The rising cost of professional indemnity insurance and its impact on business sales

The mounting cost of professional indemnity insurance (PI) has become an issue that neither business owners, nor potential acquirers, can avoid. High PI costs and strict terms are now being described as a make-or-break factor in business sales, with warnings that the issue has the potential to kill deals. Meanwhile, increasing prices have been cited as a factor in a number of administrations.

Professional liability insurance is used to cover legal costs and expenses incurred or damages and costs won by a company if a client or customer accuses them of providing inadequate services, advice or designs that have caused them to lose money.

In some professions, PI cover will be a requirement of the industry’s regulatory body. But even if this isn’t the case, many businesses have a policy to guard against the potentially high cost of legal fees or compensation, as well as lost income from time spent in court, if they face an allegation from a client.

Generally, PI cover is required for businesses such as advice or professional services firms, such as consultancies, and businesses that provide designs to clients, for example architects. It is also common for contractors or freelancers to arrange PI cover if requested by a client.

To give a sector-specific example, the Solicitors Regulation Authority requires its members to take out and maintain PI “that provides adequate and appropriate cover” according to its minimum terms and conditions. On top of this basic cover, however, firms generally take out top-up cover depending upon their likely risk exposure.

With their basic and top-up cover in place, the Law Society states that law firms often spend up to 5 per cent of their annual turnover on PI cover.

Why is it causing so many problems?

Reading the above, PI cover may sound like a fairly routine form of insurance. A sticky area, yes, but the sort of thing that many businesses will have as standard. But the answer to why it has become so problematic is simply that costs have begun to skyrocket - a trend that may be set to continue.

Prices have begun to rise particularly over the past year or so. This has proven damaging due to the fact that cover is generally renewed (i.e. increased) on an annual basis and because the steep rise has come at a time when many firms are seeing revenues and profits impacted by the COVID-19 pandemic.

Some of the figures are startling. Law firms, for example, generally renew their PI cover at the beginning of October. On October 1 2020, many law firms found that even the most basic level of cover had risen by close to 20 per cent on average, while the cost of top-up cover had often risen by over 100 per cent.

Elsewhere, financial planning firms have been quoted increases of 250 per cent when it came to renewing their policies, with reports that one small firm saw its premium increase 900 per cent, going from £13,000 (a rate that had remained static for four years) to £130,000.

What’s to blame?

This can of course be partly attributed to the impact of COVID-19, which has seen an increase in risk, not least due to the huge rise in working from home. However, other factors suggest more than just a crisis-driven blip.

Rising claim volumes, increasingly complex legal cases, stricter PI cover terms and an increase in the severity of claims have all been cited as drivers of higher PI prices. PI specialist Brian Boehmer of Lockton says that claims are “The single biggest catalyst for the change in insurance market conditions” with the severity of claims having risen to “unprecedented levels”.

In January 2020, before the pandemic had begun to fully impact the UK, 92 per cent of members of the Civil Engineering Contractors Association (CECA) said that they had experienced “substantially” higher insurance costs in the wake of the Grenfell Tower tragedy. One firm reported that its premium jumped from £24,000 in 2016 to £68,000 in 2017, while its excess payments for each claim rose from £5,000 to £50,000.

These examples suggest that the pandemic has merely accelerated an existing trend.

Mounting costs putting businesses under pressure

Such enormous increases are likely to be unsustainable for many businesses. After all, how does a small firm go from budgeting £13,000 per year to £130,000 per year for PI cover that is a non-discretionary requirement?

While this example is at the extreme end of the spectrum, it’s still a tough ask for a business to cope with a premium increasing by even 20 per cent. This is particularly true in a year when revenues across many sectors that use PI have been severely impacted by COVID-19 and its associated lockdowns.

Considering the scale of PI cost increases, the wide array of sectors it affects and the near-universal impact of COVID-19, there is little doubt that the number of companies falling into distressed, cash-starved situations will be materially raised.

Often, underlying factors contributing to a company’s cashflow difficulties are not at all intimidating for acquisitive parties that actively seek out distressed businesses. But in this situation, the crippling PI costs that have been a major factor in the company’s demise (and are likely to increase on an annual basis) are going to be inherited by anyone who takes it over.

The potential impact on M&A

These kinds of exponential increases are not going unnoticed in the M&A market, with warnings beginning to emerge that the mounting costs of PI have the potential to completely derail acquisitions.

The combination of rising costs, the need to renew cover every 12 months and tighter insurance terms have led to M&A professionals describing PI cover as make-or-break for some business acquisitions. Increasingly, premiums are rising while the number of items excluded from policies grows, meaning that not only are policies themselves becoming hugely expensive, but they are covering less.

Commenting on how PI cover could impact business acquisitions, Andy Sutherland of Telos Solutions says that buyers “have to be really sure of the book of business you’ve got when presenting it to professional indemnity insurers as equally as you would be for a sale.”

"We have seen increased excesses, which ties up capital,” Sutherland says. “We've also seen tighter terms which could lead to a catastrophic event which is non-compliant cover. I have been involved recently in some due diligence where the professional indemnity insurance was null and void effectively, which then as far as the purchaser was concerned meant a toxic business and they walked away."

Regarding how the costly policies themselves are changing, Sutherland adds: "You don't need many cases to be unsuitable to cause you a lot of pain and quite quickly use up any cover you may have for defined benefit. It can hurt you very quickly."

With this confluence of factors, PI is clearly set to become (if it hasn’t already) a central consideration for potential business buyers in certain industries and a serious sticking point for owners looking to sell.



With this consideration in mind, it may be the case going forward that PI costs deter acquirers from taking over struggling companies wholesale and instead look to acquire its assets and business in different ways.

Of course, not every business with PI cover is going to be subjected to something as extreme as a 250 or 900 per cent hike in the cost of premiums, but as the widespread increases in sectors like law and construction indicate, many firms are being subjected to vastly increased rates.

There is no doubt that even rises of 20-50 per cent are going to contribute to cash flow problems and administrations at a number of firms. But, with PI also being a major obstacle for potential acquirers, the issue over the coming years will be what impact it has on distressed business acquisitions and the wider M&A market.

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