Accountants: Beware the PI insurance risks of M&A

Consolidation in the accountancy market has been widespread in recent years.  Successful acquisition can fuel growth and attract clients and talent, but overlooking the impact on professional indemnity insurance can seriously undermine the benefits of an acquisition. 

Kerry Bremner of Howden explains how to avoid the risk of PI issues derailing M&A deals.

An explosion of M&A activity in the accountancy sector in recent years has driven consolidation in the market, and it’s not just the big firms that are acquiring. More and more mid-size and smaller firms are turning to M&A to grow their businesses.

This increase in activity has been fuelled in most part by cash investment from private equity firms coupled with the pressures of increased regulation and a need for firms to achieve scale to compete. In addition, the owners of many smaller firms are looking at exit routes and to release cash from their practices.

The benefits of M&A are well recognised, offering firms the opportunity to grow revenues, acquire talent, expand regionally, enter new markets and achieve economies of scale, especially regulatory spend which has increased significantly over the last few years.

But alongside the advantages are real risks. Not all mergers work out as intended; the expected savings may not be achieved, cultures of newly merged firms may clash, technology systems may be harder than expected to integrate or the buyer may have simply overpaid for business acquired. In addition, the new merged practice or acquiring firm will inherit professional indemnity claims for which they received no income from the work undertaken.

An often potential overlooked risk of M&A activity is the impact on professional indemnity (PI) insurance. PI cover, after premises and staff, is one of the most expensive costs for firms, who may expect to see proportional savings in the cost of PI as part of a larger merged firm. However, that is not always the case and will always depend on the target firm’s practice areas and claims record.

We have frequently experienced mergers or acquisitions being followed by an uptick in PI claims. There are possibly many reasons for this. Clients, unsettled by a merger, may complain where they would have let matters rest in the past. A change in fee earner may cause an issue with the client. In addition, it’s not uncommon for new owners to identify errors that had been missed by the previous fee earner or management.

It’s worth remembering too that significant claims can emerge from even the smallest of practices and the legal fees alone can be eye-watering. Mitigating the risk of unexpected PI issues is therefore a key element of acquisition due diligence.

Complaints management and PI claims experience

We recommend all firms check carefully with the management of the target company about their complaints management process and PI claims experience. Make sure this includes notifications which did not result in a claim as this may highlight areas of weakness or systemic problems.

Alarm bells should ring if a firm which has been in practice for a number of years has had no notifications. Most professional firms will have had some potential issues and a failure to notify could suggest a level of paranoia about reporting claims or PI considerations not given enough attention by the current management. Does this reflect a poorly run complaints procedures or a blame culture within the business which may be stocking up issues for the future?

Practice areas

Different areas of practice attract different rates from Insurers. It is therefore important to look at the main practice areas of a target firm to ensure your firm has the knowledge and expertise to understand these areas and absorb them into your business. Higher risk practice areas, such as insolvency, or audit - particularly for public interest entities -, is deemed high risk by insurers and will attract significantly higher premiums.

Partial acquisitions

Partial acquisitions where other buyers, or previous partners, retain some business lines, need careful assessment about where the liabilities lie. The Sale and Purchase Agreement should be clear which party is responsible for claims arising out of work undertaken up to the date of acquisition or merger, otherwise you may face the misfortune of inheriting responsibility for claims emerging from a business line you did not acquire. Consideration should also be given to those who have fiduciary responsibilities or personal appointments where unlimited liability can apply.

Length of cover

It is a requirement of the ICAEW rules for the PI to include cover for the two years preceding acquisition or merger. Be careful to quantify the level of cover you require, this may be more than the ICAEW rules specify. It may be possible to buy a 6 year run-off policy from your existing Insurer; this will depend mostly on the size of firm, work split and claims experience. At Howden, our policy wording exceeds the ICAEW minimum terms and conditions; this enhanced cover includes automatic cover for acquisitions as well as an agreed premium for 2 years run-off cover.

Talk to your broker

Business’s PI cover under a Non-Disclosure Agreement pre-acquisition, so you are aware of what to expect in terms of any issues if the merger or acquisition goes ahead.

We have helped many of our clients manage the PI insurance issues of M&A activity and complete smooth and successful acquisitions. If you would like to find out more, please contact the team here or speak with your usual Howden contact.