Underwriting Alternative Investments

Part 1:  The Investment Advisors Guide to Errors & Omissons Insurance

  By Gary Sutherland, CIC, MLIS

Insurance carriers and underwriters read the same publications that advisors read, and therefore they see the same ominous headlines:

“Attorney General seeks millions of dollars from broker dealer for misleading clients on private REITS.” , or

“Grandmother sues advisor for placing 50% of her assets in risky speculative investments.”

In addition insurance companies track the genesis of claims. Suitability is cited more than 50% of the time as the main allegation or driver of claims. In the most general terms, suitability is such a difficult standard to define; it easily becomes the catch-all complaint for whatever doesn’t work. Although many claims of suitability involve risk appetite, the examples above are relative to Alternative Investments.

Does this mean alternative investments are bad or never suitable? Of course not, but it does mean that when alternatives are present in the applicant’s business model, a much higher level of scrutiny takes place during the submission and underwriting process. In addition, it is essential that you carefully review the policy and endorsements to determine how the coverage of alternative investments is handled, and if it correlates correctly with your business model.

How do underwriters and insurance companies evaluate alternative investments? What’s the definition and where’s the comfort or discomfort level? How do they rate the risk?

In general, alternative investments are defined by three criteria:

– Not regulated
– Not valued daily
– Not liquid

Investments that fall within these criteria include, but are not limited to: Futures, Metals, Hedge Funds, Collectibles, and REITS, or other Real Estate Investments.

Private REITs (Real Estate Investment Trusts) are currently an alternative investment that generates increased scrutiny with insurance companies and underwriters. We will use them as examples of the potential impact alternative investments may have on your application process and policy coverage.

REITs are often excluded in policy coverage or offered terms outside the standard policy language through the addition of sub-limits and/or higher deductibles. For example, one major insurance company has the following provision:

Excluded are the following: private placements or any Securities exempt from registration with the SEC; however, this exclusion does not apply to any assets managed by you for others for a fee, provided that they were part of an existing client’s portfolio and you do not promote, sell or recommended these instruments.

The first part of the Exclusion eliminates insurance coverage for the sale or recommendation of the alternative investments going forward. The second part of the Exclusion amends – or gives back – coverage for investments that are currently in the client’s portfolio prior to your engagement.

As you can see by the complexity of this coverage language, it is critical that you understand the policy language, and consider activities your firm does, and has done in the past, regarding private placements, alternative investments, and overall the overall nature of your professional services.

This example exemplifies the importance of not limiting the underwriter’s review to your firm’s current portfolio construction and activities, and highlights the necessity to understand how prior professional activities and recommendations can be crucial to an accurate application review.

If your firm currently – or has in the past – offered alternative investments, you should be aware that each insurance carrier’s appetite and threshold is different. They may reflect this in their unique underwriting guidelines, premium pricing, and most importantly, their policy wording.

We offer the following specific recommendations relevant to the review of alternative investment activity in your errors & omissions insurance application process:

– Do not rely solely on review of your current application. Make sure to consider past activity in the alternative investment space, and review policy wording for relevant coverage (existing portfolio vs. current sales).
– Provide additional narratives that explain and detail the types of alternative investments in your client portfolios. Doing so provides you a platform to proactively address the underwriter’s comfort level with the particular investment.
– Read and understand all of the insurance policy conditions, exclusions and endorsements.
– Do not rely on verbal communication that coverage is provided. Get it in writing and identify relevant policy language.

Conclusion

Like you, we recognize the value of utilizing experts in a particular field of specialty. Therefore, our industry bias drives us to recommend that you work with an experienced agent to represent your firm. An experienced agent can address the previously discussed issues, as well as potentially negotiate policy and premium endorsements in your best interest.

Some suggestions for working with an agent:

1. Provide detailed narratives regarding your involvement with any alternative investments. The narrative should proactively and specifically address the underwriter’s questions regarding your activity and demonstrate your knowledge and investment philosophy in the particular area.

2. Do not assume coverage exists for these investments. Obtain a complete understanding of the present risks and insurance solutions available in order to a make an informed decision.

3. When necessary, you may have to accept sub-limits, higher deductibles, and/or higher premiums to properly insure your alternative investment recommendations and holdings. Weigh these costs against having no coverage at all.

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Contact us for additional information:

Gary Sutherland, MLIS, CIC    Garys@mcgowanprofessional.com    508-656-1350