Professional liability insurance: go bare or not?

James H. Thompson, CPA, PhD, professor of accounting, Meinders School of Business, Oklahoma City University, Oklahoma City, 73106, and Laurie J. Henry, CPA, instructor, School of Accountancy, University of Mississippi, University, 38677, reveal what CPAs are doing to lower or replace professional liability insurance.

More lawsuits have been brought against accountants in the last 20 years than in the entire history of the profession. This increase in litigation has been accompanied by higher professional liability insurance costs. In general, premiums and deductibles have risen while coverage has fallen. As the cost of insurance moves ever higher, accountants are reported to be canceling policies in favor of self insurance accompanied by strategies to limit exposure. This article discloses the results of a survey of whether and why CPA firms have chosen to go bare and what preventive measures they take in addition to or instead of their firm's own professional liability insurance.

CONTRUBUTING FACTORS

There are many factors behind the dramatic increase in liability claims, including the nature of the U. S. legal system, legislative changes (such as passage of the Racketeer Influenced and Corrupt Organizations Act) and public perceptions of the performance of ancillary services for audit clients. In addition, recent court cases have promoted the "deep pockets" doctrine, which appears to some plaintiffs to be an open invitation to sue accounting firms.

CPAs generally limit exposure to liability either externally, by purchasing professional liability insurance, or internally, through various quality control techniques.

Basic professional liability policies cover allegations of acts, errors or omissions by accountants acting within their capacity as accountants. Accountants' professional hability insurance protects them from claims of gross or ordinary negligence arising from contact with clients or third parties. Policies generally provide defense costs in addition to indemnification of losses.

In the past, "occurrence" coverage was available for any error or omission that took place while the policy was in effect, regardless of when the claim was made. Now, many policies are written on a "claims made" or "discovery" basis. Thus, only claims reported within policy effective dates are covered regardless of the occurrence date.

The policy's scope generally is restricted by a "prior acts" exclusion clause that denies coverage for work performed before the policy's effective date. When a firm doesn't renew its policy or it is cancelled, there's a potential for "lack of continuity of coverage," or coverage gaps. Coverage problems also can arise when a firm terminates its business. Many insurance companies now offer "tail policies" to cover prior acts or for earlier unreported claims arising after termination of the business.

Liability insurance is available to accountants in two layers: primary and excess. Primary layers are basic policies stating the risks and people covered, policy limits and period. Additional coverage or endorsements for special risks or events may be purchased at additional cost.

Most professional liability insurance is offered in several primary layer amounts depending on firm size. Some firms may find their litigational risk exceeds the maximum primary layer offered, but excess layers can extend a firm's coverage.

ALTERNATIVE CHOICES

A growing number of firms now look at options other than insurance policies, such as risk management, because of rising premiums. The most basic measures usually are the most reliable. They include stressing quality control within the firm by hiring qualified personnel, submitting to regular peer review and participating in continuing professional education courses. In recent years, the American Institute of CPAs has required member firms to submit to peer reviews, and an increasing number of state CPA societies have encouraged members to undergo peer reviews and pursue continuing education.

Other useful risk management techniques include educating the public and clients about the nature of CPA services, and the regular use of engagement letters and well-documented workpapers. Engagement letters should stipulate the engagement's purpose, those expected to rely on the information, a disclaimer for unintended users and also require the client's signature. Management should review all Subordinates'work to ensure there is no mechanical reliance on previous workpapers. Lawyers suggest documenting any controversies or questions arising between auditor and client.

Client screening is another effective Way to control exposure to liability. In the past few years, some CpAs have avoided corporations with financial or organizational problems. Other client screening concerns are the size, industry and public or private status of the client. These areas have proven to be a good measure of litigational risk. If a firm accepts a client that increases its exposure, the firm should take steps to mitigate the higher risk.

A SURVEY OF FIRM STRATEGIES

We developed a questionnaire to study how firms reduce exposure to litigation. The survey also determined the nature of the firm's insurance coverage, its carrier and problems encountered in obtaining insurance. We asked about changes in premium costs, coverage and deductibles from 1985 to 1989, a period of very volatile premium rates. Firms also were asked to state the approximate number of claims they filed in that period. We also asked firms about the use of seven quality control measures, current-year revenues and location to see how these factors affected insurance experience. We mailed the questionnaire in February 1990 to the administrative managers of 474 randomly chosen firms throughout the United States. We sent a second mailing in June 1990. We had a 32.5% response rate, representing 44 states. The results, shown in exhibits 1 through 4 on pages 112, 114 and 116, provide insights on practitioners' experiences with insurance and their reactions to them and may help in decision making about limiting firm exposure.

ALTERNATIVE MEASURES

Many CPA firm managers have begun to question the costs of professional liability insurance and some, particularly small firms, have been unable to justify incurring such an expense. Insurance companies say the profession should look for internal ways to limit litigation. Our study shows premiums and coverage are stabilizing, but deductibles continue to fluctuate. As a result, both firms with insurance and those without have begun to limit their exposure through other means. 11