Protecting the Proctectors Fiduciary Liability Coverage

The duty of those entrusted with the safe-keeping and responsible administration of employer-based investment funds has become over recent years a question foremost on the minds of an increasing number of Canadians. From an insurance risk perspective, this question ultimately focuses on the purpose of fiduciary liability insurance, particularly developing areas of fiduciary liability exposure – and the future of the product.

Trustees of employee benefit plans have a legal duty to act in the best interests of the plan members and the sponsor, being the employer. In order to protect themselves from lawsuits, the plan and the sponsor organization typically purchase fiduciary liability coverage. A Pension and Welfare Fund Fiduciary Liability Policy provides protection for losses the insured is legally obligated to pay on claims for damages resulting from wrongful acts. Typical examples of exposure to loss involve allegations against fiduciaries arising from: administrative errors, improper advice or counsel, misrepresentation, conflict of interest, imprudent investment, failure to arrange adequate funding for the plan, denial or change of benefits, incorrect benefit calculation, wrongful termination of the plan and civil rights denial or discrimination.

PLAN TYPES

There are essentially two basic types of pension plan arrangements: defined contribution (DC) and defined benefit (DB). Plans providing benefits based on the amount(s) contributed to an individual employee account, plus any earnings allocated to that account are labeled DC plans. DC plans typically include profit-sharing, RSPs, employee stock ownership plans (ESOPs), as well as thrift and money purchase plans.

Plans providing a benefit based on a formula established for the plan are referred to as DB plans. The amount of the ultimate benefit is a known factor. The two most common forms of DBs plans are:

Flat benefit plan (e.g., at age 65, the plan participant will receive a benefit equal to 60% of the participant’s average compensation); and

Unit benefit plan (e.g., at age 65, the plan participant will receive a benefit equal to 2% of average compensation for each year of service).

Either plan can be “single-employer” or “multi-employer”. Single-employer plans are those whose employer contributions come from one employer or company. Multi-employer plans enjoy contributions from a variety of companies. From the viewpoint of a fiduciary, a defined benefit plan carries more risk because a promise has been made to the beneficiaries to pay them specific amounts far into the future. Furthermore, single-employer plans generally present more of a risk compared to multi-employer plans simply because the health of the plan (receiving employer contributions and therefore being able to pay benefits) depends on one employer or company rather than a number of employers or companies. This is simply the risk-spreading principle.

PENSION REGULATION

Canadian pension plans are governed by the Pension Benefits Standards Act (PBSA), which is administered by The Office of the Superintendent of Financial Institutions (OSFI). The PBSA outlines minimum standards for benefits, administration, and information – as well as defining investment guidelines.

Similarly, American fiduciary responsibilities are governed by the Employee Retirement Income Security Act of 1974 (ERISA). This federal law sets minimum standards for most voluntarily established pension and healthcare plans in private industry to provide protection for individuals in these plans. ERISA sets out fiduciary responsibilities for those who manage and control plan assets. It requires plans to establish a grievance and appeals process for participants to get benefits, and gives participants the right to sue (the plan sponsor, the trustees, etc.) for benefits and breaches of fiduciary duty.

RECENT TRENDS

In Canada, issues concerning government protection of defaulting private pension plans and employer access to pension surpluses are hot topics. The cases that follow illustrate that pension plan fiduciaries are exposed to liability from many different angles (including both under-funded and over-funded pension plans).

The inadequacy of potential government “bail-out funds” for defaulting private pension plans is illustrated with the well known Stelco case, which produced a sizeable pension deficit of $1.2-billion (source: The Globe and Mail, March 2004). Ontario is the only Canadian jurisdiction to offer a government sponsored pension bail-out fund. However, the Ontario government’s pension guarantee fund has only $230-million (source: “Stelco Plan may hit taxpayers hard”, The Globe and Mail, March 2004). Clearly, the pension guarantee fund balance is inadequate in light of current pension fund deficits.

On the end of the funding spectrum, the July 29th, 2004 Monsanto court ruling (Monsanto vs. more than 140 of its former workers terminated in 1997 and 1998) illustrates that companies do not have sole discretion over the use of pension fund surpluses. Monsanto had claimed that since the company assumes the responsibility and risk of investing pension fund assets, it should be able to dictate when employees receive their share of a surplus. Monsanto said employees could not get their share until the fund was completely closed, or wound up. The court declared the surplus should not remain in the fund after workers are terminated. The court also said that waiting to pay out until a plan is fully wound up is impractical. At the time of the firings, the pension plan had generated a $19.1 million surplus, and the portion of the surplus in question amounted to $3.1 million (source: “Judgment rips open pension debate”, The Toronto Star, July 30, 2004).

CANADIAN DIRECTION

As with so many other aspects of Canadian business, the impact of the American pension plan environment on Canadian regulation of pensions is significant. Consequently, it is useful to identify trends in litigation and fiduciary liability exposures in the U.S. as many such trends may well be experienced here in Canada sometime in the future.

Corporate scandals like Enron have made headlines over recent years. In Enron’s case, the pension plans were tied to the value of Enron stock that workers received in an employee stock ownership plan (ESOP). Though workers were allowed to diversify the stock held in the ESOP over five years, many did not. With Enron’s stock currently virtually worthless, so too is the value of many workers’ pensions. Combine the scandals with increased legislation and regulatory requirements like the U.S.’ Sarbanes-Oxley legislation (which introduced significant changes to financial practice and corporate governance) and we have an environment that makes good corporate governance over fiduciary duties more important than ever.

FUTURE VOLATILITY

While it is true that, by their promissory nature, DB plans present a higher risk for a fiduciary, DC plans are not immune to risk. Current litigation in the U.S. points to the development of claims against fiduciaries of DC plans for giving plan members “too much choice” in terms of investment decisions. The premise here is that the vast majority of plan participants may lack training when it comes to selecting balanced portfolios and other investment criteria. By affording plan participants such choice in the self-directed plans, one could argue that the fiduciaries are in fact doing a disservice to plan participants and subverting their own fiduciary responsibilities.

The current market for fiduciary liability insurance is volatile. Over the last few years, average premiums and retentions have increased significantly. Some carriers have made even more drastic changes by adding limitations or exclusions or even withdrawing from the market. Such moves are made in a defensive position in anticipation of losses. In such a volatile market, rigorous underwriting will be extremely important as it is not possible (or desirable) to underwrite with broad strokes of risk classifications. For example, rather than using the assumption that all multi-employer plans pre sent less of a fiduciary risk than single-employer plans, underwriters will need to delve further into the details by examining the financial health of each contributing employer before making such a generalization about the risk.

INSURERS’ RESPONSIBILITY

In my view, the current uncertainty and volatility in the fiduciary liability market does not warrant full retreat. Indeed, insurance carriers should be cautious of using the “emergency exit” as doing so places the broker network in the awkward position of explaining seemingly unjustified coverage restrictions and/or premium increases, not to mention the inconsistent signal sent to the market.

Fiduciary liability insurance is not a one-way street. It requires both insurer understanding (i.e., difference between single/multi-employer risk exposures, etc.) and broker understanding (i.e., be prepared to work with underwriters and lawyers in seeking information pertinent to new and developing potential litigation issues). Brokers, plan administrators and trustees are rightly concerned that insurer understanding and technical competence remain current. It is important that insurers not act as “rainy day friends” by participating in the market only when the risk is deemed low and leaving the market when risk is recognized as high.

Failure of insurers to respect these concerns will inevitably lead to increased market volatility and perhaps, loss of insurance business with plans moving to self-insurance schemes. Rather than retreat from a market due to uncertainty, insurers can use the current environment as an opportunity to build relationships with their broker networks by demonstrating consistency in underwriting and market participation. Underwriting criteria will adjust as both U.S. and Canadian litigation issues develop. In light of the current market volatility, it is perhaps more important than ever for the broker to review policy wordings and coverage differences when approaching the market for fiduciary coverage.