Carrier failures could make B-Ds liable

Broker-dealers, registered representatives and advisers could be on the hook if they sell products from major carriers whose risk-based capital is crumbling, plaintiff's attorneys say. Last month, insurance juggernauts Prudential Financial Inc. of Newark, N.J., and The Hartford (Conn.) Financial Services Group Inc. revealed to analysts that plummeting equity markets had adversely affected their capital. During a conference call with analysts, Prudential had estimated that it would have a risk-based capital ratio between 350% and 400% in the event that the Standard and Poor's 500 stock index ended the year at 900. Meanwhile, the Hartford gave an estimate of about 440% for its Simsbury, Conn.-based affiliate, Hartford Life and Accident Insurance Co., which writes life insurance and variable annuities. That's down significantly from last year's levels of 1,148% for Prudential and 831% for The Hartford. Generally, state regulators become concerned when a carrier's risk-based capital ratio falls to below 200%, or twice as much capital as regulators deem necessary for an insurer to conduct the business it does. At that level, regulators require insurers to submit a plan with corrective measures. Although current ratios are satisfactory, attorneys are looking at the extent of a salesperson's liability for judging a carrier's strength, as much of that information is hard to obtain. The issue is especially important in an age when broker-dealers and sales forces still rely largely on ratings agencies to vet insurance carriers' strength, despite the scrutiny these agencies are now facing from regulators. "Registered reps and agents rely on those agencies, and to now find out that the agencies' criteria [don't] reflect the balance sheet is probably shocking to most of them," said Rodney J. Heggy, a trial lawyer and partner at Oklahoma City-based Heggy & Associates LLC. "If an agent or rep represents the insurance company as being strong enough to justify the premium and the product, they have a problem if that turns out to be untrue," he said. But therein lies the rub, Mr. Heggy said. How would the agents, advisers and reps recommending the product know of a problem at a carrier if the ratings agencies and analysts are having a hard time unearthing that information? If a disgruntled client were to purchase an insurance product from a company with capital problems that are below the surface — and were that product to fail as a result — insurers, broker-dealers and the direct sales force could all be held responsible, plaintiff's lawyers and insurance company counsel said. Though the insurers are ultimately responsible for prudent investments and maintaining clean balance sheets, broker-dealers are the ones who screen the carriers and ensure that their own reps aren't recommending bad products — so they face the greatest burden. "My argument as a lawyer suing the broker-dealer on the behalf of the rep is, 'You had a fiduciary duty to monitor this stuff because I could not, and you failed,'" said Dan Taylor, attorney and founder of Advisor Freedom, a Charlotte, N.C., consulting service for advisers.

MORE LITIGATION?

He questions carriers' ability to pay for the income guarantee features that come with variable annuities, and expects advisers and reps to take their employers to court for not instituting quality control measures in their dealings with the insurers. It would be a firm's responsibility to perform proper due diligence on the products it sells — which would probably be beyond the scope of the rep's expertise or access. However, broker-dealers have a limited amount of information before them, putting a lot of faith in the state-required statutory reserve levels for each company and the information from the ratings agencies. On top of that, if a company works with a dozen different carriers, they have a multitude of balance sheets to analyze as they perform research, Mr. Heggy added. "They are already caught by surprise when there is a product failure, so either they do it and don't do it well, or they don't do it at all," he said. "They rely on the statutory reserves and ratings agencies, and if it falls apart, they deal with it as it comes." Mr. Heggy, who represents insurance agents and registered reps, said that in the event of a product failure, issuers and broker-dealers may simply pay up, as they have done in the auction rate securities debacle. Other attorneys, however, in-sist that agents, advisers and reps could indeed face legal action for breach of fiduciary duty, particularly if they sell a product despite public warnings of a carrier's troubles. "It's everyone's responsibility to make sure that the information is there," said Jon E. Drucker, an attorney at an eponymous Los Angeles firm. "The insurance company owes a duty to the clients and so does everybody in between. Not having the information at their fingertips is no excuse." And while the ratings agencies are the conflicted critic in charge of judging a carrier, their obligation to the end consumer is iffy under the law, Mr. Drucker added. Trying to head off lawsuits, some are looking for possible areas of concern. Fixed annuities may become a trouble spot, said Jim Sorebo, president and chief executive of Four Seasons Financial Group Inc., a Mount Laurel, N.J.-based wholesaler to banks, agents and broker-dealers. "Insurance companies have to set aside reserves to back up their fixed-annuity portfolio, but if there's a capital crunch right now, then where are they getting the capital to back up above-market interest rate yields?" he asked. Mr. Sorebo has an attorney on his company's board and informs reps and agents of recent developments. Some broker-dealers are also outsourcing their research to wholesale insurance brokerage firms, as is the case for Walker Capital Management Corp. The Norcross, Ga.-based firm went through a due-diligence process with The Dempsey Cos. of Atlanta and received a vital-signs report that examined the ratings, broke down the assets and liabilities, and examined press reports on the insurer. For Lewis J. Walker, president of Walker Capital Management, the extra work is also a matter of protecting the firm and having indisputable proof that it went the extra mile. "Reps need to understand the due-diligence process so that if anything goes wrong, you have some basis for selecting the company," he said. "And you can show you put every effort to put the clients with reliable companies that can deliver on their promises." E-mail Darla Mercado at dmercado@investmentnews.com.