Financial advisors are increasingly the target of errors and omissions claims, particularly in the wake of the financial crisis. There are many ways, however, of protecting yourself against these claims, explained Joanna Reid, vice president, consumer practice at Marsh Canada during a presentation at the Canadian Institute of Financial Planners (CIFPs) 9th annual conference held this June in Ottawa.
There has been an uptick in E&O claims in areas such as wrongdoing, failure to advise, failure to explain, etc. (See Claims against advisors spiked after financial crisis, p.15).
Technical compliance is not enough, warns Ms. Reid since communication problems can occur which may result in the client claiming to have not understood a product or investment advice given. Ms. Reid emphasizes that effective documentation is critical in such situations.
Why are there more claims now? Ms. Reid answers, “There are more complex transactions and there is more reliance on the advisor. There is definitely more willingness to sue.”
There is also the deep pocket theory. A lot of clients now understand that advisors have E&O insurance, so they do not necessarily see suing as personal attack. She says instead they think, ‘Hey, I know my advisor has insurance, the insurance company is going to pay.’
Another factor in increased claims is the level of attention to detail. “We know there are obviously goals to increase your sales and production. As a result, sometimes what happens in there is less attention to detail.” An example of this would be inadequate documentation.
She also notes that there is less cooperation from providers. “We have seen cases where insurance companies and product manufacturers will revert the blame back to advisors, versus, say, taking responsibility for a defective product or unclear instructions on how a product actually operates or is designed to operate.”
On the clients’ side, she has also noted less of a sense of personal responsibility. “We have seen cases where the advisor has done everything right…the clients have had full disclosure, they signed off on KYC forms, they’ve signed off that they understand the risks associated with certain strategies and they come back and say, ‘No I didn’t understand. I am not a sophisticated investor. I relied on my advisor.”
Ms. Reid says if you have an office staff, be extra careful. When you actually employ other individuals, you have added exposure. “You are responsible for the acts of those people working under your company mantle and that’s important.”
What are the most common allegations she sees? Failure to determine and understand the plaintiff’s personal circumstances and objectives is a common one, as is failure to ascertain the plaintiff’s true risk tolerance and failure to adequately explain the risks or projections not being realized.
Another common allegation is that the advisor has placed “his own interest before the plaintiff’s by recommending investments that would increase commissions rather than be in the best interests of the plaintiff’s,” she explained.
Misrepresentation is another common claim, which can be unintended ie, how a product functions or the tax implications involved with a product or strategy. These situations would be due to lack of training.
Intentional misrepresentation and fraud, however, are not covered by E&O insurance, she warns. “So if you intentionally misrepresent a product or defraud your client, it should be noted that your E&O policy is not going to be designed to protect you in that case.”
Disability income products and how they integrate with benefits and other policies can be a problem area for claims. Cancellation of other policies is another pitfall to watch for, as is the definition of disability. Definitions vary from carrier to carrier, product to product, she says, and advisors must make sure they understand the differences among the products they sell.
Annuity products or other investment strategies and their potential tax consequences is another danger zone. “One of the things we stress about tax consequences is that if you don’t actually know and appreciate the tax ramifications, get a specialist in to help you with that.”
Suitability of a product or investment for a client is also an area that is attracting allegations. When it comes to financial products, advisors can be in a very tough position if these products experience bad performance. “Their first point of contact is you. So even though you may have explained that you have no control over what happens in the market place, the client can come back afterwards and say, ‘Well you didn’t tell me that I had this risk and that I could lose in this particular investment.’”
Another pitfall can occur in situations where the client gives an advisor discretionary control of their assets, i.e., buy and sell on their behalf. When they don’t like the results of their advisor’s decisions, clients have been known to deny that they have authorized the advisor to act.
Holding various professional designations as an advisor is certainly a good thing in that it means you have an increased level of education and more awareness. Ms. Reid points out, however, that it also implies a higher level of care. Designations affect clients’ perception of their advisor’s level of expertise. This could create higher liability because the advisor is holding him or herself out as a professional with an expertise. “So when something goes sideways, the client will hold you accountable.”
Best practices to avoid claims
In terms of best practices, Ms. Reid underlines that advisors have duties to the insurer to know their underwriting guidelines and disclose all facts, especially on applications involving health insurance or life insurance. Advisors also have a duty “to operate with the utmost good faith.”
Advisors have duties to their clients as well that include selecting carriers with financial strength and knowing their product. “That is really key – to know and understand the products that you are advising and recommending to your clients and to understand the needs of your client.”
In terms of best practices, replacement of policies can be a concern. An advisor must ask him or herself whether they are necessary. “You always want to put yourself in the position where you avoid the appearance of twisting and churning, which is creating replacement policies just for the purpose of gaining extra commission.”
Are there tax consequences to replacing the policy? “Make sure you understand and you explain to your clients if there are.”
Does the replacement policy provide identical coverage? “We have seen cases where a policy has been replaced and the new policy does not necessarily provide identical or better coverage.”
Policy cancellation errors can be another pitfall. Ms. Reid explains that the most common scenario involves the cancellation of an old policy before the new one is in place. This may happen when there is an unexpected delay in obtaining approval of a new group health policy, for example.
Making changes to policies also requires caution. “You need to make sure you’re documenting the reason for the change, the appropriateness and the timeliness.” One of the biggest concerns in this area is changing the policy beneficiary. “We’ve had some claims where the client has requested a change in beneficiary and it was not acted upon in a timely fashion and a claim actually did come forward because there was a wrong beneficiary noted on the policy.”
Relying on memory is a major obstacle in defending against a claim, she points out. “Memories fade over time. Keep strong written records regarding transactions and discussions. The reality is that you can do everything right in your practice…and your client can still bring suit against you,” she says, adding that “the tool you have to defend yourself is the proper documentation of your file. That’s the critical piece.”
One final piece of advice with respect to avoiding claims or defending yourself is to remember that an “advisor recommends but never chooses,” says Ms. Reid. This means that you can recommend a product or strategy, but the client must make the decision. Never say, “This is what you’re getting and this is what you should do.”
Claims against advisors spiked after financial crisis
In the year following the financial crisis, Westport Insurance saw errors and omissions claims made against financial advisors shoot upward, Stephen Ritter, senior vice president, insurance and specialty at Swiss Re, told advisors at CIFPs 9th annual national conference held in Ottawa in June. Westport is a member of the Swiss Re group of companies through which it provides insurance products in Canada.
“We saw a 100% increase in the amount of claims that came through. It just spiked.” The good news is that the claims level has settled down since then.” Mr. Ritter made these comments while assisting with a presentation on errors and omissions insurance.
He showed a pie chart on claims that have come through Westport Insurance over the past five years by claim type or process.
“Over 50% of all the claims that we see coming in have a financial component to it, such as a financial product.” This percentage does not reflect actual dollars that have been paid out, only the amount in terms of claims coming in.
Another slide showed the process step that was involved with respect to sales and service. Allegations involving investment advice error were number one by far at 24%. Directly related to it, Know Your Client made up 7% of claims. Trade errors, either not executing properly or making a mistake, accounted for 14% of claims.
Another slide showed alleged error. “What’s happening is your customer has made a complaint…What was the underlying cause of that complaint or dissatisfaction? Again, over 50% are financial product related and it’s very similar to the recommendation error at 17%.”
While the most significant number of claims are financial product related: mutual funds, annuities, various financial products, etc. In terms of claims severity, however, “it’s just the opposite. It’s more the insurance product, specifically life insurance,” he explains. If there is an error in a mutual fund trade, the numbers can be sizable, but the stakes can go much higher with life insurance. “If you have some high net worth individuals that are buying whole life policies or large limit policies and if something goes sideways on it, we do see seven figure amounts getting involved in this.” The other area where he has seen growing severity is leveraged investments.
Referring back to the post-crisis claims spike, Mr. Ritter explained that the situation was not as bad as it looks. “As we went through the financial crisis, the market tanked then it came up. The loss didn’t happen unless someone executed a trade order.”
Often the advisor had recommended that the client hold steady and this would be taken into consideration in the claims ajudication. So despite the 100% claims increase, “the actual damage amount was not as bad as it seems.”
Mr. Ritter warns advisors to keep excellent documentation to defend themselves against such situations. “You’re always going to get those allegations because when people lose money, they’re looking to recover it someway somehow.”