Professional indemnity: regulation -ready to take risks

If you talk to people within the professional indemnity industry, they will
say that accountants have had an easy ride for the last few years.

The insurance market opened up, insurers flooded on board to win market
share, and the costs to insure the accounting profession plummeted. Even now
that the market has settled down, accountants still appear to be on easy street.

But if you ask accounting professionals their opinion on PI insurance, you’re
unlikely to get the same response twice. The Big Four cannot even get
conventional insurance cover, following years of huge claims that the insurers
were no longer prepared to cover.

The mid-tier and smaller firms are paying less than they have done since the
Enron and WorldCom accounting debacles (and 9/11) sent premiums through the
roof. But there are changes on the horizon that are unlikely to keep their own
premiums down.

Two pieces of legislation ­ the companies bill and the EU’s eighth company
law directive ­ are set to change the relationship between accounting networks,
auditors and their clients. The impact of the legislative changes is still up in
the air, but insurers and accountants expect things to change. Unfortunately, no
one is sure whether these changes will mean good or bad news for the profession.

Mid-tier insurance premiums could rocket, the Big Four may be able to buy
some insurance ­ perhaps the status quo will be maintained. Opinions differ
widely.

For example, PricewaterhouseCoopers’ head of professional affairs, Peter
Wyman, believes the limited liability set to be introduced in the companies bill
is vital for firms, but even that will not be enough to persuade insurers that
risks are at a level where they can sit down and talk numbers with the Big Four
again. ‘It’s clear that, for the Big Four, we aren’t able to obtain any
significant insurance. That’s the position,’ says Wyman. ‘I suspect some would
say we could buy the insurance [when the bill is implemented] but would it be
economic? It won’t be a situation like that with a car where you pay a modest
amount and get great cover.’

Wyman’s concern that the bill, and the eighth directive’s aim of
revolutionising and standardising the rules by which auditors operate, will not
make it less likely that auditors will be sued. For the next tier of firms,
there are other points contained within the legislation that could ramp up PI
premiums.

David Turner, an executive director at insurance broker Willis, told
Accountancy Age that you can lower PI rates depending on the risk
profile of your firm ­ an area within the control of individual firms. ‘With the
right risk profile, if you can demonstrate to underwriters that you have a good
approach to risk management, and your loss history reflects this, premium
reductions are achievable.’

However, the eighth directive could mean that so-called ‘accounting networks’
would become liable for member firms within a network ­ a move that would take
risk management for smaller firms into the realms of the Big Four and put the
likelihood of getting a premium at risk.

Concerns over liability for other member firms came to the fore when Parmalat
collapsed. Former Italian auditor Grant Thornton SpA was ditched by Grant
Thornton International, which claimed it could not be held responsible for the
actions of its Italian arm.

The directive is seeking to define accounting networks so that lines of
responsibility and liability are clear.

For firms outside the Big Four presenting themselves strongly as part of a
network, there are clear concerns ­potential liability for firms they might not
even be that closely linked with. ‘Smaller networks are burying their heads in
the sand,’ says Jane Howard, partner and accounting specialist at insurer
Reynolds Porter Chamberlain. While the larger member networks such as the Big
Four have the resources to deal with this risk, Howard fears others are igno
ring the issue.

EU sources indicate the directive would mean firms making decisions about
their relationships under various criteria. A firm could be classed as being
within an audit network, according to one country’s understanding of the rules,
yet other countries might not accept this to be the case.

A senior Brussels source says the issue of defining networks is still
uncertain, and it is unknown what criteria would make the directive. The
directive has created these potential adverse effects on premiums, especially if
mid-tier networks carried each other’s liabilities while handling bigger audit
clients and potentially bigger claims, but only time will tell, says Howard.
Those projects are in the pipeline, but are unlikely to have an immediate
impact, she argues.

Howard cites the proposed criminal offence against auditors contained in the
companies bill, where auditors could face unlimited fines for knowingly or
recklessly misrepresenting an audit. ‘When will it be invoked?’ questions
Howard. ‘How often will it be used?’

Not everyone is so unsure about the effects of new legislation on the value
of PI insurance. Robert Bass, claims director at PI insurers PYV, believes that
limiting auditor liability will be of a ‘huge benefit’ to insurers. ‘With finite
claims figures, insurers could go into deals with their eyes open, even though
the Big Four are dealing with such large companies and there are frightening
sums of money at stake.’

Even with concerns that the mid-tier could find themselves under more
pressure of potential claims through their networks, and their attempts to win
more big audit clients, Bass sees the situation similar to that suggested by
Turner: effective risk management will encourage insurers to back them. ‘They’re
already working with insurers, so if they knew the worth of a possible claim in
advance they could work around that.’

But a new report for the European Commission by London Economics reveals some
harsh truths about the audit insurance climate, and where it is likely to head
in the near future. It says that the largest estimated claim against a Big
Four’s network, at e540m (£282m), far outstrips the level of cover the firm can
provide itself through a mutual fund known as a captive, and could put the firm
and its network at risk of collapse. ‘Once the insurance coverage provided by
the captive is exhausted, a settlement that would result in a drop in partners’
income would gravely imperil its survival.’

With dozens of claims around or lower than this level, the risk of a Big Four
Firm taking a damaging hit is ‘far from nil’. The report asks: What can be done
to get the insurance providers onside? LE’s discussions with insurers found no
specific solution, even with auditor liability around the corner.

Proposals include the introduction of international legislation to force
insurers to provide Big Four insurance, a levy on investors to finance a claims
compensation fund, and making governments cough up to protect firms from
collapse. They’re all controversial ideas, although LE also suggests the more
common proposal of a liability cap.

General insurance for the Big Four does not seem to be around the corner,
however. And smaller firms may even face the same situation if legislation deems
they are operating as larger networks.

Better in than out

The Big Four accounting firms’ problems in gaining insurance to cover their
activities reached a head in the 1980s.

Professional indemnity insurers found themselves in a position over the
decade where they paid out more on claims than they had received. The insurers
dropped the biggest accounting firms, which at the time numbered around ten
prior to consolidation and the collapse of Andersen. The accounting firms were
then forced to set up ‘captives’ to provide low levels of coverage with wide
coverage to ensure the protection of the smaller member firms.

Captives are mutuals owned by member firms, so even this cover is limited.

Generally, mid-tier firms are able to get traditional insurance cover because
the networks they operate within are much looser. However, there are concerns
that the definition of such networks is currently up for debate, most
significantly by the EU’s eighth directive.

The directive, which will influence the way auditors operate around Europe,
is currently unclear as to what will constitute an accounting network. This
could put mid-tier firms in a position where they are considered liable for
their member firms and drive insurance fees through the roof. It is understood
that some are considering rebranding to make sure it is clear that their
networks are looser than they appear.

But at least these firms can get insurance coverage. The latest report into
the risks faced by audit firms, undertaken by London Economics for the European
Commission, suggests that a balance has to be struck between the risk carried by
the audit profession, including through its captives, and the risk that can be
transferred to a third party.

Swiss Re, for example, is classed as the only lead re-insurer with an
established audit liability programme, but the cover available from it is less
than5%of some of the so-called ‘mega-claims’ currently outstanding against the
Big Four firms across the globe.

With a small number of global audit firms comes a lack of diversity for
policyholders, future awards and settlements are unpredictable and difficult to
assess, and claims can take years to be resolved. Therefore, the report claims,
it is likely that the insurance industry’s appetite for providing coverage looks
set to remain ‘muted’.