As Professional Services Liability Mounts, Consider These Highly Relevant Risk Management Tools
When professional services firms (PSFs) are sued by clients, the likelihood of an insurance claim increases when the client suffers a significant loss.
This could be a dramatic fall in stock price for a publicly traded company or a reduction in equity for a private company. Many of these lawsuits occur regardless of the quality of work performed by the PSF. It is difficult to convince a jury that the PSF complied with professional standards when it signed off on financial statements and the business filed for bankruptcy the following year.
To safeguard against these types of lawsuits, PSFs should purchase professional liability or errors and omissions (E&O) coverage.
Large and midsize PSFs often retain a layer of coverage and then buy excess insurance coverage from the commercial market, many with limits of $500 million or more per claim. However, this requires the insurance underwriters to have substantial knowledge of current and future claim trends and more importantly have substantial knowledge of the PSF’s risk management process to vet clients.
Risky clients (such as those in poor financial shape) are more likely to generate lawsuits against the PSF regardless of the quality of the work.
The State of the Professional Liability Market
Poor profitability of professional liability insurers has been putting upward pressure on rates in recent years.
In fact, most liability lines of business are experiencing consistent rate increases, with an expected 2021 property and casualty (P&C) industry combined ratio of 99.3 projected by AM Best. Accountant’s professional liability, specifically, saw rate increases of between 10% and 15% for firms with losses, while favorable firms received rate declines at the beginning of 2020.
Other professional liability lines such as lawyers, engineers and architects are also expected to experience rate increases. Some published 2021 market outlooks are even forecasting premium increases as high as 50%.
The large PSFs are seeing the more dramatic rate increases.
Directors and officers liability (D&O) results were also very poor for the last several years in the United States and Lloyd’s markets, which are often correlated with professional liability performance.
In fact, D&O pricing in the last quarter of 2020 rose 46.6%. This follows an increase of 67.9% in the preceding quarter. According to Cornerstone Research, the 2020 median settlement was $10.1 million, which is nearly 20% higher than the prior nine-year median. Of the 2020 settled cases, 42% of them were from GAAP violations.
It is likely that we will see more claims against accountants and other advisors.
Accountants’ Professional Liability
Accountants’ professional liability rates have risen over 10% in 2020 and are expected to continue, especially for firms with reported claims.
Accountants’ professional liability has been experiencing increased frequency and severity in recent years. According to Cornerstone Research, there were 70 securities class action filings involving accounting allegations in 2020. This is the second-highest count in the last decade.
In 2020, there were several large settlements, causing the average settlement to increase 240% from 2019. The median settlement amount however increased only modestly over 2019, implying severity trends for large claims are exceeding those of small claims.
Further, the trend of increased filings against larger firms is persisting; therefore, large PSFs will likely be a major target.
In addition, several lawsuits that are in the early stages may also result in significant settlements or judgments, such as DC Solar, Wirecard, Direct Lending Investments, GPB Capital Holdings, and tax claims involving the Cum-Ex scandal and syndicated conservation easements.
Whether or not frequency increases, the trend of increased severity is expected to persist.
Another driver is the growing skepticism in the accounting space in light of some high profile bankruptcies following a clean report produced by accounting auditors.
Some well-known examples include Thomas Cook and Platinum Partners. Thomas Cook was the oldest travel firm prior to its collapse, leaving thousands jobless. Its demise came after an Ernst & Young (E&Y) audit that is now under investigation in the UK. Platinum Partners was a hedge fund that was raided by the FBI prior to its bankruptcy, and the audits have also come into question.
In response to these bankruptcies, the UK is requiring the big four accounting firms (Deloitte, KPMG, PwC and E&Y) to split their consulting and auditing businesses by June 2024.
According to the UK Financial Reporting Council, “The move is meant to ensure that audit practices are focused on ‘delivery of high quality audits in the public interest’ and do not depend on financial support from the rest of the firm.”
Some attribute the reduced duty of care to the growth in the firms’ consultancy businesses.
In the United States, there has been a conscious effort to accelerate the investigations of U.S. Securities and Exchange Commission (SEC) actions.
In the last four years, there have been SEC enforcement actions for accounting malpractice against over 100 audit firms. Some alleged violations include failing to meet auditing and ethical standards and failing to comply with independence rules, while others involve more serious allegations that result in suspension of the individual auditors.
Additionally, when the SEC initiates an investigation, the Public Company Accounting Oversight Board (PCAOB) is typically running a parallel investigation, and all of these investigations tend to incur substantial defense costs that can impact underwriting.
Lawyers’ and Other Professional Liability
The overall concerning trend in the professional liability market is increased severity. According to a 2021 Ames & Gough survey, almost 50% of the top 20 professional liability writing insurers indicated claim experience worsened in 2020. This is likely going to lead to more strict underwriting standards and rate increases across the board.
Lawyers’ professional liability (LPL) rates are expected to increase at least 5% to 10%. LPL experienced similar rate increase amounts in 2019 and 2020 due to historically low rates and increased frequency of high severity claims (despite total claim frequency remaining stable).
Epic Insurance Brokers and Consultants published its 2019 State of the Insurance Market Lawyers’ Professional Liability report and cited high 2017 and 2018 insurance costs.
In policy year 2017, $172 million in large losses occurred, of which $91 million came from claims exceeding $25 million.
In policy year 2018, a claim that exceeded $100 million occurred, with many others exceeding $10 million.
This is rather concerning as these years still have time to develop. For example, the 2015 policy period had over a 50% increase in incurred losses from calendar years 2018 to 2019, over three years after the claims occurred.
One of the drivers contributing toward LPL claim severity increases is the continual rise in attorneys’ fees, which have been cited as increasing 2% to 5% annually.
Other professionals such as architects and engineers are expected to renew at higher rates. According to the 2021 Ames & Gough survey, insurers plan to increase rates at least 5%, with some even looking to push past 10% due to the worsening claim experience. Again, the rate changes are much greater for larger PSFs.
One factor driving worsening claim experience is the fallout from gray swan events such as the opioid crisis.
McKinsey & Company, a global management firm, was slapped with a $600 million fine for its role in helping manufacturers sell opioids. The lawsuit demonstrates a growing trend in holding PSFs publicly accountable for their role in questionable actions and behaviors for profit. McKinsey and other alleged contributors to the opioid crisis could still be subject to future litigation.
As the world becomes more socially responsible, these types of lawsuits could become more common.
Impact of COVID-19 on the Professional Liability Market
Unfortunately, the hardening liability insurance market is expected to persist.
In fact, the COVID-19 pandemic is likely exacerbating the hard market. The economic impact of COVID-19 has been unprecedented. The 2020 year began with the DOW hitting new record highs every day, but ended with a 3.5% real gross domestic product (GDP) decline for the year.
Most economists are expecting the economy to rebound in 2021 due to the rollout of the COVID-19 vaccine and additional stimulus from the federal government, including the American Rescue Plan Act of 2021 and potential further infrastructure legislation.
The federal stimulus alone will likely be insufficient to repair the damage that COVID-19 has done. State and municipal governments are likely to face significant shortfalls in their tax receipts, forcing them to make deep cuts. For example, Kansas City was forced to turn off the fountains in its parks, and mass transit, sanitation and other services have been cut in many municipalities.
While these cuts are not on par with what some states did following the financial crisis, they do add up.
Still, full reopening is the key, and getting everyone vaccinated will take time. As of April 9, 2021, roughly 1 in 5 Americans were fully vaccinated and 1 in 3 Americans had received at least one shot. This comes four months after the very first COVID-19 vaccine was administered.
While cities are easing restrictions to help businesses in response to the COVID-19 vaccine, most are doing so slowly. Distressed businesses struggling to hang on may not be able to for much longer.
Similar economic concerns exist across the pond. According to the World Health Organization (WHO), the vaccine rollout in the European Union has been very slow.
As of April 1, 2021, “the region has been more worrying than it has been for several months.” This will likely lead to more EU companies suffering financial blows.
The bottom line is that until there is a firm handle on COVID-19, “business as usual” is unlikely. It will take time, regardless of lifted restrictions, for people to return to flying, eating, entertaining or working as they did before, at pre-pandemic levels.
While there are some very good signs for the economy, there are several headwinds that businesses must navigate as well. Making it through those headwinds will require deft sailing by companies, and not all will survive.
An acceleration in bankruptcies in 2020 that is unprecedented since the global financial crisis of 2007-2010 (e.g., Hertz, LATAM Airlines, J.C. Penney, Neiman Marcus) will likely continue in 2021. Commercial bankruptcy filings were up 20% in the first six months of 2020 compared to 2019, the highest since 2011. In the first three quarters of 2020, Chapter 11 commercial filings have been up 33% over the same period in 2019, with a total of 5,529 filings. Half of the companies filing in the third quarter had assets over $500 million.
Overall commercial bankruptcy filings were steady from June 1, 2019 to June 1, 2020, but they are likely to increase over the 2020-2021 period, especially if COVID-19 cases continue to increase and city and country re-openings remain slow and cautious.
With stress on the economy and increased bankruptcy filings, the quantity and severity of claims against PSFs and especially accounting firms are likely to increase as there normally is a strong correlation between accounting liability lawsuits and bankruptcy filings.
The types of claims that might arise are securities/shareholder suits, claims by tax clients and cyber claims. Failure to detect fraud and/or missing red flags are typically the type of claims that have the highest severity and result in the highest profiles.
Additionally, as incomes go down or claims by tax authorities of increased tax liability and penalties go up, which also may result from state revenue departments being under pressure, claims against accountants for incorrect tax advice increase.
Further, embezzlement schemes that may have gone unnoticed for years are often uncovered when companies look closely at their books or shut down in times of economic hardship.
While the emergency associated with the pandemic will end at some point, the long-tailed nature of bankruptcy claims needs to be considered. Claims that arise from bankruptcies in 2020 may still be around in 2030.
For example, PwC had one of the largest-ever assessments for the 2009 bankruptcy of Colonial Bank following the global financial crisis, at $335 million. The award was assessed in 2018, a decade after the bankruptcy. Claims from Stanford, Madoff, and Petters — companies that went defunct in 2008 — are also still ongoing.
Further, the COVID-19 shutdowns caused a backlog in court cases because they were halted or delayed. This could cause bankruptcy suits to be pushed back. As severity increases in professional liability claims, this could cause the awards to be larger than if they had been settled at an earlier date.
Risk Management Tools
The insurance underwriting process could provide PSFs, such as accountants and lawyers, with clues on how to reduce losses and ultimately their insurance rates.
In professional liability underwriting, a key factor evaluated is a PSF’s risk management process. Unfortunately, when a client’s stock price falls abruptly and unexpectedly or the entity files for bankruptcy, its professional advisors are more likely to be sued regardless of the quality of their work.
Insurance underwriters need to evaluate the PSF’s underwriting of clients and help them improve their client acceptance models.
The claim trends discussed have led to most midsize and large PSFs to design and implement strategic risk management procedures.
PSF risk management strategies will include an evaluation of new and existing clients and the risks they pose to the PSF. The effectiveness and management culture associated with these risk management practices is a key factor in insurance underwriting along with the PSF’s actual loss experience (which is believed to be correlated with its risk management plan).
There are several elements to an effective risk management plan:
- Outright rejection of a client assignment or terminating an existing client. A PSF may consider a company or assignment as too risky. Some characteristics that could lead to this conclusion include:
- A senior management team that has a history of criminal, reckless or other questionable behaviors;
- A situation where there is a clear conflict of interest or a strong appearance of a potential conflict;
- Rapid growth such as, hypothetically, when a client has quickly tripled in size in a short period in a mature industry;
- A client with significant debt, low equity or hard-to-value assets; and/or
- A client in a jurisdiction that is very favorable for securities plaintiffs (e.g., Oregon).
- Limit the number of clients with certain attributes or in a certain geographic region. Some clients may be viewed as potentially very risky and require approval of the PSF’s chief risk officer, risk committee or board of directors. By requiring approval of these accounts, the PSF can limit the number of clients in this category and better monitor the size of the exposure.
- PSFs can institute other procedures to ensure high quality of work and independence:
- Rotating the partner or office performing the work;
- Requiring a higher level of peer review (e.g., two peer reviewers, an independent analysis for part of the analysis); and/or
- For riskier assignments, only allowing individuals or offices with substantial experience in the subject to complete the assignment.
The sophistication of the PSF’s screening model is a significant element in insurance underwriting.
Underwriters can help a PSF in this regard by advising the PSF on improvements to its model based on their analysis of historical claims and other factors that are correlated with claims (e.g., jurisdiction, type of work, industry, financial statistics). The models will also show variation by type of PSF (e.g., accounting firm, law firm).
Impediments to Risk Management
The above factors can be implemented, but the ultimate determinant of their success is the PSF’s culture regarding risk management.
PSFs have a strong incentive to grow the numbers of their clients and revenue. In fact, many firms require individuals to generate a certain amount of revenue to become a firm “partner.” So there is constant juggling around the balance between meeting revenue targets and risk management procedures.
Well-run PSFs will make the tough yet correct decisions. As an incentive, some PSFs compensate staff based on risk management evaluations.
Professional liability underwriters need to get a sense of the PSF’s culture and whether the PSF is willing to walk away from a big client deemed “too risky.” This is especially true now as COVID-19 financial challenges may have left some partners to desperately accept clients that normally would not have made it through the screening process.
Another impediment to risk management is when a PSF has had numerous years of good claim experience leading to the belief that it is being too conservative with its risk management procedures. If the good claim experience is actually a result of a strong economy (e.g., if stock prices increase or remain stable PSFs are less likely to be sued), then a shift in the economy or gray swan event could result in significant claim activity under relaxed risk management procedures.
Underwriters need to be aware of these practices especially because the economic decline due to COVID-19 could result in increased company failures.
Overall, PSFs will likely be paying more for their professional liability insurance, at least in the short term. Understanding the insurance underwriting process and building up an effective risk management process are just some of the ways to combat it. Insurance underwriters can help PSFs develop more robust client screening models due to their insight into the entire market. &