Who Insures Your Investment in the Stock Market

Savings deposits are protected by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000 per account, but money in the securities markets had virtually no protection of any kind for much of Wall Street's history. This changed in 1970 when Congress created the Securities Investor Protection Corporation (SIPC).

Are Investment Losses Insured?

There's no insurance against the possible loss of your initial investment when you invest in a stock, bond, or mutual fund. Insurance that you can purchase protects only against unexpected occurrences such as fire or theft, not depreciation in value. This is the case even if you're investing in collectibles.

The element of risk is inherent to investing, which is why investments cannot be insured. The return is a reflection of the type of risk you're taking on, whether it's in the form of interest, dividends, or capital gains. The higher the risk, the higher the potential return.

Conversely, a reduction in risk means a reduction in potential return. Consider the investment products that guarantee your principal. Your money is guaranteed because you'll receive a relatively low rate of return.

Insurance Against Broker and Dealer Bankruptcy

Congress created an agency known as the Securities Investor Protection Corporation (SIPC) in 1970. The agency's only function is to cover the losses of investors' accounts that are incurred by the bankruptcy of their broker or dealer. The SIPC doesn't cover any kind of loss incurred as a result of market activity, fraud, or any other cause of loss.

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

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

An example of SIPC protection

An investor has $300,000 in cash and $150,000 in securities that are held in street name with a broker or dealer that becomes insolvent. They also deposit $450,000 worth of securities registered in their own name with the broker or dealer just before it declares bankruptcy.

The SIPC guidelines dictate that this investor will receive $250,000 of their cash and all their securities that are held in street name for a total of $400,000. The SIPC will reimburse up to $500,000, but the remaining $50,000 in cash won't be covered because it's over the $250,000 cash limit. They'll get all their stock certificates back, provided they're still registered in their name.

When SIPC Protection May Not Apply

Not all types of securities are eligible for SIPC reimbursement. Securities that the SIPC won't reimburse for include commodities, futures, currency, fixed and indexed annuity contracts, and limited partnerships (LPs). These are covered separately by insurance carriers. Any security that isn't registered with the SEC won't be eligible for reimbursement, either.

Like the FDIC, the SIPC only covers member firms, so you should make sure your brokerage is a member firm. You're probably okay if you're a customer at a large brokerage house, but check to make sure. If your account is at a smaller firm, make sure that it's a member and determine whether another company handles transactions on behalf of your brokerage as well. Make sure that this other company is also a member of the SIPC. This 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 due to unauthorized trading, which is a frequent cause of brokerage insolvency.

Make sure to send a letter to the firm for documentation purposes if you suspect that an unauthorized transaction on your account has taken place. Creating a record can help the SIPC decide which portions of your accounts are covered and which are not if your firm ever becomes insolvent.

Special Considerations

Few investors nationwide have lost any actual assets from insolvency when the SIPC was involved. Between the pro rata recovery distribution, the return of all registered securities certificates, and the insurance coverage limits, there's little chance that an investor will suffer a net loss as a result of broker or dealer insolvency.

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

Frequently Asked Questions

The Bottom Line

The SIPC can help you recover assets in the event that your broker or dealer goes bankrupt, but it doesn't protect you against losses that result from market activity. Nor will it protect you if you're dealing with a firm that isn't a member.

You can take steps to protect your investment by documenting interactions with your broker or dealer if you have reason to believe that unauthorized trading caused its insolvency. You may have to prove that this event led to your loss. Many brokers and dealers provide their customers with additional "extra SIPC" coverage, and you'll want to check into this as well.