How new RIAs should shop for E&O insurance

This is the 16th installment in a Financial Planning series by Chief Correspondent Tobias Salinger on how to build a successful RIA. See the previous stories here, or find them by following Salinger on LinkedIn.

Just as tenants and homeowners rely on insurance for certain protections, financial advisors who launch a registered investment advisory firm with one or more custodians are likely to need “errors and omissions” coverage.

That may come as a surprise to advisors accustomed to having their prior firms’ policies cover them. But amid everything else involved with opening a new RIA, insurance rarely tops the to-do list. And annual premiums of, say, $2,000 to $20,000 for small or midsize RIAs — or much more for larger ones with more service offerings — may not give them as much joy as other steps involved with starting their own firm.   

Regardless, E&O policies are “one of the safety-net insurances that all RIAs should have and, in a lot of situations, are required to have by the custodian they sign with,” said Kyrstin Ritsema, an executive director of compliance services working with wealth and asset managers at international regulatory technology firm Confluence. With the exception of cases in which an advisor is convicted for fraud or other criminal conduct, the policies generally cover advisors’ legal defenses, settlements and judgments, up to a prescribed limit. 

“Without E&O, a single claim can take down a firm,” Ritsema said. “I do not know a single RIA that does not have it, and most custodians require it.”

READ MORE: Should financial advisors be dually registered or RIA-only?

Risk protection for RIAs

In fact, a lot of custodians mandate that RIAs have insurance policies to cover cybersecurity breaches and to protect the personal assets of directors and officers (D&O coverage) from claims related to their work for the company and vice versa, she noted.

E&O policies generally pay for an advisor’s legal defense and settlements. Common claims include allegations of trading errors during times of stock volatility and failure to perform due diligence of a product. Also common are claims of heirs who “take issue with something the advisor has done with their parents’ portfolio,” said Patrick O’Brien, an advisor in the financial institutions group of insurance and risk management firm Windermere.

“You may have completely explained the risks associated with a certain asset,” O’Brien said. “It’ll pay the cost to defend you.”  

At a basic level, RIAs get E&O coverage because not doing so represents a “very high risk,” said Doc Kennedy, the founder and president of compliance and law firm AdvisorLaw.

“You don’t want to try to save money by cutting corners there. Make sure you have good coverage and that you go with a carrier who’s legit,” Kennedy said, noting the threat of an arbitration filing or another legal claim filed by a well-resourced plaintiff. “You don’t want to be in a position where they can bully you into any kind of settlement or bully you into shutting down.”

READ MORE: Here’s a financial advisor’s estimated value to clients

The possible price tag of E&O insurance

The expenses for premiums can vary significantly for advisors who break away from wirehouses or other large wealth management firms for their own RIA, according to Ritsema. Besides the overall coverage limit, the factors tying into the price include the assets under management and the types of clients and services, as well as their claim history and regulatory records. And most RIAs would refrain from tapping into their policies if their legal costs in a given case are below $50,000. That could raise their rates in the future, she said.

“Just like shopping for any other insurance,” Risema added, “you should shop around to see where you’re getting the best benefit for the cost.”

Those prices for premiums probably won’t break the bank for RIAs, but they’re worth keeping in mind when creating a new firm. 

In broad strokes, RIAs with about $250 million in client assets should plan for premiums of about $5,000 to $7,000 for a policy with a limit of $1 million; those with $500 million could anticipate paying $7,000 to $10,000 for $2 million worth of coverage, and firms with $1 billion might spend $15,000 to $20,000 for a $3 million contract, according to estimates provided by O’Brien. But when factoring in additional coverage (like cybersecurity, D&O, general liability and workers compensation), the respective annual premiums for firms of those sizes can rise to $8,000 to $12,000; $10,000 to $15,000, and $30,000 to $45,000.

The policy price stems largely from whether an advisory practice is performing comprehensive planning with a relatively common mix of securities in client portfolios and offering other typical services. That is “favorable from a pricing standpoint,” O’Brien said. 

Tax preparation, family office services, trustee work, private fund management, alternative investments and cryptocurrency could alter the rates. He and Ritsema pointed out that independent consultants and brokers can help advisors sort through the insurance options.

“It’s a pretty stable market, and there are a lot of carriers who are willing to write this business,” O’Brien said. “Our job is really to find the RIA the best fit.”