Subprime loans are leading to sublime times for the PlaintiffsaEUR(TM) Bar. The Credit Crisis, which began when some mortgage-backed securities were found to be as solid as Jell-o, has spread beyond arcane financial instruments such as aEURoecredit default swaps,aEUR? and is affecting all businesses, large and small.
Most states follow the rule that a broker is not liable for placing insurance with a carrier that is, at the time, admitted in the state where the risk attaches. One seminal California decision on point is Wilson v. All Service Insurance Co., 91 Cal.App.3d 793 (1977), in which a licensed broker had placed auto insurance for a customer with Transnational Insurance Company, which was at the time a California-admitted insurer. After the policy was placed and an auto accident had occurred, Transnational was declared insolvent by the California Department of Insurance. Before Transnational was formally liquidated, the injured plaintiffs settled with Transnational for $10,000, though they claimed that they were entitled to $30,000 in damages, and $50,000 in punitive damages against the carrier for its pre-litigation handling of the claim.
Insurance professionals know the truism, aEURoeBad times lead to increased claims.aEUR? We are in a bad time, as measured by an overall drop in equity markets, by the highest number of bank failures in 2008 of any recent year, and by the large-scale layoffs that have begun. Some types of claims are already sharply on the rise, such as class-action and derivative lawsuits against corporate directors and officers of failed financial institutions. Like an earthquake out at sea, the Credit Crisis hit the financial sector immediately and dramatically. Will it also set off a tsunami that will reach as far as Main Street?
Our shared experience during the tech-driven equity meltdown beginning in mid-2000 tells us than a ripple effect on claims is likely, but not how high the wave will be. Brokers and agents can take preventive steps now to lessen the likelihood/severity of claims that may be coming their way. Some of these measures are suggested in this article.
aEURoeHereaEUR(TM)s Another Fine Mess YouaEUR(TM)ve Gotten Us IntoaEUR?
Oliver HardyaEUR(TM)s classic put-down of his comedy partner, Stan Laurel, should be the title of the eventual Congressional investigative report on the Credit Crisis, because todayaEUR(TM)s aEURoefine messaEUR? follows an oft-repeated pattern in the business world, one which we never seem to recognize until itaEUR(TM)s too late. Whenever somebody starts talking about a aEURoenew paradigm,aEUR? we should run for the hills, because aEURoenew paradigmaEUR? is code for aEURoeignore the fundamentals.aEUR?
We saw it during the Savings and Loan Crisis of the late 1980s and early 1990s, when 747 S&Ls failed, having loaned out unregulated multiples of their actual assets. The loan to asset value ratio is one of the fundamentals. The resulting losses totaled $160 billion, of which you and I (meaning aEURoeU.S.aEUR?) paid about $125 billion.
We saw it in the tech-driven stock climb up to mid-2000, the aEURoeirrational exuberanceaEUR? as then-Fed Chair Alan Greenspan called it, followed by the inevitable tech meltdown. The aEURoeirrationalaEUR? part was believing, just as some later did with collateralized mortgage obligations, that the value of a companyaEUR(TM)s stock is whatever someone will pay for it, not the value of its earnings. The earnings-to-equity ratio is another fundamental.
Along with the other two Co-Chairs of our law firmaEUR(TM)s national Subprime Credit Crisis team, Fred Knopf in New York and Stefan Dandelles in Chicago, I believe that the Credit Crisis had its genesis in another failure to recognize fundamentals. For years the lending industry relied on an ever-inflating housing market, rather than borrowersaEUR(TM) actual income, to pay for jumbo mortgages with low teaser rates and big payments after the first two years or so. Please note for future reference: when lending money to someone, his ability to repay it is a fundamental consideration.
The past crises noted above have been followed by benefit-of-hindsight investigations, token criminal prosecutions, floods of civil lawsuits, and the enactment of new regulations. That pattern is also being repeated in the Credit Crisis. We are just seeing the first inning of what may be a long game.
AgentsaEUR(TM) and BrokersaEUR(TM) Fundamentals
For the insurance agent or broker, the fundamental principles of avoid an E&O claim are the same as they have always been. When a broker has promised to review the policyholderaEUR(TM)s insurance needs, or where the law imposes on the broker a duty to do so because of a long-term relationship with a customer, three simple steps can mean the difference between winning and losing an E&O lawsuit:
1. Provide options to the customer, even for lines or amounts of coverage that youaEUR(TM)re not certain sheaEUR(TM)s interested in, but might need;
2. Do so in writing, or send a written follow-up to a discussion about the options; and
3. Also confirm in writing any coverage or limits that the customer declines.
(For this discussion, weaEUR(TM)ll assume that other fundamentals, such as aEURoeobey your StateaEUR(TM)s surplus line laws,aEUR? need not be expressly stated. IaEUR(TM)m also using aEURoebrokeraEUR? rather than aEURoeagentaEUR? so that we can focus on brokers and independent agents who can offer products from multiple carriers to the public.)
How does the Credit Crisis affect the customeraEUR(TM)s risks, and the brokeraEUR(TM)s possible duty to advise the customer about those risks? LetaEUR(TM)s examine a few examples.
Stock market drop, Take Two
Few people would have predicted on December 31, 1999 that the new decade would bring two huge, systemic losses in the equities markets. The main concern of the day, aEURoeY2K,aEUR? turned out to have little impact. The tech-driven stock market drop starting in mid-2000 and continuing until 2004 created far more losses, particularly among those who could not wait until the eventual recovery due to age, illness, or impatience.
Since many insurance brokers are dual-licensed in securities, the 2000-2004 market drop had a direct impact on them. Annuities, especially variable ones, in retirement plans came under especially close regulatory and legal scrutiny, but in a market-wide meltdown there is no safe place to hide, except for Treasury notes, money market funds, and other government-backed investments.
One reliable barometer of investor claims is the number of binding arbitrations filed against securities brokers in the Financial Industry Regulatory Authority (aEURoeFINRA,aEUR? formerly known as the NASD, National Association of Securities Dealers). In 2008, the rate of filings of FINRA arbitrations is projected to nearly double that in 2007. Through September 2008, 3,469 FINRA arbitrations were filed, a 46% increase over 2007, and the number of FINRA cases closed fell by 34%, indicating that the system is already becoming overloaded. The peak year for new FINRA filings in recent times was 2004, at the tail of the first market meltdown, when nearly 9,000 arbitrations were filed. We wonaEUR(TM)t beat that number in 2008, but if the trend in claims continues, we may in the next year or so.
Insurance agents and brokers who are dual-licensed in securities may face increased risks, apart from those in their own investments. First, they may find themselves in FINRA arbitrations or civil lawsuits. Second, if they advise or are fiduciaries of any employee benefit plans they may face suits brought under ERISA. Third, if they place E&O coverage for securities brokers, they may see claims from their broker-customers if there are problems with that coverage.
This is an opportunity for each of us to perform his or her own risk analysis, to identify the accounts that may be problematic, and to make sure that they have been handled and documented thoroughly.
Policy limits
One of the oldest questions in insurance is aEURoeHow much should I buy?aEUR? The Credit Crisis puts a new spin on that question. Should a homeowner insure her house at the full value of the mortgage loan, for the cost of rebuilding, or for todayaEUR(TM)s depressed market value?
Mortgage borrowers are often contractually required to insure the residence with a sufficient policy limit to protect the lenderaEUR(TM)s interest in the home. In a deflating housing market, some borrowers might be tempted to reduce their home insurance payments, but their broker (or agent) needs to know what amount of coverage the borrower has agreed to maintain. In this context, seeing is believing aEUR" donaEUR(TM)t accept at face value a request to reduce property coverage limits. Ask the realtor and confirm the response that you receive in writing.
How about liability limits in an E&O policy aEUR" how much is aEURoeenough?aEUR? If your customer is a securities broker, mortgage broker or realtor, this might be a good time to consider higher limits or an excess policy. Financial sector insureds arenaEUR(TM)t the only ones who might be exposed to Credit Crisis claims. There is no single right answer to the aEURoehow muchaEUR? question, but a good answer will lay out more than one option. For example, you might provide a quote for a simple renewal of the existing policy, along with a quote for a higher primary limit, or a renewal plus an excess policy.
Where the gist of the claim against an insurance broker is that he failed to recommend sufficient limits, a plaintiffaEUR(TM)s lawyer can always find an expert witness who will say that higher limits were available, affordable, and could have been procured. The best defense against that sort of claim is to be able to show in writing that the policyholder chose not to buy a higher limit before the loss occurred.
Insurance company insolvency
As of this writing, no major insurers have gone out of business due to the Credit Crisis. We generous taxpayers helped AIG through a loan that is to be repaid over two years at a high interest rate. In the coming weeks and months there will be rumors of imminent failures, and possibly actual failures. What can an insurance broker do to protect herself against the risk of a carrier going under?
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