This is the latest installment of a regular column to answer questions from advisors who are considering transitioning to an RIA model. To see Brad’s previous articles, click here. To submit your question, please email Brad here.
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At its core, transitioning your practice to the RIA model is an exercise in identifying what your current firm/affiliation model provides for you and replicating it on your own – preferably with more flexibility and at a lower cost.
For an advisor at a broker/dealer, errors and omissions insurance (“E&O”) is generally not only provided but is forced upon you. The latter is not bad per se, as having E&O coverage is a universally accepted best practice.
Depending on the type of broker/dealer affiliation model you are under, you might pay for the coverage as part of your payout or as a separate expense line item. Whether or not it is transparently shown to you, you are paying for the coverage.
Many large broker/dealers with the financial strength to do so often self-insure their advisors’ E&O policies. While you might pay a monthly “E&O fee,” that premium is not necessarily going to a third-party insurer and instead is going to an in-house risk pool. That risk pool is managed and financially backed by your firm.
The objective of the self-insured approach is generally not to try to create a profit-center, but to (hopefully) provide lower overall E&O costs for the firm’s advisors.
The byproduct of this “forced upon you” approach is that you must go with your firm's coverage package. If you’ve been in that scenario, you probably have never pondered, for example, how raising/lowering your deductible would affect the premium. You have no choice. It is “take it or leave it,” or more accurately, “take it.”
Consider my own experience with health insurance. I worked in a corporate environment for a large financial services firm for many years. One benefit of being an employee was access to the firm’s health insurance program.
The annual enrollment process was essentially a binary choice with some slight variation over the years. Did I want to sign up for it or not? I had no say in how the deductibles were set, which doctors and facilities were part of the provider network, etc. If I wanted to access health insurance through my employer, it was “take it or leave it.” For better or worse, I never had to learn how the variables involved worked.
When I left that employer to start my own company, I had to source my own health insurance. Instead of a binary yes/no option, I now had multiple different plans and options from which to choose. This involved more work to source but resulted in more flexibility with the plan I chose.
The same scenario occurs when advisors leave an environment that has historically provided them with E&O coverage. If you leave a broker/dealer environment and move into, for example, the RIA model, E&O will need to be sourced.
(I am unaware of any regulatory requirement that an RIA must have E&O coverage. But it is a universally accepted best practice. Further, some custodians have begun requiring any RIA that uses it for custodial services to maintain E&O coverage. I suspect that requirement will become the norm across the custodial industry.)
E&O coverage is often included in the overall pricing if you join an existing RIA platform. If you start your own RIA, you will need to source it on your own.
Having to source E&O is a common and simple process. Some providers specialize in working with RIAs who understand the nuances and needs of the business model.
Typically, you source E&O coverage at the firm level. There is one policy for the entire RIA, and each individual investment advisor representative (IAR) of the RIA does not source their own policy.
Variables that go into premium pricing include the overall size of the practice, the types of investment products used, and the deductible desired. Policies are usually 12 months in length.
E&O providers will talk to you about the process for obtaining coverage well in advance of when you “breakaway” to start your own firm. However, they cannot give you a finalized premium quote until two to three weeks from signing the policy. But they can provide you estimates in advance to help with budgeting.
As with all aspects of transitioning to the RIA model, sourcing your own E&O policy is not complicated or intimidating if you understand how to navigate the process.
Brad Wales is the founder of Transition To RIA, a consulting firm uniquely focused on helping established financial advisors understand everything there is to know about WHY and HOW to transition their practice to the RIA model. Brad utilizes his nearly 20 years of industry experience, including direct RIA related roles in compliance, finance and business development to provide independent advice regarding how advisors can benefit from the advantages of the RIA model.
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