Have you ever wondered how your insurance company determines the premium for your accountant professional liability insurance? This article shows you exactly what’s involved.
As an accountant, CPA, bookkeeper or tax preparer, you’ve likely heard about accountant’s professional liability insurance. You may even have your own policy. However, you might not know what it covers exactly and what determines the premium you pay. Finally, you might not fully appreciate how the value of malpractice coverage far exceeds its cost. This article will provide basic insight on these questions to help you become a more informed buyer.
What is accountant malpractice insurance?
Accounting and allied professionals do challenging work. They spend most of their time collecting client financial information and then analyzing and reporting it in various formats based on client needs. It’s extremely detailed work that can lead to computational and/or analysis errors, both of which can harm a client financially. When clients believe their accountant or bookkeeper made a costly mistake, they often decide to sue to recover their losses. Enter professional liability insurance for accountants.
What is malpractice insurance? It’s a type of insurance that covers accountants, Certified Public Accountants, bookkeepers and tax preparers against the legal costs of being sued for professional negligence. If a client files a claim against you for a financial loss you caused, your malpractice policy will pay for 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.
Accountant legal exposures are inherent in long-standing common law, as well as in statutory law. That’s why it’s crucial to purchase malpractice coverage. In fact, liability grounded in common law goes back hundreds of years and imposes responsibility for client financial losses due to an accountant’s breach of contract, negligence or fraud. Statutory liability arises from an accountant’s violation of federal statutes such as the Securities Act of 1933, the Securities Exchange Act of 1934, the Racketeer Influenced and Corrupt Organizations Act (RICO) and state-level securities laws.
What’s more, liability can arise from many different types of mistakes—from accounting malpractice, fee disputes, failure to uncover fraud, mistakes in consulting projects or errors of omission while conducting an audit or bungling client financial planning.
In short, since lawsuits against accountants and related professionals come from every angle, you have a strong and compelling need to maintain robust professional liability coverage. This need is even more acute when you operate under a fiduciary stand of care. When there’s a high degree of fiduciary trust between accountant and client, plaintiffs will have a low evidentiary standard to prove that you violated your professional duty to them.
Knowing what malpractice insurance does and why you need it is just the starting point, however. It’s 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 will be a fraction of the cost of defending and/or settling a client lawsuit. And if a court orders punitive damages, your financial obligation might be far greater than what you pay every year for malpractice coverage.
How insurers calculate malpractice insurance premiums
Your malpractice premium—the payment you make each year or quarter— results from your insurer’s careful analysis of your firm’s risk exposures. This exercise commonly involves a review of the following underwriting factors:
- Firm location. Your insurer considers your location in its 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 your malpractice coverage because the cost to resolve client litigation will be higher.
- Annual revenue. The larger your firm is, as a general rule, the more likely you will get sued. That’s because big firms handle more cases and tend to manage more complex matters. Also size might spark litigation from plaintiffs who assume the bigger the firm, the deeper the pockets for legal settlements. Due to these factors, large firms pose a greater risk to insurers, which will increase their premiums to cover the extra risk.
- Years in business. A newer accounting, bookkeeping firm or tax preparer will tend to generate more lawsuits because it will may have less expertise and, as a result, be more likely to make mistakes. The more errors or omissions you commit, the more often you may get sued. You’ll need to compensate the insurer for this additional risk.
- Number of employees. The size of your staff affects risk potential, as well. 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.
- The length of time you’ve had your malpractice insurance. Insurers issue this form of insurance on a claims-made policy form. This means 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 your 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 (otherwise known as your retroactive date).
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. What does this have to do with your premium calculation? It means that 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.
- Claims history (also known as claims experience). One of the best indicators of your firm’s litigation risk is whether you’ve been sued in the past. Prior litigation leaves a breadcrumb trail of claims activity. This helps your insurer to project how many claims your firm might produce in the future. Obviously, the more claims, the greater the risk you pose to your insurer and the more the insurer will need to charge to cover that 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, the company may reward you with a premium discount. This will incent you to become a customer and keep paying your premiums.
- Practice areas. The type of work your firm does is one of the largest determinants of liability risk. If a firm does an extensive amount of auditing, 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 their 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 in such cases. Therefore, audit-heavy accounting firms will generally pay more for their malpractice insurance than will those who have a broad mix of engagements, including tax, bookkeeping and attest work.
The above factors are intrinsic pricing elements, since “they are what they are.” You can’t change them because they either happened in the past or they represent what your firm is today. But other pricing factors are extrinsic since you can modify them to reduce your insurance costs. These include factors such as:
- Limits of liability. Limits of liability or 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. However, 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, and 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 your insurance. If you’d like to reduce your malpractice insurance cost, talk to your agent about reducing your limits of liability. But keep in mind that skimping on coverage may increase your risks. Try to do what’s best for your business.
- Deductible. This represents the amount you must pay on a malpractice claim before your 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 your insurance cost.
- Premium-payment mode. Insurers prefer their customers to pay their premium in full once per year. This reduces their administrative expenses and allows them to offer you a modest premium discount. However, if you prefer to break your annual premium down into smaller installments (example: quarterly), then your insurer will add a fee to cover the costs of issuing additional premium bills.
- Insurance bundles. Some malpractice insurers may package professional liability insurance with another type of insurance, commonly commercial property insurance. Because you’re bundling two coverages into one policy, your insurer will likely charge you less than if you wanted to buy the two policies separately.
- Loss prevention activities. Insurers may offer premium discounts for accounting firms that have taken aggressive steps to lower their litigation risks. This may involve taking risk-management courses, developing a loss-control program or using engagement letters, among other things.
Ultimately, you should take comfort in the knowledge that your professional liability insurance premium is not an arbitrary number. It results from a precise actuarial process that equitably assigns cost based on your observed risk exposure. If you adopt measures that are known to reduce claims risk, then your insurer will likely respond with lower pricing. And regardless of what your insurer charges you, rest assured that your cost will be far less than what you’d pay to settle a client lawsuit without insurance.
Concerned about what you’re paying for your accountant malpractice insurance? Then compare your current policy with those offered at 360 Coverage Pros.