Authors: Jennie Kauke Rob Erzen
Introduction
At the beginning of 2022, there was uncertainty regarding how the hardening insurance market would impact broker-dealers. Broker-dealer Errors and Omissions (E&O) insurance is typically the primary insurance cost driver for firms. For the most part, broker-dealer E&O has been shielded from industry-wide hardening market shifts, because domestic and international equities continued their march upward until 2022. In 2022, the equity markets began to underperform. Rising stock markets generally mean brokerage customers are less likely to sue their advisors. An increase in market volatility may lead to an increase in arbitrations filed.
However, the premium for broker-dealer E&O insurance is almost exclusively driven by loss ratios of each specific client and has less to do with overall direction of insurance markets. So, firms live and die by their own claim history, and for the last five years, most firms have had historically low claim volumes.
Below is a summary of some of the headwinds we're currently facing and how they may influence the market conditions for broker-dealers in 2023.
What broker-dealer insurance trends we saw in 2022
2022 insurance coverages for broker-dealers impacted by insurance market include:
- Cyber insurance: Cyber insurance continues to be the most challenging placement for broker-dealers, the same as we see in other industry sectors. Broker-dealers are experiencing increased premiums, although the market is starting to stabilize. How advisors are managing cybersecurity in the field continues to be a focus, especially having multi-factor authentication (MFA) for remote access as well as endpoint detection and response (EDR).
- Management Liability insurance, (including Directors and Officers (D&O), Employment Practices Liability (EPL) and Fiduciary Liability): For broker-dealers, the increases in revenues broker-dealers were seeing in 2021 and 2022 impacted management liability lines. Few markets exist for primary D&O for broker-dealers, and those markets rely heavily on the placement of the primary E&O.
Current state of the broker-dealer market
Errors & Omissions (E&O)
In the E&O marketplace, 2022 remained favorable for firms with good loss experience. Some firms are starting to see an uptick in claims that will impact overall loss ratios. We're slowly starting to see the impact of a new capacity in this space.
Finding coverage for small broker-dealers continues to remain a challenge. Insurer capacity has reduced significantly for small firms, and premium increases are typically needed to continue to support any losses under those programs. We haven't seen any major changes to coverage or limits for our larger broker-dealer clients.
- Investment products: In 2022, product failures or investment products that have filed for bankruptcy have presented challenges for some broker-dealers. Any time you see a product file for bankruptcy, you're almost guaranteed to see the product excluded on the E&O policy for any claim arising from or related to the sale of that product. It's still too early to predict how recent product failures will impact future pricing for broker-dealer E&O policies.
- Regulatory landscape: Broker-dealers continue to face scrutiny from the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC). The regulatory agencies will also take deeper dives in broker-dealers practices, especially when you see a failed product sold to investors. Emphasis will be on the disclosures and diligence completed in the process. It will also shed light on firms' compliance with Regulation Best Interest (REG BI).
With regards to the insurance, limited regulatory coverage is available on E&O policies. Small sub-limits are available for firms and their advisors for regulatory proceedings to investigate a wrongful act related to professional services covered under the E&O policy. Insurers haven't expanded coverage in 2022, and we don't expect that to change.
Fidelity
Fidelity bonds have always been a challenging line of coverage for broker-dealers. The fidelity bond is intended to protect the firms from dishonest acts committed by their employees and by their advisors. The most common claim scenario is an advisor stealing or misappropriating customer funds. Severe losses continue to limit insurance carriers willing to take on this distressed class of business. As a result, we saw broker-dealers take increased retentions and/or increased pricing to offset those severe losses. Placing the fidelity bond with the same carrier as the firm's E&O can offset or reduce the impact of the increasing fidelity costs.
Social engineering fraud continues to be a hot-button issue for many clients. Most broker-dealer firms require their advisors to verify any funds transfer request with a call to the client. Still, we continue to see claims where the callback procedure isn't adequately followed and even scenarios where the fraudster deceives employees or advisors into thinking they're the client contact. While we typically look for the bond policy to cover this exposure, we also see carriers putting limited coverage on the E&O policies with small sub-limits and at lower retentions than the bond policy.
Merger & Acquisition (M&A) Activity
M&A activity continues to march full speed ahead. We saw several transactions in 2022. Private-equity-owned broker-dealers are looking for ways to grow assets and advisor count with aggressive growth targets quickly. M&A isn't slowing down, and we expect this trend to continue through 2023.
More firms are also incorporating Reps & Warranties insurance as part of the transaction. These deals present their own insurance challenges to tailor the insurance program to fit each individual transaction, particularly the E&O and fidelity bonds. Advisors rely on this insurance to conduct their business, and often these transactions leave out the reps past liability (or prior acts). We evaluate this exposure early on. As part of our review, we ensure insurance effectively covers any past claims or any troubled products insurance when firms buy or bring on new advisors.
Claim Activity
In 2021, the number-one security involved in customer arbitrations was real estate investment trusts (REITs).1 We're seeing a slight shift: Although alternative investments, including REITs, continue to drive claims in 2022, common stock, options and mutual funds are also contributing to claim volume.
Market volatility will continue to be a challenge. In 2022, the S&P 500 is down about 17%.2 The first half of 2022 saw significant drops, with rising inflation being a driver for these drops. What does that mean for broker-dealers? 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.
With market volatility, we typically see an increase in filed arbitrations. However, the number of arbitrations filed through October is 2,179.1 It's about 14% lower from the prior year.
Can we expect to see more claims in 2023? We think the answer is yes. Many clients are looking forward to an end of rising rates and a potential of a soft landing for the economy and an end to the down market for equities. However, many analysts believe corporate profits will suffer significantly in the first half of 2023 as the full effect of the dramatic rise in interest rates is felt throughout the world economy. As corporate profits suffer, so will their corresponding stocks.
Another year of a down market will most certainly convince clients who haven't yet brought an action against their advisor this year to do so in late 2023 or 2024.
Looking ahead at the broker-dealer industry
As we move into 2023, we will continue to watch changes to the below and any impact those changes may have on coverage.
Merger & Acquisition (M&A) activity: We will continue to monitor clients' M&A activity and/or an increase in recruitment and evaluate the impact on coverage. Any increase or changes to the risk profile can lead to an increase in cost on a per rep basis for the broker-dealer.
Product failures: If we see any more failed products or insolvent products, these failures may be a driver for additional coverage exclusions or increases in premiums.
Market volatility: If poor performance of the equity markets continues in 2023, it may be the primary driver of claim activity. We will also watch for any changes to investments broker-dealers sell and any changes to claims activity around these products.
Regulatory changes: We will monitor any new regulatory changes and priorities that can impact coverage and pricing for 2023.
Conclusion
Based on the highly nuanced nature of this market and the broker-dealer, it is imperative that you are working with an insurance broker who specializes in your particular industry or line of coverage.
Gallagher has a vast network of specialists that understand your industry and business, along with the best solutions in the marketplace for your specific challenges. It is extremely important to start renewals as soon as possible and to work with your Gallagher team with dedicated expertise in this space to deliver a comprehensive and professional submission to underwriters.
Please note: A client's risk profile is the primary variable dictating renewal outcomes. Loss experience, industry, location and individual account nuances will also have a significant impact on these renewals.
