Risk Dimensions Newsletter Issue 11: February 2024

As April approaches, thoughts return to professional indemnity insurance budgets or renewal for some organisations. 

The latest edition of Marsh’s Risk Dimensions newsletter for solicitors considers what law firms should address when purchasing the appropriate limit of insurance cover, along with the related risk issue of controlling exposure to clients by agreement. 

John Kunzler, Marsh’s Risk and Error Management team leader, explores the complexities of this decision-making process, while offering insights on how to assess a reasonable limit to purchase. This discussion reviews the recent Axiom Ince intervention – which further highlighted the importance of adequate indemnity insurance limits for law firms. 

Additionally, William Glynn, Legal Director – Insurance, Financial, and Professional Disputes, Clyde & Co LLP, provides valuable guidance on liability caps and how law firms can enhance their effectiveness. 

Professional indemnity insurance: How much is enough?

Author: John Kunzler, Risk and Error Management, Marsh

Determining how much insurance is enough can be a challenging question for all businesses. Law firms and legal regulators may now be reconsidering how much professional indemnity insurance is enough − especially given the Axiom Ince intervention. Although much is unknown, recent reports of losses have sparked discussions about the existing approach to client protection and whether it remains fit for purpose. This is particularly relevant for scenarios where funds significantly in excess of the compulsory limit – £3 million for Limited Liability Partnerships (LLPs) and limited companies – are temporarily held in client accounts by an entity that benefits from limited liability.

Professional indemnity legal obligations

The Law Society’s Guidance Note recognises funds held in client accounts as a relevant factor in choosing appropriate limits. Additionally, law firms have obligations under the Solicitors Regulation Authority (SRA) Standards and Regulations. We would suggest firms should refer to the SRA’s factors and make a note of their thinking when making a decision about the limit.

Despite changes, specialisation, and suggested alternatives, both large and small law firms continue to handle significant levels of client money for no charge. However, there are some key differences in the regulatory requirements for law firms compared to other deposit holders, such as banks and financial institutions. One notable difference is the approach to transparency and minimum capital for corporate entities. Regulators, like the Financial Conduct Authority (FCA), have long mandated transparency and minimum capital for regulated entities − following the direction set by Basel II in 2004.

The SRA’s Minimum Terms and Conditions are extremely broad. By covering any default on client account, the terms relating to client money protection function like bond and guarantee insurance for appointment holders such as liquidators or Court of Protection Deputies. This may justify the lack of capital adequacy compared with other deposit holders, but this cover is also the source of losses that drive significant pricing volatility, especially in the SME sector.

The mechanism for consumer protection provides another notable contrast between the FCA and the SRA regimes. In the case of financial institutions, regulated entities (not individuals) pay a levy to the Financial Services Compensation Scheme (FSCS), which acts as a limited safety net for consumers. This scheme provides compensation to consumers in the event of a financial institution’s failure. The SRA does not have a similar contribution scheme in place for firms – instead individuals pay a levy in respect of the Compensation Fund through their Practising Certificate.

An evolving landscape

Crucially, the landscape of law firms has significantly evolved since 2004. The concept of LLPs was then still relatively novel, having only been permitted in 2001, so the total number of SRA-regulated LLPs was limited to around 190 by 2004. Similarly, the number of limited company entities regulated by SRA was relatively low. Fast forward to the present day, and we see a different picture. Currently, approximately, 70% of law firms operate as LLPs or limited companies – there are now around 6,600 limited liability entities, either partnerships or limited companies.

According to Law Society figures, only 2,700 firms practice through sole practitioner or Partnership Act 1890 structures with unlimited liability. This shift in the composition of law firms highlights the changing dynamics and the increasing prevalence of limited liability structures. It reflects the recognition among legal professionals of the benefits and protections offered by limited liability entities. In particular, the change in interpersonal responsibilities between members to limited rather than unlimited liability, reduces the financial underpinning involved in a partnership. From the individual members’ point of view, the personal risk of joining a partnership or allowing someone into it, and the attitude to future stability, are different for limited and unlimited partnerships.   

Considering the significant changes in the business landscape and the shift away from personal liability as the norm, it is prudent to review current designs against present and future requirements. Part of that design is the existing claim limit of £3 million, which was established in 2005 and has not been adjusted since. This could be reviewed to align with the recent spike in inflation, with the equivalent value today being approximately £5 million.

In addition to law firms’ internal requirements, the SRA also expects firms to demonstrate a rational and reasonable assessment of what constitutes “adequate and appropriate indemnity insurance”. On the basis a firm can demonstrate the limit was selected on a reasonable and rational basis and there was reference to any of the factors in their guidance, the SRA has indicated it would “not seek to second guess that decision.”

Although it may not have been emphasised or discussed extensively, it is important to note that there are additional expectations placed on individuals and firms by the SRA. These expectations go beyond the requirements for indemnity insurance and encompass various aspects of governance, compliance, financial stability, and risk management. Specifically, the SRA expects firms to have effective governance structures, arrangements, systems, and controls in place to ensure compliance with SRA regulations. Firms should “actively monitor financial stability” and “identify, monitor, and manage all material risks” to their business “including those that arise from connected practices.”

Insurance coverage may not always respond consistently or as expected − which can further complicate determining “how much is enough”. While insurance policies may state that “any single claim up to £x million” is covered a theoretically infinite number of times during the policy period, there are limitations to how this operates in practice. The policy wording allows for the aggregation of multiple claims that arise from the same or a related series of events. This means that only one liability limit is available to cover those claims. Therefore, a margin of safety should be built into the chosen figure that evaluates factors, such as whether the firm engages in high-volume repetitive work. Such work carries the risk that the same mistake could affect multiple clients and be treated as a single claim by insurers. However, whether a claim aggregates or not can be unpredictable. This will rest on specific circumstances and the outcome for limits and excesses payable may not always suit the firm or the insurer. The policy response can also be affected by individual or collective behaviours, such as dishonesty. Both aggregation and imputing dishonesty to others have recently been considered by the Court of Appeal.   

Professional indemnity claim values, 2014 and 2024

Maximum and mean professional indemnity claim values from 2004-2014 were collected by SRA. However, it would be reasonable to double those values after accounting for inflation since 2014. Additionally, it may be prudent to include a small margin to accommodate the possibility that some of the maximum payment cases could have originated as early as 2004. The table below displays the SRA’s data by area of law with a rough estimate of equivalent adjusted amounts for 2024. There are some limitations to this approach:

• The original data from some carriers may have included only claim payments, but not all the costs involved in claims.
• Further, claims in excess of the compulsory limit may not have been fully recorded.

Despite these limitations, the data still provides a valuable indication of claims potential.

In order to provide a comprehensive view, we also examined recent data from small to medium sized firms over the last eight years. Although this data represents a smaller sample size and may be less mature, it provided a check on the adjusted mean averages for 2024 – and appeared to be reasonably consistent with the values adjusted for inflation. It is noted that the maximum losses observed for the Marsh SME firms were generally lower than the estimated adjusted maximum losses. This could reflect the likelihood that the very largest losses in the SRA whole of profession data tend to come from the largest transactions dealt with by large firms.

Source: Law Society 2004-2014 and Marsh claim data

Firms catering for lower or modest value work might think that looking at the maximum sums across the profession is unreasonable, as their work could never generate that level of loss. However, although not captured in the above data, the 2011 case of Godiva v Travellers demonstrates that large claims can stem from firms carrying out relatively routine residential conveyancing. Willmett, insured by Travellers, was a Thames Valley firm of solicitors with four offices. A significant professional indemnity claim was made against the firm reportedly involving losses of £50 million.  Aggregation of loss was an issue in this case, with Travellers reportedly seeking to argue only one primary limit of indemnity (£2million) was available to pay all the losses.

Limits practitioners should consider buying

When deciding on the appropriate limit to purchase for indemnity insurance, practitioners should consider the following factors:

• Transaction values and maximum sum held on client account
  Firms should have a good understanding of the transaction values they handle, and the maximum amount held on client accounts. Taking into account these figures, and subject to any other work areas with higher potential exposure outlined in the table above, as a rough rule of thumb, practitioners may select three to five times the value of the largest transaction, or the maximum total held on client account at any point in the year, whichever is higher. This approach is likely to provide a reasonable level of protection against losses from negligence claims for the firm, and the risk that a few large (or multiple average size) claims might aggregate.
• Firm-specific considerations
  Different firms may have varying needs based on the assets they possess and wish to protect, or may weigh up what would protect the value of the firm continuing as a profit-making business. These are important factors to consider when determining the appropriate coverage limit.

While taking note of what others buy may not be the most useful approach, the following data and analysis by Marsh may prove valuable:

• For firms of one to three partners, claims exceeding £3 million are rare. 
• Most firms with four partners or more purchase cover beyond the compulsory limit, with a significant number opting for £10 million or more.
• The largest firms buy cover in the hundreds of millions. 

It may be beneficial for internal decision-making processes to ask and keep record of the following nine questions:

1. Purpose
   Rather than asking “why should we change?”, ask what exactly are you aiming to protect and how is that changing? Are you primarily concerned with safeguarding your firm’s assets or ensuring the ability to continue trading in the event of a claim?
2. Business appetite
   Are there specific boundaries on the types of risk you want to be involved in? For example, do you want to examine and maybe restrict the size of the largest transactions you handle, or limit the potential risks associated with multiple transactions for one development or linked transactions?
3. Control of exposure
   How effective do you believe your limitation of liability with clients is? Do you actively monitor and review this limitation, and do you have a process in place for varying it if necessary?
4. Financial
   Rather than asking “what do others buy?”, ask what is the maximum amount of money you typically have on client accounts at any given time? This information can help determine the potential financial exposure your firm may face in the event of a claim.
5. Loss history
   Instead of asking “why do we think we might have a claim?” or considering that the firm has historically a record of no loss, ask what is the profile of the work you currently undertake or have done in the past? Understanding the nature of your work can provide insight into the potential risks and liabilities associated with your practice.
6. Likely losses
   Rather than reflecting on budget constraints, assess what size and type of claims your existing and past work might generate. It can be helpful to analyse any available data (such as noted above) or other historical information to gain a better understanding of the potential magnitude of claims that may arise, and the risk of aggregation.
7. Client demands
   Are any clients currently requiring minimum levels of insurance cover? If so, do you want to pursue this type of work?
8. Adequacy versus inflation
   How do you think inflation has affected the value of the £2 or £3 million minimum cover which was set in 2005? Understanding the impact of inflation on insurance coverage can help determine if the current minimum levels are still adequate in today’s economic landscape.
9. Culture
   What kind of firm do you want to be, and what culture would you want to foster? The approach to deciding the limit will reflect and contribute to the ethos of your firm.

Making judgements for reasonable limits

Insufficient or inadequate coverage can expose firms to various risks and potential financial hardships, such as vulnerability to closure in the event of a significant loss. Indirectly, this can lead to personal guarantees − to banks or landlords − being triggered, so although the limited liability protects the individual from a claimant, if the firm closes, there can be consequential personal exposures for past and present partners, and regulatory consequences and penalties may also follow. Overall, the risks of not having enough insurance in a law firm can have catastrophic consequences, both financially and professionally.

Those that manage the firm, taking time to inform themselves on their risk profile and potential exposures, are well placed to make a judgement to assess a reasonable limit to buy. When considering higher limits, it is particularly valuable to focus on:

• The true purpose – What is it exactly that are you trying to protect or make resilient?
• The level of certainty – Do you want the insurance to be sufficient to meet any claim on a one in ten-year basis or a more unusual (and therefore higher) one in fifty-year loss?
• Proportionality – What proportion of current profit does it make sense to spend to buy that level of certainty?

It is crucial that firms are informed when deciding what limits to buy – Marsh can offer additional services for those seeking greater certainty.

Our team of experts can provide actuarial-style statistical modelling using our Risk Finance Optimisation tool. This tool takes into account the firm’s loss history and our extensive law firm loss database to optimise limit and excess structures specific to the firm’s needs. Firms spending six figures or more on PI insurance may find this service generates value. Your usual Marsh contact will be happy to discuss this with you if this is of interest.

“If the cap fits…” – how can law firms help to ensure that their liability caps will be effective?

Author: William Glynn, Legal Director, Clyde and Co LLP

There is no particular magic to a law firm’s engagement letter or terms of business; they are designed to set out the terms agreed between two parties and are accordingly subject to the ordinary rules of contractual interpretation. However, when seeking to agree terms with clients, law firms in addition need to consider their regulatory obligations.

It is common practice for law firms to attempt to limit their liability by including a cap in their terms of engagement which endeavours to put a maximum figure on what the law firm can be required to pay in the event of a claim. Liability caps are expressed in different ways, usually by setting out a specific figure, using a multiple of the fees charged, or with reference to the firm’s insurance cover.  An effective liability cap should have several benefits: reducing the law firm’s loss in the event of a claim (with a consequential improvement in the firm’s claims record), deterring exaggerated claims, and (if a claim valued in excess of the cap does arise) allowing a Part 36 offer to be made which may have an increased prospect of success. Moreover, even if a claim is not taken to trial, a properly drafted liability cap can act as a settlement lever in negotiations.

Whilst liability caps are therefore of potentially significant benefit to the firm, we regularly see instances where the wording or approach to incorporating a cap creates a serious risk of it being held to be ineffective or, at the best, subject to rigorous and credible challenge. What can firms do to increase the prospect of a liability cap being effective? And what balance needs to be struck between imposing an effective liability cap and the regulatory obligations of firms in relation to how they treat their clients?

Statutory framework

Generally speaking, a liability cap will be found to be effective provided that it is fair/reasonable. Whether a cap is fair/reasonable requires consideration of each engagement on a case-by-case basis. However, the statutory framework provides some insight into how a liability cap will be judged. There are two primary statutes which apply to law firm engagement terms; which one is relevant depends on the nature of the client.

Consumer Rights Act 2015 (“CRA”)

A client will be a consumer under the CRA where they are ‘an individual acting for purposes that are wholly or mainly outside their trade, business, craft or profession.’ The CRA provides, that in relation to retainers with consumers, liability can be restricted by way of a cap provided that the cap is not lower than the firm’s fees for the matter and is “fair”.

To be “fair” the cap must comply with the requirement of good faith; it must not cause a significant imbalance in the parties’ rights and obligations under the contract, to the detriment of the client.

Unfair Contract Terms Act 1977 (“UCTA”)

We regularly see Claimants relying on UCTA with a view to trying to undermine a liability cap in a law firm engagement letter.

UCTA applies to business contracts and provides that a firm can limit, exclude, or restrict its liability for negligence by way of a contract term (e.g., a liability cap) provided that the “requirement of reasonableness” is satisfied. The Court will consider whether a contract term is a fair and reasonable one having regard to the circumstances of the parties at the time that the contract was made. A further consideration of UCTA is the resources of the parties and their ability to obtain insurance to protect themselves.

Again, therefore, whilst the wording of each retainer will need to be judged on a case-by-case basis, UCTA guidelines provide that the following considerations will be taken into account:

• The strength of the bargaining position of the parties – a client who has a strong bargaining position (for example, a corporate entity which directs numerous instructions to the same firm) will be considered more likely to have been able to negotiate any liability cap, and accordingly will be more likely to be deemed to have accepted it as being reasonable.
• Whether the client received an inducement to agree to the cap or had an opportunity to engage another firm without having to accept the cap.
• Whether the cap was brought explicitly to the client’s attention – this does not necessarily need to have been discussed in person; a clear reference to the existence of the liability cap in the covering email or letter may be sufficient.
• Where the clause would be effective based on compliance with a particular condition, whether it was reasonable at the time of making the contract to expect that compliance with that condition would be practicable.
• The level of a firm’s insurance cover (in comparison with the proposed liability cap) and whether the parties could have obtained additional insurance cover elsewhere.

The onus of proving the reasonableness of a liability cap is on the party which seeks to rely on it. This test is discretionary, and if the Court concludes that a cap is not reasonable it will not impose a substitute clause.

Therefore, a firm wishing to rely on a liability cap should be able to justify its implementation, and the level at which it is set.

Regulatory framework

The SRA Standards and Regulations (“StaRs”) require that clients should be treated fairly and that solicitors must not take unfair advantage of clients. To avoid a regulatory issue when trying to impose a liability cap, it is essential that firms:

• Ensure that any limitation of liability is fair and reasonable in light of the specific circumstances of the client, including that it reflects the nature of the engagement.
• Ensure that any liability cap reflects the balance of power between the parties and their respective knowledge.
• Communicate the liability cap to the client so that they can understand its impact and so that they can ensure that they are able to make informed decisions about the services they need, how their matter will be managed, and the options available to them.

In any event, a liability cap cannot be lower than the level of cover mandated by the Minimum Terms and Conditions (for LLPs this is £3 million, and it is £2 million for other firms), as that would undermine the very purpose of the Minimum Terms.

Case law

As noted above, whether or not a liability cap will be effective will depend on the circumstances of each case. However, there have been a number of cases which consider the reasonableness of liability caps and which therefore provide some guidance as to the Court’s approach to determining whether or not a liability cap will be effective. Whilst a number of these relate specifically to liability caps in solicitors’ retainers, there are cases involving other professionals or contracts which are nonetheless illuminating as to how the Court may determine whether a liability cap will be effective.

Gilbert-Ash v Modern Engineering [1974] AC689

The seminal decision stated that a party relying on an exclusion clause “must establish that the words show a clear intention to deprive the other party of a remedy to which he would otherwise be entitled”. The Court held that this was due to a presumption that neither party intends to abandon any possible remedies in law, and that “clear words must be used in order to rebut the presumption”.

Marplace v Chaffe Street [2006] EWHC 1919

A cap of £20 million was held to be reasonable, under the UCTA test of reasonableness, where the firm had £20 million of Professional Indemnity cover. The Court considered that the relevant factors were that the Claimants were sophisticated and wealthy, and that they were used to engaging professionals on the basis that the terms of engagements included limitations of liability. The Claimants were also made aware of the cap.

Hirtenstein v Hill Dickinson LLP [2014] EWHC 2711 (Comm)

Albeit obiter, in this case the Court made clear that (had it been required to determine the issue) it would not have found the liability cap (of £3 million) to be effective. The solicitors had failed to show that it was reasonable to limit their liability to that sum. Furthermore, the solicitors did not bring the liability cap specifically to the Claimant’s attention, and the retainer letter with annexed terms and conditions was sent too late in a time-pressured matter.

Persimmon Homes Ltd v Ove Arup [2015] EWHC 3573

The Court reflected the principle that, for commercial certainty, full effect should be given to the allocation of risk expressly agreed by parties, in a fully negotiated commercial contract. Both parties were capable and astute, and so the terms were agreed knowingly by both parties. The Court accordingly determined that the liability cap in this case was enforceable.

Hawksford Trustees Jersey v Halliwells [2015] EWHC 2996 (Ch)

In this case, Halliwell’s terms of business limited liability for claims in breach of contract or negligence to £3 million. The Claimant submitted that the clause was unreasonable, as the solicitors' insurance cover was £150 million. Albeit again obiter, the Court emphasised that the onus of proving the reasonableness of a clause, under UCTA, rested with the party which intended to rely on it. The Judge concluded that, had he been required to determine the issue, he would have found that the cap was reasonable (applying the UCTA test) because the parties were “sophisticated and experienced commercial players”, and that the Claimant knew that the solicitors would probably seek to limit their liability. Furthermore, the cap was not so absurdly small so as to be inherently unreasonable and the parties should be free to apportion the risks as they considered appropriate.

Lyons v Fox Williams [2016] EWHC 2427 QB

It was not necessary for the Judge in Lyons to consider whether a limitation of liability clause in a retainer applied. However, obiter, the Judge observed that it would have been a considerable challenge for the solicitors to discharge the burden of proving reasonableness under UCTA, in the absence of evidence which related to whether or not it could have obtained insurance at a higher level.

Drax Energy Solutions v Wipro [2023] EWHC 1342 (TCC)

In Drax, the relevant clause attempted to insert a single aggregate cap applicable to all claims, but unclear drafting led to it being argued that there were multiple caps applicable to each claim. Here, the Court stated that the starting point was the natural and ordinary meaning of the language in the clause. Whilst the claim was successfully defended, and a single aggregate cap was applied, Drax serves as a warning of the need to ensure clarity when it comes to drafting clauses which purport to limit a party’s liability.

Innovate Pharmaceuticals Limited v University of Portsmouth Higher Education Corporation [2024] EWHC 35 (TCC)

In this very recent decision, the Court held that a liability cap of £1m was effective and reasonable under UCTA due to the fact that the terms were negotiated by a solicitor and – importantly – because the value of the claim compared to the value of the payments made under the contract “underlines the commercial reality, perhaps necessity, of the two [limitation of liability] clauses.” It was also held that the limitation of liability clause was effective even in relation to allegedly dishonest breaches of contract.

As can be seen from these examples, the Courts have taken a fact-specific approach to applying the reasonableness test pursuant to UCTA. The case law also emphasises the importance of the parties’ respective standing and sophistication.

Practical steps to improve the prospects of an effective liability cap

In summary, law firms can take various steps to help improve the prospects of a liability cap being deemed to be effective:

• Drafting should be unequivocal and clear. It is useful to include:
  • Clear wording to reflect who is being advised and regarding what;
  • A clear and express reference to the liability cap limiting claims in negligence; and
  • A cap expressed in figures, instead of with reference to a multiple of the fees charged, which may lead to uncertainty.
• The cap should be in writing and must be properly incorporated into the contract.
• The existence of the cap should be explicitly drawn to the client’s attention – to allow them to consider, negotiate, or consent to the cap – either in the covering email or letter, or in an in-person meeting (which should be recorded in a contemporaneous note).
• The client should be advised as to the significance, applicability, and the manner in which the cap might operate.
• Ideally, the client will be required to return a signed copy of the engagement letter before work commences.
• Any proposed variation of the liability cap should be clearly recorded in writing, including the reasons for the change.
• An arbitrary approach to caps should not be adopted. The cap should reflect the financial risk that may arise if a retainer were to be negligently performed.

To cap it off

Liability caps are a key method of risk mitigation for law firms. They can be effective in limiting claims, may be attractive to insurers when it comes to renewal, and are subject to reasonably well-established judicial principles. However, there are various steps that firms should take in order to increase the likelihood that a liability cap will be upheld and each retainer should be considered on an individual basis.