What Factors Determine a Professional Liability Premium?

Nov 30, 2020

Insightful lessons can be learned by reviewing professional liability issues. With this in mind, Gallagher Affinity provides this column for your review. For more information about liability issues, contact Irene Walton at irene_walton@ajg.com.

As a CPA, there’s a good chance you have professional liability insurance, either on your own or through your employer. However, you might not know what exactly it covers and what determines the premium you pay. This article provides some insight on these questions to help you become a more informed insurance consumer.

Accountant Malpractice Insurance

CPAs collect client financial information and then analyze and report on it in various formats based on client needs. It is extremely detailed work that may include inadvertent computational or analysis errors, both of which can harm a client financially. When clients believe their CPA has made a costly mistake, they often choose to sue to recover their losses. Enter professional liability insurance.

Malpractice insurance covers CPAs against the legal costs of being sued for professional negligence. If a client files a claim for a financial loss you may have caused, your malpractice policy will pay your covered legal expenses. This includes the expense of hiring an attorney to mount your defense; settling your case with the plaintiff; or paying a court-imposed judgment, court administration costs, and expert witness fees, if any.

Liability exposure is grounded in common law and goes back hundreds of years. It imposes responsibility for client financial losses due to a breach of contract, negligence, or fraud. What’s more, liability can arise from many types of mistakes – accounting malpractice, fee disputes, failure to uncover fraud, mistakes in consulting projects, or errors of omission while conducting an audit.

The need for liability coverage may be even more acute when you operate under a fiduciary standard of care. When there is a high degree of fiduciary trust between a CPA and client, plaintiffs have a low evidentiary standard to prove that you violated your professional duty.

Knowing what malpractice insurance does and why you need it is just the starting point. It is also important to determine if your malpractice policy’s premium represents a good value. In most cases, it does because the annual cost for a comprehensive accounting malpractice policy is a fraction of the cost of defending or settling a lawsuit. And if a court orders punitive damages, your financial obligation might be far greater than what you pay every year for malpractice coverage.

Malpractice Insurance Premium Calculations

A malpractice insurance premium is determined by a careful analysis of your firm’s risk exposures. This commonly involves a review of the following underwriting factors:

• Firm location – Location is considered in pricing because states often have different accounting regulations and legal climates. For example, it might be easier to bring suit in a certain state or its courts might be more generous to plaintiffs in calculating financial judgments. If you’re in a high-cost state, you will likely have to pay more for malpractice coverage because the cost to resolve client litigation will be higher. Typically, Pennsylvania is on the lower side when compared to neighboring states. New Jersey, for example, always includes a surcharge on policies.

• Annual revenue – Larger firms are, as a general rule, more likely to get sued. This is because big firms handle more cases and tend to manage more complex matters. Also, size might spark litigation from plaintiffs who assume bigger firms have deeper pockets for legal settlements. Due to these factors, large firms pose a greater risk to insurers, increasing premiums to cover the extra risk.

• Years in business – Newer accounting firms tend to generate more lawsuits because they have less expertise and, as a result, may be more likely to make mistakes. You’ll need to compensate the insurer for this additional risk.

• Number of employees – Staff size is a proxy for annual revenue. So, the larger your employee roster, the more client engagements you will complete in a year. The greater the number of cases, the more risk you’ll face, all other things being equal.

• How long you’ve had malpractice insurance – You’re only eligible to receive benefits for a covered loss when the incident occurs during the policy period (the time the policy is in effect). You must also file an official notice of loss – or claim – during the policy period. Because of these requirements, your insurance not only will cover a loss that occurs today, but also one that happened as far back as the first day from which you maintained continuous malpractice coverage. For example, if you maintained your insurance for a year and then a client filed a claim for an incident that occurred in your first coverage month, you’d be covered. Similarly, if you maintained your insurance for five years and a client sued you over something that happened in that same month, you’d still be covered. For premium calculation, the span of time your insurer covers grows with each successive policy period. When you first take out the policy, your premium will be quite low because there is no prior work to insure. In year two, the policy will have one year of operations to cover, so your second-year premium will be somewhat higher than your first-year premium. In the third year, you’ll pay even more because your premium now has to cover two years of your prior work. This gradual premium escalation, known as step-rate pricing, generally continues for five years. At that point, insurers consider your policy to be “mature,” no longer needing a premium increase. Check with your carrier as to their step-rating methodology.

• Claims history – One of the best indicators of litigation risk is whether you have been sued in the past. Prior litigation leaves a trail of claims activity. This helps your insurer project how many claims your firm might produce in the future. The more claims, the greater the risk you pose to your insurer and the more the insurer will need to charge to cover the risk. If your claims experience is excessive, the carrier may refuse to cover you entirely. On the flip side, if you’ve had no or very few claims, a company may reward you with a premium discount.

• Practice areas – The types of work your firm does is one of the largest determinants of liability risk. If a firm does extensive auditing work, a single mistake in a key engagement can spark a major lawsuit. This is because third parties, such as banks or investors, rely heavily on audits to make decisions. If they use your audit to support an action and it turns out you provided faulty information, they may suffer a big financial loss as a result. A lawsuit may not be far behind. Therefore, audit-heavy firms will generally pay more for their malpractice insurance than will those who have a broad mix of engagements, such as tax, bookkeeping, and attest work.

The above factors are intrinsic pricing elements. You can’t change them because they either happened in the past or they represent what your firm is today. Other pricing factors can be modified to reduce insurance costs. These factors include the following:

• Limits of liability – Limits of liability (coverage limits) represent the amount of insurance you’re buying. A policy with a $1 million limit means you have protection against one or more lawsuits totaling $1 million during the policy period. Be careful. Policies often specify two types of limits: per occurrence and aggregate. The first limit sets a cap for what an insurer will pay for a single claim; the second determines the maximum it will pay for all claims in a given year. The higher your per occurrence and aggregate limits are, the more you’ll pay for insurance.

• Deductible – This represents the amount you must pay on a malpractice claim before insurance benefits kick in. Increasing your deductible reduces the insurer’s risk exposure, which allows it to decrease your premium. Selecting a small deductible will increase insurance cost.

• Loss prevention activities – Insurers may offer premium discounts to firms that have taken aggressive steps to lower litigation risks. This may involve taking risk-management courses, developing a loss-control program, or using engagement letters, among other things.

Take comfort in the knowledge that your professional liability insurance premium is not an arbitrary number. It results from an actuarial process that assigns cost based on observed risk exposure. If you adopt measures that are known to reduce claims risk, then your insurer will likely respond with lower pricing.

Regardless of what your insurer charges you, be assured that your cost will be far less than what you would pay to settle a client lawsuit without insurance.


Irene M. Walton is Greater Philadelphia area vice president for Gallagher Affinity. She can be reached at irene_walton@ajg.com.

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