Professional Indemnity: be prepared

Accountants have benefitted from low professional indemnity insurance premiums for years, but that might be about to change.

Partially as a result of the credit crunch and fall out from the US sub-prime crisis that has had significant implications for the UK economy, accountants should brace themselves as the PI insurance market could be about to experience a shock to the system. Frequently, following economic shocks like the one we are currently experiencing, there is a significant increase in the number of claims against professionals.

The sub-prime crisis is causing a great deal of uncertainty in the financial services market and accountants might well be considered prime scapegoat material by certain companies and sectors whose margins and figures on the bottom look set to take a hit.

Before focusing on PI for accountants, it might be instructive to compare professional indemnity trends in other professional sectors. For example, although the PI market for legal firms is at a similar state of the insurance cycle as that for accountants, the same certainly cannot be said for the market for mortgage brokers and IFAs.

A PI broker colleague of mine explained recently that due primarily to a mixture of regulatory issues and the recent financial markets turmoil, a large number of mortgage brokers were now unable to obtain PI insurance. The lucky ones who did manage to obtain coverage were experiencing a huge spike in premiums ­ in many cases a hike of over 100% and in some cases by as much as 500%.

No one is suggesting something similar is going to happen to accountants’ PI rates, but one certainly has to question whether the market’s current low premium levels are really sustainable for much longer.

As it currently stands, The PI market place is very healthy for accountants. The insurance market goes through cycles and is currently experiencing what is known in the insurance business as a ‘soft’ market. That means that for a number of reasons ­ primarily because of the law of supply and demand and the intense competition between insurers ­ PI insurance for accountants is low.

On guard

However, a number of observers and respected organisations are saying that insurance premiums are unsustainably low and to be wary of a possible correction that could lead to a sharp hardening (or spike) in rates.

In which case, now is the time to renew on a two-year fixed deal because if you can obtain such a deal from an insurance broker, you might be able to mitigate some of the exposure to higher premiums that may come with a rate hardening.

The risk is amplified because it is an unfortunate aspect of the soft/hard rate cycle in insurance that soft markets tend to drift down quite gently whereas a hard market usually experiences a rapid spike in rates that tend to take firms by surprise.

The widely respected business intelligence and market research service Datamonitor has also predicted that the market is expected to harden in 2008 or 2009 due to changes in competition and product penetration in the sector.

The report goes on to suggest two separate plausible scenarios in which premiums go up. If premiums begin to harden in 2008 it is forecast that gross written premiums (GWP) in the PI sector will grow to over £2.5bn by 2011. If the market hardens in 2009, however, the forecast is GWP growth to ‘only’ £2.1bn ­ but still a 25% increase on the figures for 2006.

Meanwhile, the instability and volatility in the financial markets is increasing. High levels of borrowing could land ‘a significant minority’ of people in trouble in 2008, the Financial Services Authority (FSA) has warned in a report issued recently. Its Financial Risk Outlook report said that adverse market conditions were putting the business models of some financial institutions under strain.

The report also warned that people may lose confidence in financial regulators and market participants and consumers may lose confidence in financial institutions and in the authorities’ ability to safeguard the financial system. Consequently, the FSA expects that tighter economic conditions will increase the amount of financial crime and fraud being uncovered.

One of the biggest risks for accountants is failure to pick up on a fraud committed by a client’s employee with the potential that has for a professional negligence claim and ensuing litigation.

Fraud indicators include false invoicing that leads to inflated turnover and share price, acts which persuade lenders that a company turnover is higher, theft by the finance director and/or his colleagues, and exaggerating the figure for debtors to mask insolvency.

Every accountancy firm should be fully conversant with the money laundering obligations on the profession.

The latest money laundering legislation further increases the exposure of every profession and exposes individuals to criminal negligence claims as well as civil liability actions.

The risk is not just limited to the Big Four either. Any accountancy firm that fails to spot a fraud is at risk because, under current law, that practice can be considered guilty of professional negligence with all the potential liabilities and proportional losses suffered by the shareholder that entails.

It is certainly the case in PI insurance ­ which in many respects is no different to other areas of our business ­ it can sometimes pay dividends to build up a relationship with an insurer over time rather than enjoy the illicit thrill of a ‘one night stand’ with an new entrant to the market.

Although new entrants offering the promise of lower premiums may be tempting during a soft market, they frequently prove to be less than accommodating when the market turns and the serious claims start to mount.

Things are looking up

For example if a PI insurer has underwritten a long-standing policyholder with a good claims history they are much more likely to be less hostile when a large claim comes in and it is time to renew the next year’s premium rate.

If we are towards the bottom of the market cycle (as most industry commentators agree we are) it means that premiums are highly likely to start to rise in the near future. On top of premium increases, we expect insurers to adopt a more serious discipline in their underwriting approach. They will also start to take a firm’s quality assurance procedures into account when calculating premiums

If a firm’s, or a profession’s, claims experience is poor, it could also result in a general lack of availability of insurance. Look no further than the challenges faced by IFAs only five years ago in this respect and what is happening to mortgage brokers today.

Mark Bracher works at Lockton International

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