Litigation is increasing and managing risk is vital. This special report explores the options available
A recession tends to put the squeeze on every aspect of a business, but one area you shouldn’t be ignoring is your professional indemnity (PI) insurance cover, according to the experts. For many consultants, PI can be the third highest cost after staff and premises, so it may be tempting to try to cut costs while money is tight. But senior vice president of risk and insurance giant Marsh John Doe believes there is a “perfect storm” on the horizon that could leave firms underinsured while their risks increase.
This “storm” is brewing through a combination of factors, some relating to the state of the construction industry and the wider economy, and some specific to the insurance market. The first of those factors is increased competition for work.
While the consultancy market is always competitive, for the last few years most firms have seen plenty of work. That is now changing, with some markets disappearing altogether, leading to consultants moving into markets that are new to them and increasing competition for the firms already there.
“More competition means people are going to face risk,” says Doe. “People are going to be undercutting on price, and maybe coming out with softer contract controls.
“At the same time, we’re seeing increased project sizes, on average, and professional fees within those projects are also growing.” This is borne out by a survey into risk carried out by NCE in conjunction with Marsh, which showed that average project values have gone up by 22% in the last three years and the fee amount by as much as 50%.
Another factor that will affect consultants’ risk profile is the limit of liability that clients request on projects. As NCE reported recently, firms who have landed contracts on Crossrail are being told they must be covered for £25M of liability (see box). But Crossrail is not a one-off, according to Doe. “We’re seeing that as a common theme across quite a lot of our clients,” he says. “We know they’re under pressure to show increased limits of insurance. They’re obviously pushing back and resisting that, but across the board there seems to be a tendency by owners to ask for larger levels of insurance.”
Recessions often lead to an increase in litigation, and this seems to already be evident. In the survey, 56% of respondent said they had seen increased litigation against them, and 25% said the size of demands is getting larger.
“People are telling us that they are seeing an increase in claims,” says Doe. “A number of those may be frivolous, because clients are looking for a way to avoid payment, of course, but there’s definitely been a recent uplift. We have seen some bigger settlements in recent years compared to past years, so there is a trend there.”
“A lot of it starts with money,” explains Marsh managing director Tim Payne.
“Someone starts to default on their payments and then suddenly you’re into litigation, and they just find any reason not to pay.” During the economic crisis, risk can originate from clients, joint venture partners, sub-consultants and contractors, in fact any entity that may suffer financial problems during the course of a project.
This combination of factors should lead companies to take a closer look at their risk profile, and how they manage that risk, says Doe, but that doesn’t seem to be happening. “They’re competing on projects where there could be more competition, on projects which are getting bigger and on projects where they have increased professional activities,” he says. “All this suggests that individually they have more risk on any one project and across their business.”
Increased risk should be reflected in levels of PI cover, but Doe and Payne are concerned that consultants may not have enough cover in relation to the potential risk they’re carrying. “As a group, architects and engineers don’t take a lot of limits of liability for the exposure,” says Payne.
The situation could be exacerbated if premiums go up. In recent years the UK PI insurance market has been very competitive, so premiums have stayed fairly low – even decreasing. But the recession is likely to change that. “Pricing could start turning in the future,” says Doe. “It hasn’t done yet, because of the competition, and competition’s one of the key solutions to holding those insurance prices going forward. But the pricing could come under pressure at a time when the engineers’ revenues are also coming under pressure, and at a time when the risk they’re taking is coming under pressure as well. So you’re getting a perfect storm developing here. It’s not there yet, but you can see it just over the horizon.”
The insurance industry is expecting premiums to rise across the board – not just in the construction sector. “Insurers have suffered from a number of losses,” explains Payne. “And we’ve seen some very big settlements – in excess of £50M – for engineering-based losses.”
Insurance firms face other difficulties, like paying out to people whose property has been damaged in the recent hurricane season, something that has led to re-insurance costs going up by as much as 10%. Like other firms, insurers also plan to make money on the investments and property assets, but they can’t rely on that in the current sector, leaving premiums as their major form of income.
“We know the insurers have had problems making investment income returns on the premium, which they used to do, and that for some their asset base has been hit by the credit crunch. All that suggests there’s going to be pressure on premiums,” says Doe. As Payne says: “They’re going to have to underwrite for the premium, rather than relying on the premium plus income. This is against a background of historically low premiums following many years of rate reductions.”
Doe is convinced that premiums will go up – whether it is in the next six months or 12 – and consultants need to be ready. “Professional indemnity insurance is rated on work that’s been done,” he explains. “So you could end up with engineers having less income, but with their risk being rated on what’s been done in the past, because it’s what’s been done in the past that comes through to claims.
“That gets you into the nasty situation of reducing income but increasing insurance costs at a time of potentially increasing risk. If that happens in the future it’s the wrong combination, so you get the perfect storm.”
The good news is that, while premium rates are still low, this is the ideal opportunity for a firm to take a realistic view of the amount of risk it is exposed to and still get a good deal for an increasing level of cover and to develop risk and insurance placing strategies to strengthen its position in the future.
But if they assume things are just going to carry on as before, they may well find themselves underinsured, according to Doe. “I think people have been taking an artificially optimistic view,” he says. “There are a lot of rose tinted glasses out there. What’s happened in the past is not necessarily a good indicator of the future. You can see there’s going to be more competition and more risk in the industry, and you can see the insurance market might be turning in the future.
“A lot of people probably have been underinsured, and there seems to be pressure from some owners to push limits declared to higher levels. So you can see a combination of problems coming through. At the moment there’s so much capacity on the insurance side that people shouldn’t be scared. You can go and create competition and get a good deal for yourself – at the moment. But the future is a bit of a concern.”
Crossrail goes the PI route
Crossrail is asking framework designers for its tunnels, railways and stations to sign contracts that will make them liable for at least £25M if work they are involved with on the £16bn project goes wrong.
The move has led to confusion in the insurance industry, as brokers remain unclear about what definition of“event” could trigger such claims. The 12 designers are all expected to agree to the deal even though it may bust their annual professional indemnity (PI) limits. The deal could leave them flying blind into unlimited liability territory.
Firms on design frameworks will be invited to bid for packages of Crossrail work. But, there is some confusion about the extent of liabilities consultants must take on. Crossrail says it is capping liability for designers at £25M per “event” per package of work.
But one of the difficulties facing the framework consultants is knowing what might constitute an event and whether it is a single incident such as a tunnel collapse or a series of occurrences that
could lead to a major incident like a collapse. “Event definition alone will be very specific,” says Marsh managing director for construction Jon Marsh. “But even if it is one event, that could potentially involve different contractors. So is that 10 times £25M or just one £25M? If that event is a tunnel collapse, Crossrail will want to know that everyone has £25M to cover that occurrence,” he added.
But the agreement with Crossrail could expose each company to much more than that amount, given that one package could fall victim to any number of events.
“But in reality that won’t happen,” says a Crossrail spokesman. Companies which have spoken to NCE about the issue say that the £25M limit would eat into their existing annual PI limit or even
break through it. This would require them to spend significant sums increasing their insurance cover or risk being put out of business by a serious incident.
“The issue is the aggregate of claims over a year,” said one chief executive. “Crossrail is silent on total liability which effectively means the liability is uncapped. We are going to have to take a view on which packages we are prepared to take the risk on. There are some packages we won’t be bidding for.” Typical PI cover for a major consultant ranges from £20M to £100M a year.