The lowdown on PI insurance

Interviews with potential Dover advisers are interesting exercises.

Many do not understand how their AFSL’s compensation and insurance arrangements work. They think “they are covered for everything above $15,000” or whatever.

The questions “who is covered?”, “what is covered?” and “when it is covered?” do not get much thought. But more worrying is the common attitude, “My AFSL has such great insurance we do not have to worry about compliance”.

We see it every day. And every day we have to explain that’s not how AFSL professional indemnity insurance works. And their AFSL does not have such great insurance. In truth, their AFSL does not have much insurance at all.

Section 912A of the Corporations Act requires AFSLs to do all things necessary to ensure financial advice is provided efficiently, honestly and fairly. This means they must have adequate resources to compensate clients for breaches of the law.

Who is covered?

The insurance does not protect the client.

The insurance does not protect the adviser.

The insurance protects the AFSL.

Professional indemnity insurance is not a device to pay client compensation claims. Rather, ASIC says the insurance is one way of reducing the risk a compensation claim cannot be paid because the AFSL’s financial resources are not adequate.

AFSLs are not obliged to claim on their insurance. They may choose to pay the claim out of their own resources and, for example, if the claim was caused by an adviser acting in breach of their AFSL contract, may make ultimately require the adviser to pay the damages.

An adviser cannot force the AFSL to claim on its insurance policy, even if the AFSL is able to claim.

Advisers should never act outside the terms of their proper authority. If they do, and if a client suffers damages and claims compensation, they will be on their own, with no right or ability to claim on an insurance policy.

The key takeaway here is, “If an adviser breaches the AFSL contract, i.e. the terms of the proper authority, they are not covered by their AFSL’s professional insurance policy”.

What is covered?

This is another interesting misunderstanding. Not everything is covered. In fact, many things you would think are covered are not covered.

For example, ASIC does not require professional indemnity insurance policies to cover:

• Product failure or general investment losses;
• Losses connected to the failure of a product issuer; or
• Investment returns below expectations.

But, obviously, each of these three events could involve adviser negligence if the standard of a reasonable financial planner is not met.

This is why advisers should only work with a conservative approved product list, should make sure their advice is always conservative and should not raise unrealistic performance expectations.

Institutional bias is a huge issue here. If an adviser is ‘influenced’ to recommend certain products, and the product performs worse than expected, the adviser will not be able to show their advice was within the standard expected of a reasonable financial planner. The adviser has not acted in the client’s best interests, has not provided appropriate advice and has not prioritised the client’s interests. And the damages, i.e. the below-expected investment returns, are not covered by insurance. The adviser is on their own.

When is it covered?

This is, of course, the big question. Even the biggest question. Its answer leaves most advisers woefully unprotected.

Professional indemnity insurance works on a ‘claims made’ basis. It only covers claims notified to the insurer during the policy period.

Claims notified after the policy period are not covered, no matter when they occurred.

If an AFSL cannot renew its insurance policy, that’s that. The cover ends. All over red rover. There is now no insurance. Claims made for events which occurred in previous periods are not covered, even if they would have been covered had the claim been reported earlier.

This is a huge issue because most claims against advisers do not emerge until years after the event. It’s the nature of financial planning advice. The damages connected to the negligent act or omission typically do not emerge until years after the relevant negligent act or omission.

The problem is magnified by FOS’s consumer-biased views on how the six-year statutory limitation period works. FOS says it starts when the client realises there has been a negligent act or omission, not when the negligent act or omission occurs. In one recent case, FOS awarded $250,000 damages for advice on trees from 2005, i.e. 12 years earlier. The AFSL was not covered by insurance but, luckily for both the adviser and the client, the AFSL had the financial resources to pay the claim.

To take a probable example, assume an AFSL’s insurer refuses to renew its professional indemnity insurance policy on 30 June 2018 because of its poor claims history. Or to take an even more probable example, assume an AFSL shuts its doors on 30 June 2018 due to the huge drop in commission income from 1 January 2018 on under the new LIF rules.

In each example, claims made on 1 July 2018 are not covered. This is so no matter when the insured event occurred. If the claim was reported on 30 June 2018, it is covered. But the same claim reported one day later is not covered.

Claims made from 2 July 2018 to 30 June 2030 and beyond are not covered either. An adviser age 60 on 30 June 2018 could be years into what was supposed to be a pleasant retirement but still be fighting off negligence claims, without the safety net of their AFSL’s professional indemnity insurance policy.

This is, of course, a disaster for the AFSL’s advisers. They have no professional indemnity insurance cover. They are forever exposed to claims by clients connected to events before 30 June 2018. It does not matter that the AFSL charged them $6,000 a year extra for their professional indemnity insurance cover. They paid for insurance but have no cover.

It’s a particular disaster if the AFSL ‘encouraged’ its advisers to recommend institutionally biased products and other fundamentally inappropriate and conflicted products, such as off-the-plan apartments and white label investments.

This AFSL got them into a big mess but will not be around to help them get out of it.

What can you do about this?

Unhappily, there is a not a lot you can do about your ASFL’s professional indemnity insurance contract. It is what it is. ASIC realises this and accepts AFSL professional indemnity insurance contracts do not include run-off cover.

The insurers just don’t offer it. So the AFSLs cannot hold it.

Financial planning professional indemnity insurance cover stops when the policy stops. And that’s that.

Terry McMaster is the founder and managing director of Dover Financial Advisers