Insurance is often top of mind for many accounting firms. Whether it’s professional liability insurance, cyber insurance, or tail coverage in connection with an M&A deal, insurance policy limits, premiums, pricing, and scope can be complicated issues for accounting firms.
In this article, Levenfeld Pearlstein Partner Russell Shapiro shares his conversation with David Koenen, Managing Principal at Lemme, a Division of EPIC. His organization is one of the largest insurance brokers in the country and has a special niche supporting accounting and law firms and their complex insurance needs. David has extensive experience working with CEOs, COOs, managing partners and firm administrators to secure appropriate professional liability coverage for accounting and consulting firms. As a former Big 4 professional and consultant, he understands the need for practical, real world insurance solutions so his clients can focus on what they do best – running their businesses.
Russell is a leader in advising on the legal and business aspects of accounting firm partnership agreements and mergers and acquisitions. He has twice been recognized by Accounting Today magazine among the “Top 100 Most Influential People in Accounting.”
Thank you for taking the time to answer these questions, David. Your insights will be helpful to accounting firm managing partners, insiders, consultants, and advisors. First, what are you currently seeing in the professional liability marketplace for accounting firms?
The marketplace for accounting firm professional liability/errors and omissions coverage is hardening, with premiums increasing. Looking back, our data shows this trend began pre-pandemic, in late 2019, but the challenges of 2020 added fuel to the fire. Yet overall, the impacts of the market change have been somewhat modest as compared to past hard markets, at least to this point in the cycle. While we don’t like higher rates, prior to this shift we’ve had an exceptional 10 to 12 year run of ‘softer’ market conditions in the accountants’ space. For many successful firms over this period, underwriters never fully captured the growth those entities experienced. To be clear, their premiums increased – what I’m referring to is the rate. By way of explanation, it’s important to understand a firm’s revenues are typically the exposure base underwriters use to derive their base premium for an accounting firm professional liability policy. A “flat rate” is roughly considered to be a premium change equal to the revenue percentage change. For example, a few years ago if a firm grew 12% in revenues year over year, we may have been able to negotiate a total premium increase of 6%. Yes, the premium rose, but underwriters only captured half of the firm’s revenue growth. The net rate, or the cost of coverage for each dollar of that firm’s revenue, went down in that scenario. And there’s only so long that can go on without an inflection point.
For renewals thus far in 2021, we are seeing, on average, modest single-digit rate increases when a firm’s claims history is clean and areas of practice and geography are consistent year to year. For that firm with 12% growth, however, the premium to renew a similar program is often closer to 15%. The positives we’re seeing with the current market is continued ample capacity, as well as very little restriction of the broader coverage gains achieved in recent years. In a truly hard market, pricing surges as we all struggle to find limit, deductibles rise, and the scope of coverage is reduced.
Are other lines of coverage seeing rate increases?
Yes, rates are also increasing for Cyber Insurance as well as Employment Practices Liability (EPL) and Directors and Officers Liability (D&O). Note these last two solutions are often combined in a single policy form and referred to as Management Liability. The spike in rates for these lines extend cross all industries and are not simply a phenomenon within professional services firms. In the cyber space specifically, we are seeing 20% to 40% rate increases, along with significant changes in coverage. Many insurers were eager to jump into a new line like cyber and establish a presence; however, in an evolving market with little long-term data, modeling the correct rate has been a challenge. By watching the news, and even personally receiving notices from businesses informing us they’ve had a breach, we all know this is a real exposure with costly losses. Firms should budget for higher premiums for 2021 renewals on these lines.
What should firms do given this trend?
The best suggestion I can give is to be out ahead of the process. Prepare your application early and work with your broker on a renewal strategy specific for your firm. There’s not a one-size-fits-all plan. Of course, price is always important, but firms should evaluate other key factors such as claims/pre-claims assistance, policy breadth and scope, underwriter flexibility and long-term commitment to the class. With respect to professional liability coverage, for instance, there are fewer domestic options often available to firms as they grow, with only a few insurers providing primary coverage to both the small accounting firm segment as well as firms in Top 100 space. While the policies are generally 12 months in duration, the renewal decision should be evaluated over a longer time horizon. As your firm grows in revenue and complexity, be sure your insurer has the capability to support you, now and in the future.
Is there a rule of thumb of how much coverage, in terms of limits, a firm should have?
This is a great question and one I hear often. We consult with our clients on this issue regularly. A lot of firms will look at their peers to gauge their limits and coverage. Geography can impact the need for limits. The risk tolerance of the firm is important as well. Often, smaller, up-and-coming firms may be less risk averse than owners who are thinking about succession planning and transitions. Another factor to consider is the accounting firm’s client base and the complexity of their clients’ needs. In short, there is no great rule of thumb – I wish there was a quick formula, but there are too many individual variables firm leaders should be considering when evaluating limits.
In light of the pandemic and our remote working environment, do you have any suggestions on best practices to manage claims?
We have not seen a lot of claims to date directly related to the pandemic. Although underwriters are worried about the impact on attest services and increased opportunities for fraud, there hasn’t been a cascade of claims in this or other areas. To be fair, claims often arise months or years after the fact, so the true impact will not be known for quite a while. The best management of claims is prevention. Examining your quality control and making adaptions for a remote environment is a worthy exercise. “Burn-out” and mental health is another risk area. Many firms are telling us that productivity has actually increased during the pandemic, yet leaders wonder at what cost. Drawing the line between work time and personal time is difficult when working remote. Layer on top of that people are taken less vacation time. Management has its hands full with making sure their people are doing well. Then, longer term, can firms with strong cultures keep that going when folks are face-to-face less frequently? Rethinking communication, on-boarding and knowledge transfer over the long term are challenges without perfect answers now, however underwriters would like to hear about a firm’s approach to address these new realities in the hybrid work models likely in the future.
Let’s talk about M&A insurance issues. Is representation and warranty insurance ever used in accounting firm M&A and if not, why not?
We rarely see reps and warranties solutions for accounting firm combinations. From my vantage point, such solutions are valuable to reduce uncertainty around a target firm’s past activities and issues that remain open at deal close, such as pending or potential litigation, a pollution claim, or intellectual property assurances. Because accounting firms are so service-delivery focused, we typically do not have those issues affecting a deal. I’m not saying it’s not possible, but we just see most acquiring firms utilize holdbacks, earn-outs and other tools to address the business risk of bringing on a target.
How long should the tail policy be when you buy a firm? What are common tail policies?
That’s another great question, and one we hear a lot from both sides. I’ll start by saying I’m not an attorney, my views and feedback comes from nearly 20 years of experience. Anyone involved in a transaction should consult counsel for his/her take based on the firm’s areas of practice and laws relative to the geographies in which they operate. The circumstances and period during which a professional liability claim can be made varies from state to state and should be analyzed by counsel, but in my experience, I’d say we see most deals requiring the merging-in firm secure at least a three-year tail, or extended reporting period, to address the prior acts exposure. In my mind, that should be viewed as a minimum duration, and a 5-year tail would be preferable. More cautious firms and acquisitive firms often want the longer tail durations. I sometimes hear knee-jerk reactions to durations revolve around the statute of limitations, and how anything longer than that standard isn’t needed. It’s important to remember, the statute of limitations for claims won’t necessarily start running until the impacted party has knowledge of the issue. For tax matters, it can easily be a year or two before a taxing authority formally flags a potential issue, and that notice date – not the date of services – may well be the start of a statute of limitations countdown. So, the cautious answer is to consider the cost-benefit of the longer tail period options.
Can you explain how the tail policy works if there is still work yet to be completed by the firm merging-up?
Sure. While each policy will have its own specific wording, broadly speaking, tail provisions within a professional liability policy extend the period of time under which an insured can report a claim. In fact, matching with this definition, what we call a ‘tail’ is formally referred to in the insurance industry as an “extended reporting period” or ERP option within the policy. What we all recognize is firms agree to pay the additional premium required for this time extension. What is sometimes less understood is by invoking one of these ERP options, we also agree the policy will only cover claims arising out of work performed prior to the election of the ERP provision.
In other words, electing the tail provides coverage for prior acts only. Therefore, it’s critical that all work be issued by the merging-away firm prior to the inception of the tail. One common misconception we see is firms feel they must exercise the tail on the transaction date. That’s not the case. If the firm merging away is unable to either complete all open work that would go out under their name, or wasn’t able to successfully transition clients and work product to the new firm to be issued under their name, the policy should remain open and not in ‘tail’ mode. In my experience, firms have many boxes to check prior to a transaction’s close. A smart strategy may be for firms to try to have everything complete and out the door by the close date, but if in the days before closing, they realize this will not happen, to simply delay the election of the preferred tail option until that is complete. Understanding this flexibility may relieve some stress at closing and also ensure work is done with less concern about a rushed job impacting quality. In most cases, when firms do wait to initiate the tail, it’s generally only a brief delay, perhaps one or two weeks, but this does allow protection for all that work product.
Can you “shop” the tail policy? In what situations does it make sense to do so?
Yes, firm leaders should evaluate the price and effectiveness of the tail solution. There is a market for “stand-alone” tail policies. You do not have to just accept the option available in your current policy. In most cases, when firm leaders review options for their professional liability coverage at renewal, they rarely focus on tail options, pricing and wording unless they know a deal is imminent. Pricing of tail durations can vary considerably across insurers, so even if your annual premium is competitive, if the tail options are higher than average, the resulting cost can be excessive.
In addition to premium savings, firms should look broadly at other factors. The tail provisions of most policies only extend the duration by which the insured can report claims, they do not refresh the limit. So, if a claim or claims have significantly eroded the policy already, the value of paying additional premium for the tail is lessened. Another key factor is the insurer’s financial strength. How do the major ratings agencies evaluate the financial strength of the insurer? Will they be in a position to pay out on a claim noticed in two or three years from now, which may take several additional years to resolve? If the durations are more costly than anticipated or there are questions on financial strength and policy wording, consider asking your broker for alternatives. Only a handful of insurers will offer a separate tail policy for an entity merging away, yet those that do often write in the larger firm segment of accounting firms. Often, the relationships and goodwill the acquiring firm has earned with insurers over the years may help the acquired firm obtain that better price, better coverage solution.
Thank you, David. It has been helpful to hear your valuable insights. I look forward to future Q&A sessions.
Partner Russell Shapiro is a leader in advising on the legal and business aspects of accounting firm partnership agreements and mergers and acquisitions. He has twice been recognized by Accounting Today magazine among the “Top 100 Most Influential People in Accounting.”