For the past five years, solicitors have been enjoying a soft market for professional indemnity insurance, but will a rise in claims against solicitors force premiums up? Sandra Neilson-Moore looks at the implications for the October renewals season and beyond
The market for solicitors¹ professional indemnity insurance has been soft for the last five years. Insurance capacity, or the number of insurers willing to compete to provide insurance coverage to solicitors, has been abundant and insurers have been aggressively seeking to win their share of the market.
This has led to a drastic reduction in insurance premiums as a proportion of solicitors’ gross annual revenue over this time period. In short, although the revenue of most commercial law firms has increased dramatically in the last five years, the total premium collected by the insurers for the same firms has either reduced, or at best, remained unchanged. This has contributed to the competitive forces, as insurers attempt to boost income by winning new business.
Insurers establish their ‘rate’ based on the gross annual revenue of a firm and consider gross annual revenue to be directly correlated to risk. Therefore, the insurers’ view is that rates have reduced by as much as 100% in some cases during the last five years. Firms’ revenues have doubled, yet many are still paying the same level of premium they were at the beginning of this cycle. Insurers would universally agree that not only has there been no growth in their income for this business; they are going backwards at an alarming rate.
In general, insurers are extremely unhappy about this situation and believe things must change if they are to be able to continue to provide access to their capital. But, what is the truth of the situation? Are insurers making a profit on this business? It seems strange that, if the- business is not profitable, there should continue to be such aggressive competition to win and maintain market share. One could argue that the premiums charged five years ago, immediately after 9/11, were excessive and that the competitive activity of the last five years has represented a correction of premiums that were unsustainably too high.
Also, the situation is likely to vary from insurer to insurer, from segment of business to segment of business and from individual insured to individual insured.
The key question is: how low can the rates actually go? Are they already too low? Is an upward correction inevitable?
Professional indemnity insurance is what is referred to as ‘long tail business’. This means that the claims fall to be paid at a later date, quite removed from the time of the premium payment. These days, claims tend to be paid out some three to five years after the premiums that are meant to support those claims are paid to the insurers. Whether or not the premiums taken in are sufficient to pay the claims that must be resolved in the future will depend on investment earnings, the ability to forecast future claims with any kind of accuracy and, annoyingly for insurers and their reinsurers alike, good old fashioned random luck or the lack thereof.
The problem is that the forecasting of professional indemnity claims is very difficult. This type of claim does not lend itself well to actuarial analysis, as do, for instance, property claims. Professional indemnity claims against professional service firms exhibit a degree of volatility and randomness that makes accurate forecasts suspect at the best of times. In fact, it can be argued that there is a tendency on the part of actuaries to over-estimate, for safety’s sake.
Actuaries look over huge swathes of data and try to establish whether there are any patterns in terms of ‘claims inflation’. Once they have determined a trend that they can identify statistically, they suggest that the insurers they represent increase their premium levels and/or rates, in line with the inflation factor. Claims inflation factors estimated by actuaries for professional indemnity insurance are generally something in the order of 5% to 8% a year, depending on the insurer. Since rates and premiums have not been increasing at anything like this rate, the insurers’ underwriting results look poor. But are they worried about claims that may in fact never happen? How dependable are the actuarial projections?
The industry may have already forgotten, for example, that the Solicitors’ Indemnity Fund (SIF) forecasted, after seeking advice from actuaries, a shortfall of some £450m and collected additional monies from the profession, in order to meet the shortfall. In the end, the claims were approximately half the anticipated shortfall. Some of the money was returned to the profession, while the balance was used to pay Law Society pension expenses. The main point here, though, is that the claims that were ultimately paid out were far less than those that were forecasted.
This may have been caused by trending, incorrectly, the ‘spike’ in claims in the mid-1990s, caused by the last housing market downturn. Many more claims against solicitors were brought during this previous economic slump. Following the slump, economic boom was the norm and fewer claims were brought. The claims inflation that was anticipated did not materialise. The jump in rates was found to be unnecessary. However, because of the jump in rate, premiums were high and this attracted new capacity. This led to competition and downward pressure on rates. Market forces were at work and produced a perfectly understandable supply and demand scenario, which has been good for solicitors in terms of availability and relative cost of professional indemnity insurance.
However, the current uncertain economic conditions are leading many commentators to the conclusion that claims against solicitors are bound to rise. If claims inflate rapidly, the insurers will not have sufficient premiums, earned in the soft market conditions, to pay these claims without it affecting their margins very negatively indeed. Actuarial projections may be found, at least for the first few years of bad economic times, to be inaccurate on the negative side. Some insurers will exit this business as unprofitable. Some may even become insolvent. If this happens, capacity will shrink and premiums will rise dramatically and swiftly.
In respect of the October 2008 renewal, it is generally believed that the market will continue to be soft. Incumbent insurers will attempt to achieve at least rate stability, i.e. premium increase, in line with gross revenue increase. Whether they will be able to do so will depend on whether or not there is competition and whether or not they will be willing to meet that competition. It will also depend on the attitude of the insurers’ customers.
It might in fact be wise to accept small premium increases, particularly if your relationship with your primary insurer is a good one of long standing or if you have claims outstanding that you wish your insurer to see you through. It is almost certain that claims against solicitors will increase in the immediate future; we are seeing an increase already in fact. And, it is also almost certain that rates have reached the bottom of where they should logically be, in the current circumstances.
As to whether the current rates are sufficient to pay the claims that are now on their way however, only time will tell.
Sandra Neilson-Moore is European practice leader for law firms’ professional indemnity at Marsh.ProfessionalIndemnityJuly2008
