Professional Indemnity Insurance: What Small Firms Should Understand

Aug 19

12 min read

Professional indemnity insurance is the financial backstop of a legal practice. It exists to respond when a client, or a third party, alleges that the firm's negligence, error or breach of duty has caused loss, and when the firm must defend the allegation and, if it fails, meet the resulting award or settlement. For a solo practitioner or a small partnership, whose personal assets stand behind the firm's liabilities, the policy is often the only barrier between a single mistake and personal insolvency. Yet many small firms treat it as an annual administrative chore: a renewal form completed in haste, a premium paid, and a certificate filed away without reading the wording.

That approach is unwise. A policy for professional indemnity insurance lawyers rely on is a contract with detailed terms, and those terms determine whether a claim is paid. Cover may be defeated by late notification, by an inaccurate answer on the proposal form, by an exclusion that the practitioner did not notice, or by the simple fact that the policy was written on a basis that does not respond to a claim made after the firm has closed. Understanding the structure of the policy before a claim arises is therefore a matter of ordinary professional prudence.

This article explains, for practitioners in small firms, the elements of a professional indemnity policy, the questions to ask of a broker or insurer, the disclosure and notification obligations that attach to it, and the risk management measures that reduce both the likelihood of a claim and the cost of cover. Whether professional indemnity cover is compulsory, the minimum limits, the approved insurers and any compensation fund arrangements differ among jurisdictions and are set by the regulator and the governing legislation. The practitioner must consult the rules of her own jurisdiction, which prevail over any general statement made here.

What professional indemnity insurance covers and what it does not

A professional indemnity policy generally responds to civil liability arising from the performance of professional services by the insured. In the case of a law firm, the typical scenario is a claim in negligence or breach of contract: a missed limitation period, an inadequate title investigation, a defectively drafted agreement, advice given on an incorrect footing, a failure to register a document, or a failure to follow instructions. The policy usually pays the damages and claimants' costs for which the firm is liable, together with the defence costs reasonably incurred with the insurer's consent, subject to the limit of indemnity and the excess.

It is as important to understand what the policy does not do. It is not an insurance against a regulatory fine, a disciplinary sanction or the costs of responding to a complaint to the regulator unless the policy expressly extends to those items. It does not cover a client's claim that arises from the dishonesty of a partner, unless there is a separate provision or a compensation scheme that does so. It usually excludes liability that the firm has assumed by contract beyond what the law would impose, claims arising from the firm's own trading debts, personal injury and property damage that are properly the subject of other cover, and liability connected with business activities outside the legal services described in the proposal. Policies commonly exclude fines and penalties, and losses arising from the insolvency of the firm itself where the loss is the firm's own.

Related covers

A professional indemnity policy is one among several types of insurance that a firm should consider. Public liability cover addresses injury or damage occurring on the premises. Employers' liability cover, where it is required by law, addresses claims by staff. Cyber insurance addresses the costs of a data breach, the restoration of systems and in some cases the liabilities to third parties that follow. Fidelity or crime cover addresses theft by employees or partners. Office contents, business interruption and key-person cover address the firm's own losses. A professional indemnity policy may include limited extensions in some of these areas, but the practitioner should not assume so. A request for a written confirmation of which of the above are included, and which are not, is reasonable.

The basis of cover: claims-made and its consequences

The most important structural feature of most professional indemnity policies is that they are written on a claims-made basis. Under such a policy, the insurer responds to claims that are first made against the insured, and notified to the insurer, during the policy period, irrespective of when the underlying negligent act occurred. A policy written on an occurrence basis, by contrast, responds to negligent acts that occur during the policy period, whenever the claim is later made. The claims-made basis is standard for professional liability, but its effects are not intuitive.

The first effect is that the policy in force when the claim is made is the policy that responds, not the policy in force when the work was done. A firm that closes, changes insurer or allows its cover to lapse may find that a claim arising from work done years earlier is uninsured. The second effect is the importance of continuity. A firm that moves from one insurer to another must ensure that the new policy covers prior acts, normally by obtaining an appropriate retroactive date, and that the effective date is not set so recently that earlier work falls outside it. The third effect is the importance of notification of circumstances. Many policies allow the insured to notify the insurer of circumstances that may give rise to a claim, so that any later claim is treated as made in the year of notification. This is a valuable protection when the firm becomes aware of a problem close to renewal, because it fixes the claim to the policy that the firm knows and avoids the risk that the next insurer will exclude it as a known circumstance.

Retroactive date and continuity

Each policy should be examined for a retroactive date, which is the date before which acts or omissions are not covered. A firm that has been continuously insured on the same basis with unbroken cover may have a retroactive date that goes back many years; a firm that has just moved insurers may find that the date resets unless it negotiates otherwise. Continuity of cover, and of the retroactive date, is among the first questions to ask at a change of insurer.

Limits, excesses and aggregates

The limit of indemnity is the maximum the insurer will pay in respect of a claim or claims within the policy period. Some policies apply the limit to each claim, with an annual aggregate; others apply a single aggregate for all claims in the year. It is vital to know whether the limit is inclusive or exclusive of defence costs, because a policy in which defence costs erode the limit gives the firm less effective protection than one in which they are paid in addition. A related point is whether claims arising from the same underlying cause or a series of related acts are treated as a single claim, in which case only one limit is available however many clients are affected.

The excess, which is called a deductible in some markets, is the amount of each claim that the firm must bear itself. A higher excess reduces the premium, but it must be an amount the firm can actually fund. A firm that selects an excess it cannot pay is, in practice, under-insured, since the cost of settling a modest claim will fall on the partners personally. The excess may apply to defence costs as well as to damages, which should be checked.

The following is illustrative arithmetic only and is not market data or a recommendation of any figure. Suppose, hypothetically, a firm has a limit of indemnity of one million units for each claim and in the aggregate, with defence costs inside the limit, and an excess of ten thousand units. A claim arises in which damages of eight hundred thousand units are awarded and defence costs of two hundred thousand have been incurred. The combined sum of one million exhausts the limit, so the insurer has no further obligation, and the firm bears the excess. If a second claim arising from the same cause were then made in the same year, no limit would remain. If, by contrast, defence costs were payable in addition to the limit, the same claim would leave the full limit available for damages. The point is that the firm should model several plausible claim scenarios against the wording of its own policy.

The table below summarises the principal terms that should be recorded and compared when reviewing a policy or a quotation.

Policy term	Question to ask	Why it matters
Basis of cover	Is the policy claims-made or occurrence based?	Determines which year's policy responds to a later claim
Retroactive date	Does it extend to all prior acts, and is it unbroken?	Work done before the date may be uninsured
Limit of indemnity	Is it per claim, in the aggregate, or both?	Governs the maximum recoverable in a year
Defence costs	Are they inside or outside the limit?	Inside the limit, they erode the sum available for damages
Excess	What is the amount, and does it apply to defence costs?	The firm must be able to fund it
Related claims	Are claims from one cause treated as a single claim?	May confine the firm to a single limit
Extended reporting period	Is run-off cover available on closure, and at what price?	Claims may be made years after the firm closes

Choosing an adequate limit

The regulator may prescribe a minimum limit. The prudent firm will go further and consider the largest realistic loss that one matter could generate. A conveyancing practice dealing with high-value property, a firm advising on commercial transactions, and a firm handling estates of substantial size face exposures that are far greater than the fees received. The limit should reflect the value of the assets that pass through the firm's hands or depend on its advice, and the firm should discuss the options with its broker in terms of the largest single transaction on its books, not its annual turnover.

Disclosure and the proposal form

Insurance contracts are formed on the basis of information supplied by the proposer, and the law imposes obligations of disclosure. The detail differs among jurisdictions. Some apply the traditional duty of utmost good faith with the consequence that a material non-disclosure or misrepresentation entitles the insurer to avoid the policy; others have introduced statutory reforms that distinguish between innocent and deliberate or reckless conduct and provide proportionate remedies. The practitioner should establish which regime governs her policy.

In every case, accuracy is essential. The proposal form will ask about the firm's areas of work, number of fee earners, turnover, previous claims, known circumstances, disciplinary history, claims by clients not resulting in a formal claim, risk controls and the approach to supervision. The partner who signs it should not do so without reading it and checking the answers against the firm's records. An answer that omits a known circumstance, or understates the firm's work in a high-risk area, may be relied upon by an insurer to resist a claim years later. A good practice is to keep a copy of the completed form and the supporting information supplied, and to review it at each renewal, updating it where the firm's work has changed.

Where the firm is a partnership, it should ascertain whether the policy treats the knowledge of one partner as the knowledge of all, and whether there is a protection for an innocent partner where another partner has failed to disclose. Such provisions, sometimes called non-imputation clauses, can be valuable and are worth asking about.

Exclusions and conditions that cause the most disputes

The wording requires careful reading, but the following provisions are the ones that most frequently give rise to disputes.

Notification conditions: requirements that claims and circumstances be notified immediately or as soon as reasonably practicable, with consequences for late notification that range from a reduction in indemnity to outright refusal.
Consent to admissions and settlement: conditions that forbid the insured from admitting liability or settling without the insurer's agreement, which can be breached by an apology or a hasty offer to a client.
Contractual liability exclusions: exclusions of liability assumed by warranty or guarantee, for example where the firm has promised a particular outcome or has given an undertaking beyond its ordinary professional duty.
Dishonesty exclusions: clauses that remove cover for the dishonest or fraudulent acts of the insured, together with any protection for innocent partners and any extension to losses caused by the dishonesty of an employee.
Insolvency and trading exclusions: exclusions of losses connected with the firm's own financial position or with business activities outside legal services, including acting as a director or trustee in a personal capacity, or carrying out investment business.
Cover for specific risks: sub-limits or exclusions for particular work, such as tax advice, property valuation, or work for related entities.
Retroactive date and prior knowledge: exclusions of matters known to the firm before inception.

Where a clause is unclear, the firm should ask the broker to explain it in writing. It should also consider whether the standard wording of the insurer is the only available option, or whether a different form, perhaps recommended by the professional body, offers wider protection.

Claims handling and notification in practice

When a practitioner realises that something has gone wrong, the instinct is often to repair the problem quietly, perhaps by correcting the error at the firm's own expense. That impulse should be tempered by the policy conditions. If the matter may give rise to a claim, the firm should consider notifying its insurer at once, before acting further.

A defensible sequence is as follows.

Preserve the file and all related electronic records, and suspend any routine deletion.
Inform the partner responsible for risk or compliance, and make a short dated note of what is known.
Review the policy for notification procedures and any claims helpline, and notify the insurer or broker promptly in writing, identifying the facts known and the persons involved.
Refrain from admitting liability, offering compensation or making any settlement without the insurer's written consent.
Consider whether professional rules require the firm to inform the client of the error and to advise the client to take independent advice, and comply with those duties, since they are not displaced by the policy.
Cooperate with any solicitors appointed by the insurer and provide documents on request.

The conflict that arises between the firm's duty to the client and its obligations to the insurer is real, and it is one on which the professional rules usually prevail. A firm should not delay informing a client of a material error to preserve its insurance position. In practice, insurers generally understand this and will assist in the manner in which the disclosure is made.

Closure, retirement and run-off cover

Because claims-made policies respond only to claims made during the policy period, a firm that ceases practice remains exposed to claims for the period during which limitation allows a claim to be brought. That period may be long, particularly in property and trust matters and where the claimant was a minor or under a disability at the time. The solution is run-off cover, which is an extended reporting period under the policy or a separate policy purchased on closure that responds to claims made after the firm has ceased to practise. Some jurisdictions prescribe the period for which such cover must be held and the persons who must hold it. A partner who retires, a practice that is sold, and a sole practitioner who dies each raise distinct questions, and the sale agreement and partnership documents should address who is responsible for purchasing run-off and who bears the premium. These costs should be provided for well in advance of closure.

Reducing risk and the cost of cover

Insurers price the quality of a firm's controls. A firm that can demonstrate a robust approach to risk will generally find that cover is easier to place and, over time, less expensive. The following measures are the ones that most commonly feature in insurers' enquiries.

A reliable diary and limitation tracking system, with a second person checking key dates.
Written engagement letters that define scope and limit the firm's responsibility to the work agreed.
Supervision of junior staff and non-lawyers, with documented file review.
Conflict checks at intake and on the addition of new parties.
Controls on client money, with segregation of duties and regular reconciliations.
Clear procedures for verifying client identity and the source of funds in transactions where fraud is a risk, including checks on changes to payment instructions.
Secure handling of data and email, and training of staff on impersonation fraud.
A complaints procedure that identifies and responds to dissatisfaction early.

Many claims against small firms arise from avoidable failures of this kind and not from errors of legal judgement. A firm that treats risk management as part of normal supervision is therefore protecting both its clients and its insurability.

Working with a broker and comparing quotations

A broker who understands professional liability for lawyers can be of real assistance in comparing policies. The firm should ask for a comparison of the key terms and not merely of the premium: the basis of cover, retroactive date, limit, whether defence costs are inside or outside it, the excess, the main exclusions, any non-imputation or innocent partner protection, the extended reporting period and the conditions for run-off. The cheapest quotation is not the best if it omits cover on which the firm depends. The firm should also check the financial standing of the insurer and, where the regulator specifies a list of approved or qualifying insurers, confirm that the insurer is on it.

Practical next steps

A small firm can improve its position by taking the following actions, ideally some months before renewal.

Obtain the current policy wording, schedule and proposal form, and read them against the checklist in this article.
Confirm the regulator's requirements on compulsory cover, minimum limits, approved insurers and run-off, and check that the policy meets them.
Record the retroactive date, the limit, whether defence costs are inside it, the excess and the notification conditions in a single summary note for the partners.
Review the work the firm actually performs and compare it with the description of business in the policy, informing the insurer of any significant change.
Establish who is responsible for notification of claims and circumstances, and circulate the procedure to all fee earners.
Prepare the proposal form carefully, verify each answer, retain a copy, and ask each partner to confirm the information within her knowledge.
Consider related covers, including cyber, crime and employers' cover, and ask the broker to identify any gaps.
Make provision in the partnership or practice documents for run-off in the event of closure, retirement or sale.

How practice management software supports risk control

A practice management platform such as Legalytech can support the controls on which insurers place weight, by holding engagement letters and conflict check records with each matter, maintaining a diary of limitation and court dates, keeping an audit trail of activity on each file and storing correspondence with the insurer in a controlled repository. It cannot replace the judgement of the supervising attorney, but it makes systematic risk management easier to demonstrate.

This article is provided for general information only and does not constitute legal advice. Practitioners should consult the rules of their own jurisdiction and regulator.