Authors: Jennie Kauke, Rob Erzen
Consolidation continues to be the name of the game in the broker-dealer industry. Due to ever-increasing regulatory costs, competitive pressures and economies of scale, broker-dealers continue to combine at a breakneck pace. 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/recruiting arrangements. While the industry experienced a slowdown of merger and acquisition activity in the independent broker-dealer space in 2020, likely due to the COVID-19 pandemic, industry discussions indicate this activity may pick back up in 2021. 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 & Omissions (E&O) and bond coverages have provided upward pressure on pricing in addition to those attributable to the hardening market. Overall, the market in the broker-dealer space is heavily driven by each client's loss ratios and, with no new insurance carrier entrants in this space and London appetite changing, we will most likely see continued firming on pricing. Coverage will continue to be the main component and of utmost importance for clients, as carriers face less competition and begin to limit coverage in areas with adverse claims experience.
Securities and Exchange Commission (SEC) Regulation Best Interest (Reg BI)
The SEC Reg BI rule took effect on June 30, 2020, just over two years after the long-anticipated Department of Labor (DOL) fiduciary rule was shelved. The standard is designed to improve the conduct of brokers and requires that they not only act in their clients' best interests, but also that they proactively disclose and avoid any potential conflicts of interest. We believe this imposes a more demanding standard than the previous suitability standard set by the Financial Industry Regulatory Authority (FINRA). The regulation requires that securities recommendations be in customers' best interests, and that the firm and brokers' interests cannot supersede such. Due to firms' previous preparation for the implementation of the former DOL fiduciary rule, most firms had already laid the groundwork to encourage compliance with the measure. While the rule is promulgated under SEC rules, ultimate responsibility for enforcement will be delegated to FINRA, the industry self-regulatory body. Due to the short time frame since its implementation, how this ruling will apply to broker-dealers in practice remains to be seen; we expect that initial guidance will be provided in the context of regular exams. From the insurance coverage perspective, carriers will most likely adopt a wait-and-see approach to determine if this regulation results in an uptick of customer claims and respond accordingly.
Shift to fee-based business
Over the last decade (but in earnest the past two years), firms have increasingly looked for ways to continue to move from transaction-based brokerage business into fee-based advisory business (charging a fee based upon assets under management). This shift was originally driven out of concern from the DOL rule causing firms to have to reinvent their business model before they would be forced to by pending regulations. Since that rule's termination, firms have continued to move in this direction, and the amount of revenue generated from fees continues to increase year over year. Market pressures continue to push firms to find ways to remain competitive and increase offerings to their advisors, whether through fee-based platforms or other technology offerings, and broker-dealers have invested a great deal into building out their advisory platforms in order to retain talent. Traditionally, fee-based advisory business has been viewed in a more favorable light from the insurance carrier, as opposed to commission-based business. Concerns and claim trends in the past have been driven by losses in the alternative investment space, which is not as big of a draw to fee-based advisors due to the lack of any associated commission incentive. Insurance carriers are encouraged by this development and, if claims trend down because of the increased fee-based business, we will most likely start to see insurance carriers reward this transition with lower rates.
Selling away still a major risk exposure
Selling away, the practice of selling securities and other investment products outside of a broker-dealer's approved platform, continues to be a major exposure faced by broker-dealers. While many advisors are allowed to sell insurance products outside of their firm platform, securities must be approved by the broker-dealer, and selling investment products without the knowledge or approval of a registered firm is a violation of securities laws. Review of claims data and discussion with claims executives indicate that selling away claims comprise only 2%–3% of claims reported. Though 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 twofold: 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. E&O 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. Because of the nature of the act, there is no coverage for the advisor; the coverage is 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, due to FINRA's broad interpretation of the broker-dealer's duty to supervise its representatives, 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 any higher limits for coverage. For any firms that do not currently purchase selling away coverage, we recommend securing quotations to include this in their coverage.
As mentioned above, 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.
Volatility leads to an increase in trade error costs
2020 was far from quiet with regards to market volatility and, earlier on in the year, as fear and news of COVID-19 increased, the markets suffered some of their worst losses. Due to the large market swings during that period, we saw an uptick in trade error claims in this space, making a focus on the policy language surrounding these corrections even more important. Trade error (or cost of corrections) coverage is typically provided by endorsement and is generally not sublimited for larger broker-dealer accounts, though small and midsize firms may have lower limits of coverage. When the market is volatile, in the event of a trade error, often corrections need to be made immediately, and there is often not enough time to wait for insurance carrier approval of the loss. Ideally the policy language should allow broker-dealers to correct the erroneous trade without prior consent of the carrier and submit details of loss within a minimum seven days of the error. While this might not be a guarantee of coverage, it allows the insured to correct the loss without the holdup of insurance carrier approval (which could further exacerbate the loss). While market volatility has mostly subsided at the time of this report, we would expect any large future volatility to lead to even more of these claims.
An update on arbitration statistics
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 six years. With the return of volatility to the market, year-over-year data for the first half of 2020 shows a little over a 9% increase in new arbitrations filed through September. Though there is usually a 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.
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 start to entertain financial institutions' risks, which has provided downward pricing pressure on a market previously controlled primarily by London. The response has been to expand coverage to include insurance arrangements previously considered uninsurable exposures, such as privacy liability for non-customers and social engineering/ cyber deception coverage.
The exposure for non-customers of broker-dealers has traditionally been an issue of concern, both for underwriters and for insureds. While cyber coverage for broker-dealers customarily extends to all data on their clients, whether housed on corporate servers or those of registered representatives, broker-dealers typically will allow their representatives to engage in insurance sales outside of their platform, both for broker-dealer 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 the firm product ecosystem, which can create problems if there were to be a data breach. Issues can arise if the coverage isn't correctly represented both to the firm and the representatives. Lloyd's of London, in conjunction with RPS (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 non-customer 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 in this industry 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 (E&O, 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 funds but that of funds held in customer accounts as well. That being said, some carriers are still presenting the coverage with callback 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 loss only occur when the customary policies and procedures are not followed in the first place.
Cyber liability needs to continue to be a risk exposure broker-dealers focus on, especially as firms continue to work remotely during the pandemic. Cybercriminals are aware of this trend, and we may continue to see an uptick in claims as they find ways to infiltrate systems at higher risk.
Fidelity bond considerations
Bond claims continue to be a pressure point for insurance carriers in the broker-dealer space as losses continue to trend upward, with a severity loss to hit on average once every two to three years. The fact patterns of these losses vary, but despite the great job broker-dealers have done to increase compliance and supervision, advisors still find ways to defraud their clients. The No. 1 fidelity exposure to broker-dealer clients is from one of their field advisors stealing from the clients, a typical scenario being that they have convinced the client to invest in a nonexistent product wherein the clients' funds are then misappropriated by the advisor.
As losses continue to spike in this area, insurance carriers have been forced to look for ways to manage the risk by increasing retentions for large broker-dealer risks as well as premium increases across entire books of business. We recommend that the E&O and bond policies are placed with the same carrier, which provides seamless claims handling and allows for the carrier to offset the need for increases in the cost of the bond with the E&O premium.
Broker-dealer market forecast for 2021 and beyond
Domestically, the market for broker-dealers will most likely remain relatively unchanged, with markets pursuing increases where feasible and where the losses justify the increase. 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. If we continue to see a hardening market, carriers' rates will level off. If market volatility continues or worsens, or the impact of any regulatory changes leads to an increase in customer complaints, exclusions for specific products, sublimits or 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.
Due to industry consolidation leading to fewer broker-dealers in the market, we do not foresee an influx of new carriers looking to enter the space. As such, insurance capacity will remain the same or decrease, further putting upward pressure on prices. 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 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. Please note all of the comments are generalized statements; 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 account outcomes.