account. I forgot all the specifics, but their grievance was something to do with how the advisor had allegedly managed the account over several years for their parent.
As the children had no relationship with the advisor, they took no issue with suing the advisor over this. It turned into a multi-year protracted legal battle.
The advisor ended up spending hundreds of thousands of dollars in legal fees. The children were relentless in pursuing the matter. They were entirely unreasonable.
At the end of the day, after years and hundreds of thousand of dollars, the advisor won the arbitration. Not only that, the arbitration panel even awarded him his legal fees to be paid by the other side. The advisor was fully exonerated, over a meritless lawsuit.
But before that point, the advisor had to front hundreds of thousands of dollars over the years in legal fees. He was then tasked with trying to collect his legal fee reimbursement from an opposing side who didn’t have the capacity or willingness to pay.
I don’t know how it ever fully ended up, whether he even got 50 cents on the dollar, if even that. But basically, he was out hundreds of thousands of dollars. He was exhausted during all of this. Both financially and emotionally.
I vividly recall him saying, “Once this is done, I’m going to get E&O coverage.”
I wasn’t going to pour salt in the wound, but that’s like watching your house burn to the ground and declaring you plan to now get home owner’s insurance for it.
That’s not how insurance works. Insurance is for before the risks occur.
Main point of the story, if you’re going to run an RIA properly, you need to have E&O coverage.
That dovetails into, “How much coverage do I need to have?”
As a base coverage level, this will often be dictated by your custodians’ coverage requirements.
Each custodian that mandates coverage, has set their own requirements for it. In aggregate, the coverage levels of custodians is typically around $1 million in coverage.
Where this gets more nuanced is the custodians have typically broken that $1 million into different coverage types. They might say, “You need to have $1 million worth of E&O coverage, but you also need to have $250,000 worth of employees theft coverage.”
Others say, “It’s $1 million total. $750,000 must be E&O and $250,000 is cyber security insurance.”
The idea is that, give or take, most custodial coverage requirements are in the roughly $1 million in aggregate range.
Which as I mentioned, there are different coverages that are typically bundled together with E&O that you might choose, or are required to obtain. Those other types might be employee theft coverage, cyber insurance coverage, etc.
There’s no uniformity amongst the custodians on coverage types and amounts, except they all happen to be gravitating around this roughly $1 million, give or take mark.
The way to determine this for sure if by asking your custodian(s). You can also turn to the specialty E&O insurance providers in the marketplace that know the various coverage levels mandated by the custodians.
I don’t want to dive too much into what the cost of E&O is, as I did the separate episode on that (#46) but I’ll add a few quick points here.
For starters, keep in mind, an E&O policy is at the RIA level, and then it covers all the individuals underneath it. So it’s not a matter where each of the individual producers within the RIA have to go out and get their own E&O coverage. The E&O coverage is typically at the RIA level, and it covers everyone underneath it.
Two factors that are usually the biggest contributor to what the premium will be are how much AUM the RIA has, and the investment solutions used.
The bigger the RIA, the bigger the risk is and so the bigger the potential premiums that go along with it.
As for investment solutions, if you use a lot of, for instance, alternative investments with your clients, fair or not, that is deemed by the insurance companies to be higher risk. If you use a lot of those products, the premium is going to be higher.
So just know those are two of the bigger drivers of the premium price.
A final note, and again I did a separate episode on this, there are E&O insurance providers that specialize in the RIA industry. You don’t want to go to some random insurance provider down the street asking for professional liability insurance.
In theory, you could attempt to do that, but you’re better off going with a specialized insurance provider that knows the custodial requirements, knows the best practices, etc. There are good providers that know this space, can help you through that process. Again, if you want to learn more about how that process works, check out episode #46.
I hope this gives you an idea of why you need to have E&O coverage, roughly the amount of coverage you’re almost certain to be required to have, as well as some of the different nuances and variables that go into it that you want to be aware of.
Bottom line, whether you’re required to have it or not, it’s absolutely a best practice. You will want to have it as part of your firm. One of the necessary costs of running a professional RIA practice is to have E&O coverage. But you want to make sure you’re doing it correctly. You want to make sure you’re protecting yourself and meeting all the requirements of a custodian, and perhaps one day, maybe even regulatory requirements.
With that, like I said, my name is Brad Wales. This is the sort of thing I help advisors with. If you were to transition your practice into the RIA model, what are the variables that you need to be aware of, and how are you going to solve for them? Compliance, technology, custodians, E&O coverage, etc. How does it work? How do you solve for it? Who are the solution providers? What’s the process involved?
That is a typical part of the conversations I have with advisors. I’m happy to have that conversation with you whether you want to talk about today’s topic or anything else RIA-related.
Again, as I said at the top, head to TransitionToRIA.com.
You’ll find all the resources I make available. This entire series in video format, podcast format, I have articles, I have whitepapers.
At the top of every page is a contact link. Click on that and you can instantly and easily schedule a one-on-one conversation with me. To talk about anything RIA-related and how it might affect your practice if you were to transition into the model.
Again, TransitionToRIA.com.
With that, I hope you found value with today’s episode, and I’ll see you on the next one.
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