Futures & Funds Firms: E&O Insurance Market Overview
By Andrew Royce, July 22, 2015
A 40-year veteran in the futures industry recently told me what he thought was wrong with insurance: “The problem with insurance is that the underwriters don’t understand our business.” In fairness to insurance underwriters, he went on to say, “…and we don’t understand much about insurance, either”. Historically, there has been a communication gap between insurance professionals and fund managers, which resulted in a void of relevant insurance products at a suitable premium in the marketplace.
The challenge for insurance professionals serving the futures market is often the utter complexity of the risks inherent in the futures & funds industry. A good insurance professional first seeks to understand the insured’s business before capably offering products to protect it. In practice, it is much easier for insurance professionals to insure a widget manufacturer with product liability than to understand the risks and exposures of swaps, forwards, derivatives, Reg. D offerings, etc. - not to mention compliance with regulatory bodies and back office practices and procedures.
Prior to 2003, insurance policies for financial services firms were expensive and did not provide adequate coverage, thereby making the entire transaction unjustifiable. Since then, the insurance industry has gained valuable insight into the financial services industry subsequent to the collapse of MF Global, PFG, Lehman and related catastrophic events. The heightened awareness of risk on behalf of underwriters has resulted in the following improvements to available products for financial services firms:
- An ability to properly price insurance policies
- Creation of customized policies for small to midsize firms
- Broader coverage available to insureds
This post will provide a brief market overview and detail the current products available to protect the firm, directors, officers and investors from adverse events. To begin, below are several frequently asked questions and coverage definitions:
Q: Will a policy cover Fines and Penalties, including CFTC § 1.35?
Q: Will a policy cover (formal & informal) Investigations?
Q: Does the insurance pay for attorney’s fees?
A: Yes – if the claim is covered
The insurance coverages specific to financial services firms are:
- Errors and Omissions (E&O)
- Directors and Officers (D&O)
- Employment Practices Liability (EPL)
- Fidelity Bond (Crime)
- Fiduciary Liability
- Network Security Liability (Cyber)
Errors & Omissions
This insurance (aka E&O Insurance) protects the firm, its officers, directors, employees and representatives in the event they are sued by clients for any actual or alleged negligent act, error, or omission committed in the scope of performing their professional services. Coverage includes legal defense costs even where allegations are baseless.
Lawsuits can arise even if you have not violated any laws; and even if the court rules in your favor, the cost of defending yourself could be expensive. Errors and Omissions insurance provides coverage for legal fees and settlements.
Directors & Officers
This insurance (aka D&O Insurance) indemnifies directors and officers if they are sued by stockholders, employees, clients, or others in conjunction with the performance of their duties. Coverage extends to claims arising out of alleged errors in judgment, breaches of duty, and wrongful acts related to their organizational activities.
Since a director can be held personally liable, most directors and officers will require that their firm maintain D&O Insurance to protect their personal assets.
Employment Practices Liability Insurance
Employment Practices Liability Insurance (aka EPLI) provides coverage for claims made by employees, former employees, or potential employees concerning discrimination (age, sex, race, disability), wrongful termination, sexual harassment, and other employment-related allegations. The financial services industry has above average claim activity due a number of factors including high employee compensation and employee turnover.
A Fidelity Bond indemnifies the employer for loss of money or other property sustained through dishonest acts. The scope of acts insured against includes theft, embezzlement, forgery, misappropriation, or other fraudulent or dishonest acts committed by the employee, whether acting alone or in collusion with others.
Every fiduciary responsible for managing a profit sharing plan or handling the assets of such a plan is required to obtain an ERISA bond in order to protect that plan’s assets from fraudulent activity. The amount of the bond is fixed at the beginning of each fiscal year of the plan. It must be at least $1,000.00 and never less than 10% of the amount of the funds handled by the fiduciary up to a maximum of $500,000.00 per plan.
Network Security/Privacy Liability (Cyber)
If the firm is privy to and/or electronically stores personal information, (SSNs, Bank Accounts, etc.), you should consider buying a network security policy.
A Network Security Policy provides coverage for:
- Privacy injury liability (third party)
- Network security liability
- Credit monitoring
- Breach communication
- Public relations consulting
- Pre-incident planning
- Post crisis response
- Loss or damages to your network
Alternative Risk Transfer
Obtaining one or more of the aforementioned policies is a form of Traditional Risk Transfer: You buy the policy from the insurer, which pays first dollar coverage after the deductible is paid. Alternative Risk Transfer involves a self-insurance component to financing risk. One example of Alternative Risk Transfer is a captive. Firms with $1M in annual net income are generally eligible for captive formation, which can have many benefits such as:
- Direct access to reinsurance
- Earned interest income on premiums
- Lower premium costs
- Significant tax advantages
- More control of coverage and claims
In addition to the above, most firms will also purchase Workers Compensation, General Liability, Property, and Auto. Many of these policies are required by state statute and/or by the bank or real estate leasing company. These policies are relatively straightforward; either a fire happened or it didn’t; a car was in an accident, or it wasn’t. The coverages and claims are typically black and white, and generally do not require advanced industry knowledge or specialization to obtain coverage.
Need for Specialization
On the other end of the spectrum, E&O and D&O policies are complex because the terms are different between carriers. Moreover, each carrier further negotiates coverage terms with the broker on each policy issued. Specialized brokers will understand which coverage grants to seek on behalf of the insured and how to customize coverage based on the risks of the firm. If the broker does not specialize in the industry, chances are that gaps in coverage exist.
Unlike auto claims, E&O and D&O claims have more shades of gray because coverage usually depends on how the claim was filed, the circumstances of the claim, and the policy language. No two D&O/E&O claims are the same - and when a claim occurs, (generally) the first action taken by the insurer’s claim representative is to search the policy for exclusions applicable to the claim filed. Following a claim, the insurer will either deny the claim, send a reservation of rights letter, or accept the claim.
Similar to negotiating the terms and conditions of the policy language up front, the claims process can also turn into a negotiation. If you decide to buy the coverage, start with the end in mind. That is, negotiate terms and conditions up front before a claim…when you have leverage. The biggest misconception about E&O and D&O policies is that a $5M limit will provide coverage for all D&O claims up to $5M.
However, when it comes to large D&O/E&O claims, coverage is determinedexclusively by the terms, conditions and exclusions of the policy. You could have $50M in limits, but if an exclusion thwarts coverage, you might find that you’ve been paying premiums that reap no benefits. Further, when a D&O/E&O claim occurs, it’s usually because something has gone terribly wrong, and therefore the claims tend to be large. In addition, claims can drag on for years before they settle and litigation fees add up quickly. Filling gaps in coverage is vital to ensuring your premium dollars are not being wasted.
For the numerous threats faced by financial services firms today, purchasing insurance is a cheap form of capital to deploy when an adverse event occurs. Purchasing insurance will protect the entity as well as the personal assets of the directors and officers that lead it. From a fiscal perspective, insurance will provide:
- Increased predictability and sustainable earnings
- More efficient use of capital
- Reduced volatility
Each firm has a different tolerance for risk, which has to be taken into account when determining whether to transfer risk (buy insurance) or self-insure (active awareness). The key is to assess your risk profile and determine the costs to transfer risks so that you can make an educated decision.
Benchmarking is not an exact science and each fund is different. The smallest funds can buy limits for $500,000 limit of D&O/E&O coverage while MF Global and Lehman Brothers had $250MM limit of coverage, respectively. The costs can be as low as $2,000 and go up from there.
If you have not had a claim in the past, now is a good time to obtain quotes because credits will be applied to premiums for a clean loss history. Remember that D&O/E&O claims are rare, but black swan events do occur; frivolous claims can happen, and insurance may be a good form of capital to protect your firm and personal assets.