We expect the continued soft market to slowly level out and potentially begin a slow process of gradual firming, first through coverage changes and then eventually making its way to renewal rating.
Summary

Due to ever-increasing regulatory costs, competitive pressures and economies of scale, consolidation remains a major trend within the industry. Independent broker-dealers remain a favorable segment for private equity buyers who capitalize on greater leverage with product suppliers and recruiting ability by combining firms, whether through stock or asset purchases. These large firms have traditionally been able to spread costs out amongst their field force and capitalize on cost savings on a per head basis; however, recent high profile losses on both Errors and Omissions and Bond coverages have provided upward pressure on pricing. While the market as a whole is still primarily favorable towards buyers, recent acquisitions on the carrier side coupled with changes in appetite in London will most likely begin firming pricing and restricting new coverage grants. Coverage for regulatory matters and selling away will take on new importance as carriers face less competition and begin to limit coverage in areas with adverse claims experience.

Lingering Effects of the Fiduciary Rule

With the final blow to the oft-discussed Fiduciary Rule in 2018, the industry collectively breathed a sigh of relief. For a regulation that promised to bring major changes to the industry and empower consumers, its demise was heralded with more of a whimper than a bang. Many large firms reviewed the cost of compliance with their proposed regulations and potential blowback from pulling back on additional investor protection procedures and decided to simply move forward anyways. Other firms chose the less burdensome of changes and enacted them and scrapped anything that would result in additional compliance costs or paperwork for their representatives. Regardless of the route the firms pursued, the potential ruling was a wakeup call for many brokers who felt that the increased regulatory scrutiny on commission-based products had become too much of a liability relative to the income potential. The fiduciary rule did not start the movement towards fee-based platforms but it certainly added to firms changing their business models.

One reason that many firms have chosen to move forward with additional policies and procedures designed with the fiduciary rule in mind is that while the rule itself is effectively dead and buried, its spirit is alive and well. The New York Department of Financial Services has already moved to enact some parts of the rule with respect to variable annuity sales, while various other state securities departments have signaled a desire to apply broad interpretations of existing investor protections in order to encourage compliance with various portions of the former proposal. In addition to these current regulations, the SEC has put forth a new proposal for comment, Regulation Best Interest, which would create a completely new standard of care for commission-based sales. While not fully a fiduciary standard, the new requirement is colloquially referred to as "Best Interests +", a standard that requires that advisors not only act in their client’s best interests but also that they actively disclose and avoid any potential conflicts of interest, a requirement that seems straightforward on its face but can be tough to comply with and enforce in practice. In addition, it has similarities to the existing FINRA suitability rule; if this rule is adopted we may see FINRA make changes to their rule.

The Elephant in the Room: Selling Away 

Selling away, the practice of selling securities and other investment products outside of a broker-dealer’s approved platform, can be a major problem for brokerage firms. While many advisors are allowed to sell insurance products outside of their firm platform, securities must be approved by the BD and selling investment products without the knowledge or approval of a registered firm is a violation of securities laws. Analysis of Gallagher claims data and discussions with claims executives at major carriers such as AIG and OneBeacon indicates that claims of which selling away is a major component comprise only 2–3% of claims reported. Though they’re infrequent, they account for somewhere between 5 and 15% of paid loss — a figure which is difficult to accurately assess due to the impact on multiple lines of coverage, an issue which is described in further detail below. The outsized impact of these claims is two-fold: they typically involve multiple customers over a long period of time and they’re also very difficult to prevent or mitigate.

Because the very practice itself is a regulatory violation, advisors engaging in selling away will typically go to great lengths to hide the activity from their firm, whether by using undisclosed/unmonitored email addresses for communications or by forging documents to give the appearance of normality to otherwise prohibited products. Errors and Omissions policies do not typically cover selling away without a specific request to underwriters and subsequent amendment. Due to the high severity of these types of claims, underwriters will usually seek to limit their exposure by utilizing some combination of sublimits, higher retentions or coinsurance. There is no coverage for the advisor. The coverage is primarily intended to guard against claims of negligent supervision against the firm. Though the activities are often intentionally hidden from the firm, investors bringing arbitration actions against the broker-dealer are typically successful even in the absence of any direct wrongdoing by the firm and many such accusations settle outside of arbitration. While we haven’t noted a substantial change in the frequency of these types of claims, increased pressure on pricing and terms could lead to additional difficulty in securing this coverage, thus it is recommended that any firms that do not currently carry such seek the coverage out as soon as is practicable. 

An additional consideration with respect to selling away is the potential impact on not only the E&O but the bond as well. Data on the frequency of products sold outside of the firm is scarce and information regarding their incidence of fraud is even less easy to come by, however, claims with the highest severity will typically involve some element of fraudulent behavior. As such, it is important to take a close look at fidelity bond coverage with respect to fraudulent products and ensure that the coverage is amended to appropriately address the risk. While the Registered Representative coverage rider on bonds will extend the bond down to cover actions of representatives, it’s important to also review the bond’s notice requirements, prior dishonesty clause and definition of loss to proactively address the matter as elements of fraud are not always immediately apparent in matters of selling away.

A Market in Flux

With respect to market side changes, 2018 was relatively quiet with respect to major acquisitions. We have not seen any major domestic carriers exit the market, however, if market volatility continues and eventually leads to an increase in claims, this could easily change in 2019.

Across the Atlantic we are seeing a more conservative approach taken by underwriters in London, who have been relatively aggressive in recent years and provided much needed capacity. While strategy varies from syndicate to syndicate, with Antares taking lead slip on most large and midmarket risks, their strategy has steered the market for the broker-dealer niche in recent years. Much like the U.S. market, revisions to rating haven’t had a major effect on renewals, however, new business and additional coverage grants have incurred added scrutiny than in past years and have broadly seen terms and conditions offered with a slight increase over similar accounts/ coverages, sublimits or increased retentions.

Cyber Liability Considerations

Due to the large number of entrants into the cyber liability market, there remains high variability in pricing and terms and conditions both for broker-dealers and commercial accounts more broadly. The past year has seen many of the more traditional cyber carriers such as Beazley and Hiscox start to entertain financial institutions risks which has provided downward pricing pressure on a market previously controlled primarily by London. Lloyds has responded by expanding coverage to include insurance arrangements previously considered uninsurable exposures, such as privacy liability for noncustomers and social engineering/cyber deception coverage.

The exposure for noncustomers of broker-dealers has traditionally been an issue of concern both for underwriters and for clients. While cyber coverage for broker-dealers customarily extends to all data on their clients, whether housed on corporate servers or those of registered representatives, BDs typically will allow their representatives to engage in insurance sales outside of their platform, both for customers and non-customers. For representatives engaging in outside business, the broker-dealer has a duty to supervise all transactions, even if they’re not flowing through their product ecosystem, which can create problems if there were to be a data breach. Brokerage firms have been hesitant to require their representatives to carry separate cyber liability coverage as the exposure is usually relatively minor; however, issues can arise if the coverage isn’t correctly represented both to the firm and the representatives. London, in conjunction with RPS Insurance (Gallagher’s wholesale brokerage firm), has developed a product that can provide coverage to the firm and representatives for their traditional cyber liability as well as for the data held at the representative’s office that is not customer data of the firm.

By providing a sublimit for noncustomer data and not requiring individual applications from representatives, the policy allows the firm to mandate cyber coverage for the activities they are required to supervise without the added headache of forcing representatives to provide proof of coverage and ensures that policies are not lapsed or canceled. While the policy is currently only available through limited outlets in London, it’s likely that additional syndicates will join in the future. In addition to coverage for data not held in-kind with the firm, the market tolerance for social engineering/cyber deception is also rapidly evolving. Social engineering commonly refers to the practice of impersonating a customer, employee or vendor in order to effect a fraudulent transfer of funds through deceit of a firm employee. Coverage may exist under different policies (Errors and Omissions, Bond or Cyber) with the coverage varying between policies. Finding coverage in one form or another has presented difficulty with respect to funds held on behalf of customers. As the industry matures, carriers have begun to soften their stance on such coverage. Though typically sublimited, we are starting to see coverage grants for social engineering loss not only of the broker dealers’ own fund but that of funds held in customer accounts as well. That being said, some carriers are still presenting the coverage with “call-back” requirements (conditions on coverage that require Insureds to perform a telephone confirmation for fund transfers) which can be problematic for firms as typically these types of losses only occur when the customary policies and procedures are not followed in the first place.

Claim Activity Update

Though not a perfect measure, FINRA arbitration data can give us valuable insight into the claims trend of the industry as a whole. A booming economy has provided ample returns for clients which in turn has led to depressed arbitration and claims activity over the past four years. With the return of volatility to the market, however, year-over-year data for the first half of 2018 shows a marked uptick in new arbitrations filed — a 35% increase for an estimated jump of 1,000 additional arbitrations this year1 . Though there is a bit of lag between market events and claims activity, continued uncertainty in the market as a whole can provide the underpinnings for an increase in claims frequency across the industry. In addition to systemic volatility, sharp movements in the real estate and oil and gas sectors are starting to fuel a rise in claims regarding sale of private offerings focusing on those assets. Particularly with oil and gas limited partnerships, there has been a relatively sharp uptick in claims based on softness in that market from the 2015–16 period which led to a major decline in valuations of those products. While that market has largely recovered some of the earlier losses, increased volatility is driving further claims on products that are not yet insolvent and further weakness could lead to additional claims. The real estate market has yet to result in many new claims, however, further decline in that sector could also lead to claims as REITs have just started to rebound for new sales in recent years. As has been the case for much of the past decade, in addition to the alternatives above, claims alleging unsuitability in annuity swaps and life insurance continue to represent a not insignificant portion of claims activity as well.

Market Forecast for 2019 and Beyond

Domestically the market for broker-dealers will most likely remain relatively unchanged with markets pursuing increases where feasible but without forcing the issue for clients where rate changes could cause conflict. More likely is that new coverage grants which would previously incur little to no additional premium will be priced at a higher rate than in previous years. Carriers may also offer a flat renewal at the expiring rate but with a slightly higher retention alongside an option to keep the retention as expiring at a premium in order to try and evade backlash from a strict increase. As the London market begins to harden, domestic carriers will become competitive on accounts they previously were not able to quote, which could help to smooth out any major rate changes. If market volatility continues or worsens, exclusions for specific products or sublimits/increased retentions for product classes could be applied at renewal as carriers attempt to minimize exposure to sectors sensitive to swings in the broader economy. Additional FINRA scrutiny of commission-based sales will most likely continue the trend towards fee-based advice, though recent indications from SEC officials and state regulators point to a measured response in their oversight of advisory assets to match. If the additional oversight eventually leads to claims activity, premiums could potentially begin to approach the rates charged for brokerage assets, which have typically been substantially higher than those for fee-only firms.

To recap, we expect the continued soft market to slowly level out and potentially begin a slow process of gradual firming, first through coverage changes and then eventually making its way to renewal rating. Primary placements in London will see the most changes, with excess seeing less of a shift due to a larger pool of syndicates available. Domestically, rating will mostly be claims-driven on E&O lines with some rate and retention increases on bond lines as carriers continually update strategy to try and bring that coverage to profitable levels. Cyber coverage will remain relatively competitive with carriers competing for market share less on pricing and more on additional coverage.

Rob Erzen is a Senior Area Vice President in Gallagher’s Management Liability & Financial Institutions Practices. As a member of these groups, he focuses on providing insurance and risk management solutions to all industries, including financial institutions, specifically broker-dealers. For additional information, please contact Mr. Erzen at Rob_Erzen@ajg.com or visit ajg.com/mlp.

Important Note: This paper is not intended to offer legal advice. Any descriptions of insurance provided herein are not intended as interpretations of coverage. An actual insurance policy must be consulted for full coverage details.