Fiduciary Coverage: Weighting the Differences

Why should the broker be concerned with screening applicants and mitigating fiduciary risks? There are many reasons. Some of the more salient reasons include: to avoid spending time on marketing applicants that are too high a risk for any carrier, concentrate on risks that will develop into long term opportunities for your brokerage, offer potential clients ways to mitigate their risk as fiduciaries, thereby providing a value-added service to the client.

From an underwriting perspective, there are several key strategies that can be employed to minimize fiduciary liability risk. It is useful for the broker to be aware of these. In so doing, the broker gains an appreciation of the underwriter’s “frame-of-mind” when reviewing an application for fiduciary liability insurance. Perhaps one of the most effective methods of minimizing fiduciary liability exposure is to ensure an effective investment and/or retirement plan committee is in place. While there is no requirement under ERISA (U.S.) or the Canadian equivalent (the Pension Benefits Standards Act (PBSA)) to have formal committees, the existence of such committees can only lend credibility to the plan sponsor’s attempts at “prudent” management.

Brokers can screen risks by looking for the following red flags (which are also key underwriting considerations):

Solvency deficits and under-funded plans;

Lack of history with suppliers to the sponsor;

Plans of mergers, transfers or acquisitions;

Single-employer sponsored plans, and, in particular, within industries currently struggling (i.e. steel industry); and

Lack of defined procedures for investment committees and written records of the rationale of investment committee decisions (only 60% of Canadian defined contribution (DC) plan sponsors do qualitative reviews compared with 75% of U.S. plan sponsors).

UNDER-FUNDED PLANS

The extent of under-funding in private pension plans is a growing concern. Approximately 59% of defined benefit (DB) pension plans in Canada were believed to be under-funded by the end of 2003. Covering this shortfall would require $160 billion.

The situation is similar south of our border. The agency responsibility for overseeing private pension plans – The Pension Benefit Guaranty Corporation (PBGC) – observed the following in June of this year – that companies with under-funded pension plans had a total shortfall of US$278.6 billion in the latest round of filings. That is down slightly from the US$305.9 billion reported last year, but dramatically greater than the US$18.4 billion reported in 1999.

If under-funding in all insured pension plans is included, PBGC estimates the total shortfall in the DB pension system is significantly higher than US$278.6 billion (see exhibit “A”). The problem of under-funded pension plans is just as relevant in Canada. But, statistics concerning under-funded pension plans in Canada are hard to come by. This is due mostly to the greater emphasis on disclosure of financial and related information in the U.S. (under new laws such as Sarbanes-Oxley). As such, it is important to realize that many pension plans may have funding deficits due in large part to under-performing investments and the low interest rate environment. Therefore, both the absolute dollar value and relative value of any funding deficiencies must be considered along with the industries in which the plan participates.

WORDINGS & APPLICATIONS

Having recently reviewed the fiduciary liability wordings and applications of several carriers, here are some interesting points for brokers to consider when assessing the appropriateness of fiduciary liability coverages for an insured:

Policy wordings. Retentions are common place and tend to be higher for DB plans. This is in keeping with the fact that DB plans generally present a higher inherent risk than other types of plans. While the named insured includes the plan, and the plan sponsor organization, only half of the carriers surveyed allow for the named insured to be extended to designated persons or organizations. This can be a valuable extension for plans with multiple external fiduciaries.

Coverage exclusions. Typical exclusions include dishonest, fraudulent, or the willful act of an insured, illegal personal profit/remuneration, pollution, failure to comply with workers’ compensation, unemployment insurance, social security or disability law, liability of others assumed under contract, bodily injury/personal injury/property damage, insured vs. insured claims. The broker would do well to keep these in mind when comparing policy wordings. The scope of coverage is most often defined by the exclusions specified in the wording and can vary widely between carriers. In addition, exclusionary language can also be found in the wording of insuring agreements and definitions of coverage.

New exclusions. Some carriers have added the following additional exclusion wordings: claims based on insolvency of employer, and ownership or use of plan’s actuarial surpluses. Exclusions are typically added based on a carrier’s claims experience combined with market trends in litigation. Moves like these which tighten coverage highlight the importance of the broker obtaining and reviewing the most recent wording. As a result, brokers should not rely solely on summaries of amendments to wordings when evaluating the coverage options for their clients.

CARRIER DIFFERENCES

Brokers should be aware of the following differences taken by various insurers with regard to fiduciary liability coverage:

Duty to defend – some carriers will pay defense costs with restrictions that include the carrier retaining the right to appoint legal counsel;

Coverage territory – varies from Canada only, to Canada and U.S., while others offer worldwide;

Explicit exclusions – relating to ERISA (U.S.). The US legal environment is typically more litigious than Canada, and there are many differences in regulations between ERISA and the PBSA; and

Tail, or extended reporting period coverage – some carriers limit this to 90 days from date of cancellation and specify the additional premium required to purchase this (usually a percentage of the annual premium), while other carriers offer up to a full one-year extended period.

APPLICATION FORMS

Typical requirements of fiduciary liability coverage application forms currently are the latest audited financial statements of the plan and sponsor organization, including the nature and address of the sponsor’s business, and details such as the year the plan was created plus a three-year summary of assets, contributions and participant numbers, and service provider details.

Details often not explicitly requested but which can help the underwriter and broker better understand the risk include:

How often are investment manager guidelines fixed by fiduciaries, and investment manager performance reviewed;

If the plan is not adequately funded, when will funding be restored (with many under-funded plans being negatively affected to low interest rates, it is important to know the context of under-funding and not necessarily disqualify a risk on the basis it is simply currently under-funded);

Has a plan invested more than 10% in any one corporation (this could point to potential investment risk, i.e., the importance to diversify plan investments);

Is a merger, transfer or termination anticipated within next 12 months (experience shows that fiduciary liability claims can arise when plans are combined);

Are written documentation of meetings and discretionary decisions by fiduciaries maintained; and

Has any fiduciary, or designated fiduciary, been denied a fidelity bond (this could point to potential morale problems and therefore, less desirable insurance risks).

FLEXIBILITY KEY

Insurers participating in the fiduciary liability coverage market can mitigate the evolving risks with enhanced underwriting and training of staff. Underwriters and brokers must realize that the application for insurance cannot contain all key underwriting information. Flexibility is key as the underwriter works with the broker t o highlight the important considerations.

As with other more complex casualty insurance coverages, the initial submission form serves only as a base from which to launch further investigation and analysis. The fiduciary liability insurance product is clearly an important part of any pension-providing entity’s insurance program.

The product is evolving with the changing and turbulent environment surrounding pension plans (i.e., high number of under-funded plans, increased litigation, high expectations for fiduciaries). In light of these challenging times, it is more important than ever for the broker and the underwriter to work together to fully understand and quantify all considerations. Doing so will provide a sound basis for providing adequate insurance and value-added coverage options to qualifying risks.