A reminder of due diligence points relating to firms' risk management and professional indemnity insurance

Practice mergers and acquisitions need to be approached with eyes wide open. Thorough due diligence is vital and clearly needs to address a wide range of points, including finance, personnel, regulatory and compliance issues, etc.

Occasionally, situations arise where due diligence on merger/acquisition prospects proves not to have been completely effective. This is perhaps surprising, given that the firms concerned would have advised clients against entering into a merger/acquisition without the fullest understanding of the other party’s business.

Inadequate due diligence can have serious consequences. What if it only emerges post merger/acquisition that there have been disciplinary issues concerning a partner or employee of the other firm, or that the other firm’s record of claims or complaints is worse than had been assumed? What if it only later becomes clear that the attitudes to risk, and the risk management cultures, of the two firms are incompatible?

Risk management points

Establishing the other firm’s attitude to risk and risk management ought to form part of the due diligence process. If this is not compatible with your firm’s approach, there may be problems ahead. Of course, it is possible that the other firm’s approach to risk, and their systems and procedures, may be found to be even more rigorous than your own from a risk management perspective.

As part of your enquiries in relation to the other firm’s risk management approach, you will want to establish what systems and procedures the firm has in place to minimise risk. For example:

  • What are the firm’s client vetting procedures? How do they differ from your own firm’s?

  • How are conflicts of interest identified and dealt with?

  • How do the firm’s terms of engagement compare to your own firm’s?

  • How are critical dates identified, recorded and actioned in each department/practice area?

  • What supervision arrangements are in place?

Details of notified claims and circumstances need to be considered, ideally over the last 10 years but certainly for a minimum of five years. This applies not just to the other firm but also to any predecessor/constituent practices.

Regarding the “benchmarks” panel below, the significance to be accorded to past intimations will depend on several factors, including changes to the firm and its risk profile since the dates of notifications on the firm’s record. For example, if the firm notified several conveyancing claims 10 years ago, but stopped doing conveyancing work around that time, there may not be too much to be concerned about. In contrast, if the firm has recently notified lender-related claims, this may have serious implications.

Request an explanation for all claims on the other firm’s record. How did errors occur? Was client vetting or engagement a factor? Or lack of supervision? Were fee earners perhaps “dabbling” in matters outside their areas of expertise? Was a particular partner or staff member a common denominator? If so, is he/she still with the firm? What has the firm done to prevent similar errors or omissions arising? Can the firm evidence preventive action taken? Have reviews been undertaken to establish that such actions were implemented and proved effective?

As well as claims, also ask for the firm’s complaints record. Get explanations as to the underlying causes of any complaints and how they have been addressed.

PII issues

Occasionally, events reveal that firms have proceeded with a merger without thorough consideration of professional indemnity insurance implications. If the merger/acquisition proceeds on the basis that the Master Policy records and claims histories of the two firms are carried forward by the merged firm, adverse claims experience or inadequate risk management could lead to loaded insurance premiums for the enlarged firm, potentially over an extended period.

The important issue to be considered, so far as future cover under the Master Policy (and any top-up cover) is concerned, is whose policies should respond to current and future claims and circumstances arising out of the pre-merger/acquisition activities of the acquired/merging practices, as well as dishonest, fraudulent, criminal or malicious acts or omissions within the constituent practices. If the practices have had previous practice mergers or acquisitions, consideration needs to be given to the arrangements regarding PII in respect of predecessor practices.

Some types of insurance policy operate on the basis that it is the policy in force at the time of the insured event/occurrence that provides cover for that event/occurrence. Professional indemnity insurance policies, including the Master Policy, are completely different. They operate on a “claims made” basis. That means the PII policy which responds to a claim (or notification of circumstances leading to a claim) is the relevant policy in force when the insured party receives notification of the claim or becomes aware of a circumstance which might give rise to the claim. A practical example is given in the panel, above right.

To assist firms’ due diligence and decision making on the appropriate basis of continuing Master Policy cover, Marsh can provide:

  • confirmation of intimations records;
  • illustrative premium projections for the different bases of continuing Master Policy cover.
Contact the author: alistair.j.sim@marsh.com; direct dial: 0131 311 4283.

                                           

Benchmarks

Which of the following benchmarks do you consider would provide the most meaningful measure of the effectiveness of the practice’s risk management? Why?

  • Total cost of claims against the firm paid by the Master Policy insurers in the last year?

  • Number of intimations per year over a period of 10 years?

  • Write-offs of fees and outlays?

  • Whether or not the practice has a quality assurance accreditation?

  • Movements in the firm’s Master Policy premium discounts/loadings over the last five years?

  • Number of claims against the firm which are subject to doubled/trebled self-insured amounts?

  • Number of complaints over the last five years?

  • File audit statistics showing % audited files with critical dates logged; % audited files with terms of engagement?

                                                  

Master Policy cover options – case study

Practice A merges with practice B in January 2014. In May 2014, a claim arises as a result of an error made by a partner of practice B back in 2011, prior to the merger.

Question: Which cover will respond when this claim is intimated to the Master Policy insurers in May 2014?

Possible answers:

1. The cover which practice B had in 2011 at the time of the alleged error.

2. Run-off cover put in place by practice B in January 2014 when the merger took place.

3. The cover which the merged practice has in place in 2014.

Answer 1 is definitely incorrect. This is not a possibility because Master Policy cover operates on a “claims made” basis. The relevant question is always “What cover, in force at the time the claim arises, have the parties agreed will apply to the intimation?”

Answer 2 therefore may be the correct answer. If the parties agreed at the time of the merger that both firms’ cover would go on to a “run-off” basis with effect from the merger date, a claim arising out of an (alleged) error or omission preceding the merger will be dealt with under the run-off cover of practice B. This approach is referred to as “the run-off basis”.

Answer 3 may be the correct answer if the parties agreed that any claim arising out of pre-merger activities of both practices would be dealt with by the ongoing cover of the merged practice. This approach is referred to as “the continuation basis”.

                                          

Alistair Sim and Marsh

Alistair Sim is a former solicitor in private practice, who works in the FinPro (Financial and Professional Risks) National Practice at Marsh, global leader in insurance broking and risk management. To contact Alistair, email alistair.j.sim@marsh.com

The information contained in this article provides only a general overview of subjects covered, is not intended to be taken as advice regarding any individual situation and should not be relied upon as such. Insureds should consult their insurance and legal advisers regarding specific coverage issues.

Marsh Ltd is authorised and regulated by the Financial Conduct Authority.

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