Insurers have been given the jitters by dire warnings over the financial wellbeing of law firms in the continued fallout from the Halliwells collapse. As Neil Hodge reports, this will probably mean far closer scrutiny of leading firms' balance sheets and rising insurance costs for many smaller practices

When the Solicitors Regulation Authority (SRA) warned recently that more than 30 of the UK's leading 200 law firms were in "serious financial difficulty", it set alarm bells ringing among legal industry insurers. 

Their sense of anxiety will have only deepened last month when Samantha Barrass, the SRA executive director, gave a speech adding that the regulator was receiving "more and more" reports of firms in financial difficulty, and that it was working with 51 firms where the likelihood of a costly intervention was "very high". 

She said the SRA had identified about 2,000 firms it believed were "particularly susceptible to financial difficulty", owing to – among other issues – an "over-reliance on a particular type of work".

Barrass's comments are troubling because they come at an already critical moment for law firms seeking insurance cover for professional negligence. "The timing of this could hardly be worse," is the stark assessment of one insurance industry expert.

Professional indemnity insurance is acknowledged to be a law firm's second or third-highest expense – irrespective of the size of the practice – and changes that come into force this October will probably see the cost of policies go up for many firms.

From 1 October the assigned risks pool (ARP) – a kind of 'insurer of last resort' – will be scrapped. The scheme had been the bane of many qualifying insurers who resented being financially liable for negligent work carried out by law firms that they would never have ordinarily provided cover to. 

In reality, the changes in the market are unlikely to have much of an impact on the premiums paid by the UK's biggest law firms for primary cover, which meets the SRA's minimum terms and conditions. 

As Sandra Neilson-Moore, practice leader for Europe at broker Marsh, says: "There is plenty of capacity and choice for the top 100 law firms. In fact, it's a buyers' market if a firm can demonstrate a good claims history, strong financials and a comprehensive risk management process." 

But the SRA's grim warning means that even leading firms are going to have to answer far tougher questions about their own financing from insurers eager not to fall victim to a Halliwells-style collapse.

And for smaller firms – particularly those with five or less partners – the majority view from market participants is that they are going to find it hard to get premiums in line with last year. This is because this group of firms are responsible for the highest volume of negligence claims, and are less likely to have thorough risk management processes in place. 

"Small firms are likely to find it tough," says John Kunzler, who heads the UK regulated professions practice for Marsh. Part of the reason for this, he says, is that "underwriters find it really difficult to assess whether law firms are actually taking the steps to improve their risk management process and controls that they say they are. As a result, the financial performance of law firms is going to be a key differentiator for both brokers and insurers. If law firms are dependent on bank lending, for example, then they are going to struggle to find affordable premiums."

Nick Davenport, senior partner at mid-sized Manchester-based commercial law firm Turner Parkinson, says that, because of a good claims history, its PI premium has remained at 2.9% of its turnover for the past couple of years, and he expects it to stay the same this year.

However, he says: "I know a two-partner firm that is paying 15% of its turnover for PI insurance because of several significant property negligence claims, which is just not sustainable."

Claire Smith, partner firms director at legal franchise QualitySolicitors, says: "Any significant premium hikes experienced this year will only come from firms that have experienced claims deterioration or those that have seen large increases in their fee income. Firms that take a conscious decision to switch from unrated capacity to rated may also see a premium rise."

Smith adds that being part of an affiliate such as her own, which uses Lockton as its broker, is a good way for small firms to negotiate reasonable premiums. 

Recession warning

Another reason why rates may go up is the fear that the next year will see a last-ditch push to settle property negligence claims linked to the 2008 financial crisis. "We expect that recessionary-related claims will continue to emerge for some time yet," says Jenny Screech, legal professions manager at Zurich. "This, of course, is likely to have implications for rates that might mean any downward movement is unlikely at this time."

Some lawyers are cynical about such justifications, saying that rates will go up simply because insurers have the power to raise them. "Insurers will more than likely say that they are losing money as they are paying more out in claims than they receive in premiums," says Nick Johnson, managing partner at Glaisyers Solicitors in Manchester.

"Therefore, it wouldn't surprise me if we see premiums rise in the near future, as they won't be able to support this loss-making business model without a hike in fees."

However, others admit that insurers have reasonable cause to be concerned, hinting at more potential PI disasters lurking in the wings for the legal sector. Lesley Graves, founder and managing partner at Citadel Law, a personal injury consulting firm, says there is a serious risk that PI lawyers are undervaluing the size of awards their clients should receive, which could lead to a spate of negligence claims.

"Serious injury cases are routinely being settled for £5m plus, with the largest being settled last year for £15m. If personal injury lawyers agree too small an award for their clients, there is a real danger that law firms will cease to exist with just one substantial claim against them," says Graves. 

"For example, a £7m settlement for a negligent case originally settled for £1.5m will mean a law firm has to find £5.5m plus legal fees. With a £2m-£3m PI policy, that leaves a big gap. The firm will go bust, and its last insurer will be liable for six years of run-off. This isn't a great situation for anyone."

A look at the books

Following the SRA warning, many law firms agree that one of the key determinants affecting premiums this year will be the state of their finances and their approach to risk management. 

The SRA is working with firms to try to avoid any more costly interventions. The first four months of 2013 saw 15 interventions, two of which – Birmingham firm Blakemores and Atteys of South Yorkshire – are set to cost £1.8m. The SRA now believes the total cost of interventions in 2013 may be £7m greater than the budgeted costs.

Despite its best efforts, fears remain about the impact on premiums. "Insurers have been jumpy enough from having to fund the ARP," says one senior lawyer. "Now they have been told that 2,000 law firms are potentially at risk – effectively one firm in every six in the UK – and that even 30 of the top 200 firms are in financial difficulty. If PI cover was difficult to get at a reasonable price before, it could go through the roof for some firms now."

Consequently, insurers and lawyers say firms will need to go further than previous years to demonstrate good financial standing, as well as providing more information about future plans such as mergers, growth in partner numbers, change of service offering or desire to become an alternative business structure (ABS). Memories of the Halliwells collapse are still fresh in the minds of an insurance sector that claims its legal PI profit margins are tight.

"We're noticing that insurers are asking more questions about the financial situation of law firms," says Paul Castellani, partner in the PI group at Reynolds Porter Chamberlain. "Historically, insurers wanted to know about turnover, but now they want to see the annual accounts, as well as the management accounts for the months since the year-end up until August. 

"The SRA's warning that many firms may be in financial trouble has no doubt contributed to insurers' unease about providing cover to financially 'at risk' firms and potentially being stuck with six years run-off cover, even if the insured has not actually paid the premium."

Some well-established firms bridle at the suggestion of insurers sticking their noses into their balance sheets. Peter Jolliffe, partner responsible for the PI programme at Slaughter and May, says he is "surprised" to learn that some law firms are being asked for more financial information by their insurers, adding that his firm would regard such questioning as "irrelevant and intrusive". 

"The PI cover that law firms are looking for is to cover potential claims arising from risks of negligent advice to clients: the finances of a law firm have nothing to do with that," he says.

The ties that bind

Nevertheless, lawyers approached for this article were unanimous about the importance of the strength and longevity of their relationships with primary insurers. 

Chris Taylor, litigation partner at Clarke Willmott, a large regional firm with 65 partners and a turnover last year of £33m, says there is only a handful of insurers capable of providing the primary coverage needed by top law firms – which means many firms are reluctant to change provider. 

Clarke Willmott has used the same primary insurer for five years and uses about six or seven other insurers for its excess lines. Its premium for PI cover is 1.25%-3% of turnover (between £413,000 and £1m, although Taylor suggests the cost is "closer to the lower end") and it does not expect this to rise. "Our claims history is good, our risk management is good and our relationship with our insurer is good. We therefore expect insurance rates to be stable," says Taylor.

Early communication with insurers is also increasingly important, law firm partners say. "Engagement with PI insurers and brokers should not be limited to once a year," says Roger Butterworth, general counsel and risk management partner at Bird & Bird, who recommends that law firms hold regular meetings so that "insurers feel they know the firm and its plans and development".

Anna Crew, partner in the insurance and reinsurance group at CMS Cameron McKenna in London, agrees that engagement is crucial. "Most large firms are in contact with their insurers on a regular basis and have sound internal risk management and corporate governance procedures in place," she says. "However, it is a question of persuading insurers that the firm practises in accordance with those procedures on a day-to-day basis." 

Yet while engagement with the primary insurer is important, the same is not true for those insurers that are covering the "excess layers". Larger law firms typically buy excess layers from other insurers to address risk beyond the SRA minimum terms of £3m cover. A typical arrangement would be to find an insurer to cover claims between £3m and £10m, and then in £10m tranches upwards towards £100m. 

Law firms often use a pool of insurers to share the risks: some insurers may be involved in all excess layers, while others may decide to be involved in just one tranche, or even share part of the layer with other insurers in the pool. Furthermore, insurers providing excess layer coverage do not need to be qualifying insurers, so Bermuda-based insurers, for example, take on a lot of the business. 

Castellani says that while RPC has stayed with the same primary insurer since 2000 when the Solicitors' Indemnity Fund closed, those proving excess cover can be changed year on year.

"We have 15-20 insurers providing excess lines and these can change on an annual basis depending on the premium they want to charge. As these lines are only really used in a catastrophe, we don't need to develop the same kind of ongoing relationship that we do with our primary insurer because there is not the same type of claims history," he says.

Given its grim warnings about the industry, for the SRA these extra layers of protection against a disaster will surely be a case of 'the more the merrier'.

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State of the market

Several of the biggest names in the PI insurance market are new entrants. Hanover, XL and Allianz Global Corporate Specialty joined in 2009 and account for a third of total premium income.

Yet several big providers complain that the sector is not particularly profitable given the 'restrictions' associated with the minimum terms and conditions for participating insurers. As a result, some say they have been most interested in lifting volume by winning lots more clients or boosting gross written premium.

For example, in its first year Allianz wrote about £10m-£11m in gross written premium for 149 firms: in 2012 this had grown to £18m with 210 firms in its book. But David Cable, head of PI for the UK at Allianz Global Corporate Specialty, says: "We are looking at conventional growth for the next year and do not really envisage adding to the number of firms that we write for," adding that "the legal PI market is not as profitable as other areas of PI". 

There has been consistent talk of Beazley joining the new entrants and taking a hefty slice of the business. However, a spokesman told Legal Week: "We have no plans to enter the market."

Several experts believe the market will stay about the same this year. Eamon Mooney, PI partner at Kennedys, thinks that "more insurers will come into the market next year rather than this year. My impression is that new entrants are still put off by the ongoing extension for the assigned risks pool (ARP), and they will wait until the risk of claims arising from property valuations during the financial crisis is completely put to bed, which should be next year."

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Single renewal date

This October will also see the end of the single renewal date, which means law firms will be able to purchase PI insurance when it suits them best, potentially allowing them to negotiate longer and better terms.

Some insurers such as Travelers have been testing the water by sending clients 'early bird' offers of 17 months' cover. Jenny Screech, legal professions manager at Zurich, says: "We are not imposing different date options but we will work with firms in an effort to accommodate a date change that they are looking for. This will result in us writing both shorter and longer-term policies this year." 

Some law firms are slightly underwhelmed, however, about the change and are happy to continue to roll-up all their insurance payments for October as usual. "The significance of the change from a single renewal date is to my mind limited," says Andrew Rose, insurance partner at Berwin Leighton Paisner. "There may be some thought given to the renewal date coinciding with a firm's financial year-end, but over the years the market has proved itself capable of dealing with a large number of firms renewing on the same date."