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Financial Life Advisor
An Insider’s Perspective of the Investment Marketplace Part 1 – How are Financial Products Distributed
The average person goes to school, graduates, then gets a job. Between buying a car, house, and other post-graduate purchases, there is usually not much thought giving to saving and investing, but once someone is ready to start investing, what is the first step? Everywhere you turn there is an investment opportunity.
The banker says invest your money in a guaranteed CD, the insurance agent has the “perfect” policy for you, the stock broker picks “hot” stocks which will make you rich, late night infomercials promise that you will be the next real estate mogul, and your neighbor is investing in oil & gas. How does someone sift through all of this information? Where do you begin?
In this multi-part series, I will attempt to walk you through the basic framework of the sale and regulation of investments, and the potential advantages and pitfalls of different investments.
How are financial products distributed?
When you want the latest technological gadget you know exactly where to go. Most items can be purchased or sold without a specific license. This is not true of financial products. Most securities must be purchased through a broker/dealer and insurance products from an insurance company. Generally, a registered representative of the broker dealer is the salesperson who assists you with the purchase of securities. An insurance agent sells the insurance policy for the insurance company. Even a real estate agent needs a license to broker real estate transactions. However, none of the above mentioned profession requires a fiduciary responsibility to the buyer.
Most insurance agents are only paid when you buy a policy. Real estate agents can work for countless hours without any pay. They only get a commission check when a house closes. Many securities brokers also only get paid when a securities transaction gets completed. As you seek a resource for advice and counsel, do not forget how the person across the table from you is paid. They must feed their families and cannot spend time with you without a profit motive. They often receive compensation only when you make a purchase, so that is what they want from you.
An insurance agent can only sell insurance products for insurance companies with whom they contract. Many are “captive agents”. Meaning they can only sell insurance products from the companies their employer says they can. If the agent works for an independent agency, products could be a broad range of companies; if the agent works for an actual insurance company, it is generally only that insurance company from which they can sell. The insurance agents are usually only paid upon placement of an insurance policy, and they can only sell certain policies. If you don’t buy one of those, then they don’t get paid.
While similarities exist between the insurance and the securities industries, the securities industry is somewhat different. Like insurance agents, registered reps can only sell securities products which the broker dealer allows. As in the insurance industry, some broker dealers only sell products from a specific insurance company or investment company. More common than in the insurance industry, broker dealers tend to be independent and sell investments from a broad range of companies. Independent broker dealers may sell one company’s mutual funds right along with another company’s.
I would conjecture that it is usually better to deal with an independent agency and independent broker for a broader range of investments and policies. The narrower the product offering, the more likely a salesperson will try to make you fit into what doesn’t quite fit your situation. Sales people may not be bad or out to take advantage of people, but they must make a sale of what they can offer to make a living.
Regulation
Although many investment professionals sell both insurance and securities, the regulation for each is completely different. Insurance is regulated by each individual state. The insurance license to sell life and health insurance is usually separate from the one for property and casualty policies. The exam can be taken by anyone without any educational prerequisites. Most states do require a minimum proficiency score and a background check. Typically, someone has already contracted with an insurance company or agency before taking the exam, but this is not required in all states.
I rate the difficulty of the exam as easy. When I entered the industry, the first firm I worked for gave me a textbook and some practice questions. Four days later, I took and passed the exam, and two weeks after that, I was selling insurance. Scary, I know.
An insurance agent represents the insurer. Most state regulation is based upon making required legal disclosures and avoiding “churning,” or the practice of switching from one policy to another just to generate more commissions. Insurance agents are working for and representing the interest of the insurance company by which they are contracted or employed.
Securities are regulated at the Federal level. Stocks, bonds, options, etc are sold through registered broker/dealers. The Securities & Exchange Commission (SEC) is a government agency tasked with overseeing the securities market. The Financial Industry Regulatory Authority (FINRA) is a self-regulatory organization. Broker/dealers must be members of FINRA to buy or sell securities.
To be licensed to sell securities, a registered representative must pass certain exams. To sell mutual funds, passing both the Series 6 & 63 exams is required. To sell stocks, bonds, and options, a Series 7 is required. There is no education component required for these exams, but the breadth of material for the exam is more extensive than an insurance exam. The national pass rate is approximately 65% for the Series 7.
With some insurance products, the line between securities and insurance are blurred and are regulated by both. Variable annuities and variable universal life insurance policies are an example of this. In the case of these products, both a securities and insurance license is required to sell these products.
Fiduciary vs. Suitability
Most financial products are sold to consumer either by an insurance agent or a securities broker. Neither of these people have the legal responsibility to put your interests above their own. With securities brokers, the products have to be suitable based upon the information the broker has. For instance, if the broker had access to a mutual fund which is has similar risk/return characteristics but higher fees and lower historical investment returns, he could still sell it because it is suitable. A fiduciary would be responsible for at least disclosing that a better option was available, even if they could not sell it. Even if the broker has access to the better investment, but it pays a lower commission, they can still recommend and sell the higher cost/lower performing investment without any disclosure.
Insurance agents have an even lower level of responsibility to clients. Almost all instances of insurance agents getting into trouble has to do with a practice called “churning”, selling a new product to replace an older product solely to generate additional commissions. Many insurance contracts have multi-year surrender charges or other complex contract provisions which make switching expensive. Replacing of existing insurance policies is really the only major area of scrutiny of insurance agents.
Many people trust that their insurance agent or securities broker has their best interests at heart. Many do, but are not required to or legally responsible to do so. A Registered Investment Adviser is required to be a fiduciary and put their client’s interests ahead of his own. All conflicts of interests (like compensation & product limitations) must be fully disclosed. There are many dually registered Investment Advisers who are also registered representatives of a broker/dealer.
Where to buy?
All insurance must be purchased either directly from an insurance company or one of their agents. All securities must be purchased through a registered broker/dealer or one of their registered representatives. As stated before, none of these channels have a fiduciary duty. Investment Advisors may work as a registered rep of a broker dealer (usually not a fiduciary when participating in securities transactions) or may fully be independent and have limited power of attorney to execute trades on behalf a client as a fiduciary.
Many independent Registered Investment Advisers do not work for a broker/dealer, but instead represent clients who do business with a particular broker/dealer. Some broker/dealers only sell a narrow line of proprietary products; some sell a broad range of products but charge premium rates to cover the commissions paid to registered representatives. Discount brokers generally charge low or flat fees but provide very little service. They exist only to have an inexpensive marketplace for Registered Investment Advisers to direct investments for their clients or for individuals who do not want or need the help of an advisor or registered representative.
I think that the best way for an unsophisticated buyer to purchase insurance or investments is with the assistance of an independent party who is not compensated based upon which investment they recommend. For sophisticated buyers who know what they need, a discount broker may be the best route. For insurance, there are almost no true insurance consultants who are not agents themselves. When selecting an agent, I prefer to go with an independent agent who is licensed with multiple insurance companies
The other parts of this series:
Part 2 – Insurance Investment Products
Posted by Ben Gurwitz on 26th April, 2010 | Comments | Trackbacks
Tags: April 10, Investments
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