Who Insures Your Investment in The Stock Market

Bank customers have enjoyed the security and protection provided by the Federal Deposit Insurance Corporation (FDIC) knowing their savings deposits are backed by the full faith and credit of the U.S. government for up to $250,000 per account. However, those in search of higher returns who were willing to risk their money in the securities markets — for much of Wall Street's history — had virtually no protection of any kind, even from losses due to broker/dealer bankruptcy.

Whenever you invest in a stock, bond or mutual fund, there is no insurance against the possible loss of your initial investment. Even if you are investing in collectibles, the insurance that you can purchase protects only against unexpected occurrences such as fire or theft, not depreciation in value.

The element of risk is inherent to investing, which is why investments are not (and cannot be) insured. For all types of investments, the return — whether in the form of interest, dividends or capital gains — is a reflection of the type of risk you are taking on. The higher the risk, the higher the potential return. Conversely, a reduction in risk means a reduction in potential return.

For example, consider the investment products that guarantee your principal. Your money is guaranteed because you'll receive a relatively low rate of return. Remember, there is no such thing as a free lunch.

In 1970, Congress created a new agency known as the Securities Investor Protection Corporation (SIPC). This agency's only function is to cover the losses of investors' accounts incurred by the bankruptcy of their broker/dealer. 

The SIPC does not cover any kind of loss incurred as a result of market activity, fraud, or any other cause of loss other than the bankruptcy of a broker/dealer. Regulatory agencies such as the Securities And Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) deal with issues related to fraud and other losses. 

The SIPC either acts as a trustee or works with the client to recover assets in the event a broker/dealer becomes insolvent. The SIPC will also oversee the recovery process and ensure that all customer claims are paid in a timely and orderly fashion, and all recovered securities are distributed on an equitable, pro-rata basis.

The SIPC will reimburse investors for up to $500,000, of which up to $250,000 can be cash. Any securities that are already registered in certificate form in the investor's name will be returned as well.

Let's take a look at the following example:

An investor has $300,000 in cash and $150,000 in securities held in street name with a broker/dealer that becomes insolvent. He also deposits $450,000 worth of securities registered in his own name with the broker/dealer just before it declares bankruptcy.

The SIPC guidelines dictate that the investor will receive $250,000 of his cash and all of his securities that are held in street name, for a total of $400,000. Although the SIPC will reimburse for up to $500,000, the remaining $50,000 of cash will not be covered because it is over the $250,000 limit for cash. He will also get back all of his stock certificates, provided they are still registered in his name. 

Not all types of securities are eligible for SIPC reimbursement: Securities that the SIPC will not reimburse for include commodities, futures, currency, fixed and indexed annuity contracts, and limited partnerships (LP) — which are covered separately by insurance carriers. In addition, any security that is not registered with the SEC will not be eligible for reimbursement.

Like the FDIC, the SIPC only covers member firms. This means you should make sure your brokerage is a member firm. If you are a customer at a large brokerage house, you're probably okay, but it's always a good idea to check. If your account is at a smaller firm, you should not only make sure that this firm is a member but also find out whether another company handles transactions on behalf of your brokerage, in which case you need to make sure that this other company is also a member of the SIPC. The membership of the other company is necessary for your account to be insured.

The SEC has noted that a frequent problem for the SIPC is deciding how much of a person's account has suffered losses because of normal market risks and how much is lost because of unauthorized trading, a frequent cause of brokerage insolvency. If you need to claim losses that are a result of unauthorized trading, you may have to prove to the SIPC that unauthorized trading took place on your account. Therefore, if you ever suspect that an unauthorized transaction on your account has taken place, make sure you send in a letter to the firm for documentation purposes. That way, if your firm ever becomes insolvent, the records can help the SIPC decide which portions of your accounts are covered and which portions are not.

In reality, less than one percent of all investors nationwide have ever lost any actual assets from insolvency when SIPC was involved. Between the pro-rata recovery distribution, the return of all registered securities certificates and the insurance coverage limits, there is little chance that an investor will suffer a net loss as a result of broker/dealer insolvency.

In addition to protection by SIPC, many broker/dealers also provide their customers with additional coverage through a private carrier. This type of coverage is known as "excess SIPC" insurance and coverage limits for this protection are often high, such as $100 million per account. As with the SIPC, this coverage will only reimburse investors for losses due to broker/dealer insolvency. Coverage limits for this type of insurance will vary from firm to firm.

(Find out how well your savings will be protected; read Bank Failure: Will Your Assets Be Protected?)