Discretionary vs Non-Discretionary Client Relationships

Part 4: The Investment Advisors Guide to Errors & Omissons Insurance

  By Gary Sutherland, CIC, MLIS

Every application for investment advisors and/or financial professional errors & omissions insurance requires that you break down your practice by discretionary and non-discretionary management of assets. What is the importance of this?

Each insurance carrier views the exposure (risk) from discretionary versus non-discretionary management of assets differently. Their position is typically determined by past claims experience – and severity and frequency – in either area. As a result, insurance companies have significant differences in approach and underwriting.

Some carriers specifically prefer that advisors operate with full discretion. This rational is based on the position that the advisor who is actively managing assets is constantly looking out for changes in the investment climate and making trades in real-time. In their opinion, this creates a more connected safeguard to clients’ assets, and at the end of the day it is lower risk.

Contrast that to the advisor who meets with a client quarterly to review past performance after there were significant changes in their portfolio. Some carriers are concerned that despite the lack of discretionary authority, control is missing, and the advisor’s accountability is compromised. Often in these consulting style arrangements, there is limited track record of performance.

Keep in mind that all carriers require that advisors work under a contract/investment policy of some kind and stay within those written guidelines. For the sake of this chapter “pure” discretionary authority is when the advisor utilizing an IPS or risk tolerance contract has the ability to buy and sell securities without their client’s approval or consent.

As an agent it is not our position to make a determination on risk between discretionary and non-discretionary business models, but understanding each insurance company’s underwriting appetite will make a significant difference in the submission/pricing process.

One very large “A+”- rated insurance company we work with has analyzed their book of investment advisor claims over a recent ten-year period and quantified their risk, concluding a strong preference for advisors that utilize full discretion. They actively discourage advisor submissions with non-discretionary, or consultant style management.

This is in stark contrast to another “A”-rated carrier we work closely with that has come to the opposite conclusion. In what appears almost a prima facie tone, they clearly suggest their risk is lower when all trades are pre-approved by the client.

Maybe the answer to the disparate approaches lies elsewhere in the equation, and that discretion versus non-discretion wasn’t the primary driver for two dramatically different conclusions, but rather different looking books (retail versus institutional/qualified versus non-qualified). We are not in a position to emphatically defend either approach. The key is to understand the different carrier tendencies and work with our clients to match them with the appropriate partner.

When a claim arises out of a client relationship where discretionary authority over client’s assets exists, and it can be complex and large in scope. Unfortunately theft of client funds, Ponzi schemes, and other fraud activity continues to wreak havoc in the investment industry and these risks can be difficult to underwrite. Most policies have coverage exclusions for illegal schemes, but more often than not criminal activity is seen more frequently when the advisor has full discretion.

Underwriters also consider fidelity bonding when assessing a firm’s professional liability risk. Many underwriters require firms to carry a fidelity bond of at least $1,000,000 for non-ERISA accounts; and if they have discretionary authority over and handle qualified plan assets, they look for them to carry the appropriate ERISA 412 Bond.

We believe this will continue to be a subjectivity issue when quoting professional liability insurance, as it is an effective way for professional liability carriers to insulate their exposure to complex crime and fraud issues.

A more recent question seen on advisor errors & omissions applications regards custody (the Madoff question). “Do you or any one in your firm provide discretionary or non-discretionary investment advice for accounts where you are also custodian the funds?”

If the answer is yes, then a clear explanation of existing safeguards is required to avoid outright denial of coverage from most carriers.

Underwriters are more interested or likely to ask when you have discretion; who are your largest clients and what percentage do they make up of your total AUM? The concern is that if you are dependent on a single client, or a limited handful of large clients, you could be more likely to compromise your ethical standards for fear of losing the bulk of your revenues.

Conclusion

Understanding the insurance carrier’s appetite in the market is an important element of the submission process. Accurate tracking and reporting of your firm’s percentage of discretionary versus non-discretionary relationships can have significant impacts over the errors & omissions premium rating depending on the carrier and its preference for one style of asset management over another. Our suggestions:

1. Accurately classify your Assets under Management by Discretionary, and non-discretionary. Understand how your insurance carrier defines discretion.
2. Working with an experienced agent can impact your insurance premium by matching your firm with an appropriate insurance partner.

We are often asked, what is considered discretionary authority?

It is when you or your firm has the ability to buy or sell AUM without client knowledge or consent. In some cases what you classify as discretion may not be the case, and actually it may be considered non-discretion by the insurance carrier. This confusion is seen most in the ERISA space when the advisor is making recommendations on the overall investment lineup. When in doubt, provide a schedule of AUM total with descriptions.

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Contact us for additional information:

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