Journal of Financial Planning: February 2023
HanNa Lim, Ph.D., CFP®, is an assistant professor in the department of personal financial planning at Kansas State University. She teaches insurance planning and theory courses. Before she joined K-State, she worked as a senior researcher at Samsung Life Insurance.
Matthew Sommer is the head of Janus Henderson Investor’s Defined Contribution and Wealth Advisor Services team. Prior to joining Janus in 2010, Mr. Sommer spent 17 years at Morgan Stanley Wealth Management and its predecessors, Citi Global Wealth Management and Smith Barney, during which time his roles included director of financial planning and director of retirement planning. Mr. Sommer received his undergraduate degree from the University of Rhode Island and his M.B.A. from Pace University and received his doctorate degree from Kansas State University in 2021.
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Introduction
Insurance is a commonly used tool to help individuals manage unpredictable and potentially devasting risks that are present in everyday life. For example, health and dental insurance covers the costs of receiving medical care; life and disability insurance protect against the loss of current and future earnings; and homeowner and auto insurance reimburse policyowners for damaged or stolen property while providing a limited amount of personal liability protection. Unfortunately, the liability protection afforded by most homeowner and auto insurance policies may only protect a fraction of wealth and do not provide coverage for the financial loss associated with legal actions in business and professional practice. According to the Insurance Information Institute (2020), the average jury award for premises liability and vehicular liability was $811,769 and $2,673,427, respectively, and it was $3,110,297 for business negligence. Of course, depending on the facts and circumstances, jury awards can easily dwarf these averages. This column will discuss excess liability insurance (a.k.a., personal liability umbrella policy) and errors and omissions (E&O) insurance, which provide liability protection to your clients and yourself.
Excess Liability Insurance: A Potential Gap in Your Client’s Financial Plan
As the name implies, excess liability insurance provides protection once the limits of underlying homeowner and auto policies have been reached. For example, if Roger has $500,000 of personal liability coverage under his auto policy and is found negligent in an incident that resulted in bodily harm to another driver, the excess liability policy would apply once the $500,000 is applied to any judgement or settlement against Roger. It is important for financial planners and their clients to note that excess liability insurance providers typically require individuals to maintain a minimum amount of underlying liability coverage from existing homeowner and auto policies. Baker (2021) provided the following recent examples that liability claims exceeded the policyholder’s primary liability limit:
- While traversing a crosswalk, a woman was struck by an oncoming vehicle. The impact resulted in a traumatic brain injury and damage to one leg that ultimately necessitated an above-the-knee amputation. Judgement: $26.2 million
- A woman at a party suffered a foot fracture and developed reflex sympathetic dystrophy syndrome after the party’s intoxicated host fell on her. The host’s negligent behavior was determined to be the cause of the woman’s injuries. Judgement: $5.0 million
While excess liability insurance is a convenient and cost-effective way to protect an individual’s wealth against this risk, it is often overlooked by clients, and high-net-worth clients are not the exception. In a poll of 200 families with more than $1 million in investable assets, only 10 percent reported having excess liability coverage (Mercado 2018). Identifying this gap and educating clients about the benefits of excess liability can be an important service provided by financial planners.
Excess Liability Insurance: The Basics
Excess liability coverage policy limits usually start at $1 million for an annual premium between $150 and $300 (Fidelity 2022). For each additional $1 million of coverage, the incremental premium cost gradually diminishes. A frequently asked question is how much excess liability insurance is advised. While there are no simple answers, a financial planner can be instrumental to help a client assess their options. First, a cost–benefit analysis should be conducted, which weighs the tradeoff between premiums that must be paid versus the peace of mind that a client’s wealth is protected in the event they face a personal injury lawsuit. Next, a risk assessment should be conducted as each individual and family has different levels of exposure. Common factors associated with recommendations for potentially higher coverage include having a swimming pool or watercraft, the presence of domestic servants or pets such as dogs, frequently entertaining at home, or serving on boards of non-profit organizations.
Another benefit of owning excess liability insurance is that legal representation is usually provided and paid for by the insurance company. In other words, clients will not incur out-of-pocket expenses for defenses costs. Additionally, the legal expenses paid by the insurer generally do not reduce the amount of coverage available for potential settlements or judgements.
Purchasing Excess Liability Insurance
For many clients, the simplest way to obtain a sufficient amount of coverage (under $5 million) is directly through their existing homeowner or auto insurer. The application process is easy since most of the necessary information is already on file. Further, the premiums are likely to be competitive since the excess liability coverage will be “bundled” with the underlying policies.
For ultra-high-net-worth clients ($25 million and greater), however, the process of obtaining excess liability coverage is more complex. Not only may the desired coverage limits be substantially higher than traditional homeowner and auto insurance companies are willing to provide, but the excess liability policy will also need to fit the unique lifestyle and activities of the client. For example, while some excess liability policies may include activities related to serving on a nonprofit board, particularly active clients in this area may need a separate directors and officers (D&O) policy. The advised course of action for financial planners is to refer UHNW clients to a property and casualty agent or broker. While solving the client’s problem is paramount, an added benefit of addressing these issues is that these referrals may help expand potential centers of influence.
The role of a financial planner is to not only help clients realize their goals and objectives, but also to help clients consider the unlikely but possible events that could derail their future. Lawsuits that may arise from an unfortunate car accident or a house guest who slips and falls are very real threats but can easily be mitigated through proper planning. Financial planners who incorporate excess liability insurance into client discussions are providing a differentiated experience and are truly looking out for their client’s best interests.
Errors and Omissions Insurance for Financial Advisers
Like other professionals, financial planners and advisers are exposed to liability risk.
According to the Financial Industry Regulatory Authority’s (FINRA) Dispute Resolution Statistics (n.d. a),1 customers filed 2,363 new cases in 2019, and the controversy types in customer arbitrations include breach of fiduciary duty (2,053 cases served), negligence (1,826 cases served), omission of facts (1,468 cases served), and execution errors (51 cases served). When looking at the results of arbitration cases (FINRA n.d. a), 45 percent of customer claimant cases decided in 2019 awarded damages to the customer. However, in approximately one-third of those cases, damages went unpaid, and the total unpaid award amount reached $19 million, with a mean of $484,651 and a maximum of $2,613,665 (FINRA n.d. b).
Errors and omissions (E&O) insurance is a type of professional liability insurance that protects the insured from unintentional errors and omissions while they are providing professional services and advice. “Activity that is either intentionally dishonest, criminal, fraudulent, or a willful violation of law, rule, or regulation” are excluded from the coverage (NASAA 2019). Financial advisers who are affiliated with broker–dealers usually have an E&O policy purchased by the broker–dealer or are required to purchase one by the broker–dealer. Also, E&O policy is required for financial professionals to practice in certain states (e.g., Oregon). However, if you work as a registered investment adviser (RIA), E&O insurance can be your blind spot. The North American Securities Administrators Association (NASAA) surveyed 64 firms about E&O insurance and found that 23 percent of surveyed firms did not have E&O coverage, but the percentage was higher for small firms—40 percent of small firms that participated in the survey did not have E&O coverage (NASAA 2019).
The decision about whether to carry E&O insurance and how much coverage to carry depends on your lines of business and AUM. If your business model focuses on the services that are not covered by E&O insurance or rarely elicit complaints from clients, a practice of good documentation and an investment policy statement including a transfer of liability clause might act as an alternative tool to mitigate the risk. However, they may not eliminate the risk. The level of coverage is usually based on the size of AUM—with more assets under management, more coverage is needed accordingly. You can purchase E&O insurance directly from insurance carriers or through brokers. Also, membership in select industry organizations such as the Financial Planning Association (FPA), National Association of Personal Financial Advisors (NAPFA), and XY Planning Network (XYPN) provide access to affordable E&O insurance options as a member benefit. You can check the details in the links below:
- www.financialplanningassociation.org/practice-support/insurance
- www.napfagroupbenefits.com/eo-insurance.html
- www.xyplanningnetwork.com/member-benefit/eo-insurance/
Endnote
- If you visit FINRA’s website (presented in the References), you can find data from more recent years (e.g., dispute resolution statistics up to 2021; statistics on unpaid customer awards in FINRA arbitration up to 2020). Considering special circumstances with COVID-19, this column presents the data from 2019.
References
Baker, C. 2021, October 22. “Ensure That You Are Sufficiently Protected with Personal Excess Liability Insurance.” Parker, Smith & Feek. www.psfinc.com/articles/ensure-you-are-sufficiently-protected-with-personal-excess-liability-insurance/.
Fidelity. 2022, January 31. “Do You Need Umbrella Insurance?” www.fidelity.com/viewpoints/wealth-management/do-you-need-umbrella-insurance.
FINRA. n.d. a. “2021 Dispute Resolution Statistics.” www.finra.org/arbitration-mediation/dispute-resolution-statistics/2021.
FINRA. n.d. b. “Statistics on Unpaid Customer Awards in FINRA Arbitration.” www.finra.org/arbitration-mediation/statistics-unpaid-customer-awards-finra-arbitration.
Insurance Information Institute. 2020. www.iii.org/graph-archive/96044.
Mercado, D. 2018, March 26. “This Hidden Threat Can Devour More than $100,000 of Your Wealth.” CNBC. www.cnbc.com/2018/03/26/this-hidden-threat-can-devour-more-than-100000-of-your-wealth.html.
NASAA. 2019. “NASAA Broker-Dealer Section E&O Insurance Survey Report.” www.nasaa.org/wp-content/uploads/2019/12/2019-BD-EO-Survey-Report-Formatted-FINAL.pdf.