Schwab’s Insurance Requirements and New SEC Regulations Drive Up Barriers to Independence
In 2019, commission-free trading was the shot heard ‘round the custodian world—arguably, the shot that launched the race to the bottom as the proverbial big guns, Schwab, TD Ameritrade and Fidelity, announced they would eliminate commissions on stocks, exchange-traded funds (ETFs) and options for retail investors and registered investment advisors (RIAs) on their platforms.
On the heels of this move to grab market share among RIAs, Schwab announced its acquisition of TD Ameritrade, an integration set to be completed in 2023 that will deliver $6 trillion in client assets, 28 million brokerage accounts and more than 5 million daily average trades under the combined custodial umbrella.
The latest move in the custodial chess game came from Charles Schwab, which recently announced a change requiring firms who custody with them to purchase an aggregate minimum of $1 million of the following risk insurance coverage:
- Errors and Omissions (E&O)
- Social Engineering
- Theft by Hacker
- Theft by Employee
The Impact of Insurance Requirements on RIAs
It’s always been recommended that RIAs purchase, at the very least, E&O insurance coverage, which covers settlement, judgements and defense costs associated with the following claims:
- Claims by clients for investment losses and other damages resulting from claims like negligence
- Breach of fiduciary duty in providing (or failing to provide) professional services
- Errors and omissions
- Breaches of the advisory agreement
- Failure to supervise brokers
It has not, however, been a requirement until now. Failure to comply with Schwab’s policy could prevent prospects from being able to custody assets with the firm, and existing Schwab clients that don’t meet the insurance coverage requirements could be looking at a termination of their service agreement. Firms new to Schwab have 90 days to comply.
At its core, Schwab’s insurance coverage requirement is a good thing. In a statement to RIABiz, Brian Hamburger, CEO of MarketCounsel, put it this way: “Schwab is overtly stating what we all know: that well-run businesses are properly insured to protect the enterprise and those who engage with it.”
For advisors, their clients, and Schwab itself, the mandate offers several positive implications:
- The RIA industry is growing rapidly—and with more growth comes more complexity and more risk, especially on the operational side of the business.
- By requiring comprehensive insurance coverage, Schwab is proactively trying to protect advisors and themselves, as well as end investors, from unnecessary risk exposure
- Several states are requiring that RIAs purchase errors and omissions insurance, a trend that is likely to continue. Firms that custody with Schwab will already be prepared as this becomes a more common requirement.
- Rising fraud rates and cybercrime attacks leave uninsured advisors exposed to damages that could cost them their business. Schwab’s mandated social engineering and theft by hacker insurance provides much-needed protection from these very real threats.
But it’s not all insurance and roses for some RIAs—particularly smaller firms that are just starting out. Schwab’s coverage rule indicates that all firms, regardless of size, must maintain an aggregate minimum of $1 million in coverage. This requirement significantly raises the cost of doing business—roughly as much as a new car—which is a real challenge for smaller RIAs.
As of now, neither Fidelity nor TD Ameritrade require E&O insurance coverage, although advisors that currently custody with TD Ameritrade will need to meet Schwab’s insurance requirements as the consolidation of the two firms gets closer. Fidelity has indicated they strongly encourage clients to obtain insurance coverage—a more lenient stance that could very well firm up in the coming months.
The Ever-Evolving Cost of Compliance for RIAs
In addition to new insurance requirements, the SEC also recently announced a new rule prohibiting RIAs from outsourcing certain services and functions without conducting due diligence and monitoring of the service providers.
These oversight regulations don’t directly specify which services are beholden to enhanced due diligence and ongoing monitoring; “covered functions” as they’re called in the SEC’s proposal could mean that almost anything an RIA outsources needs to satisfy pre-determined due diligence elements and will be subject to periodic monitoring of the service provider’s performance.
Most RIAs don’t have a Chief Compliance Officer in house to handle the additional compliance burden of significantly increased due diligence over outsourced providers, nor the budget for the expenses such due diligence and frequent monitoring require.
And outsourced services oversight regulations are just the latest in a long line of increasing compliance requirements for financial professionals, which include implementing cybersecurity risk management policies and procedures, new marketing and advertising rules and regulation best interest, or RegBI.
The Future Landscape for Independent Financial Professionals
Regardless of custodian, RIAs who are considering independence should not put insurance coverage or cooperation with SEC regulations on the back burner, as fines and penalties for non-compliance carry significant reputational and profitability risks.
Ultimately, the goal of both the insurance requirement and of the SEC’s mandates is protection for advisors, their firms and their clients. Advisors seeking independence should align themselves with a firm that can help them navigate the financial and operational complexities of regulations such as these.
To learn more about the resources and support independent advisors can expect from Silver Oak, click here.
