If you’re in a professional services business, you’ll almost certainly have paid a hefty premium for a professional indemnity insurance policy.
The idea of this insurance is that it covers you if you make a mistake, breach a contractual obligation in the course of your work, or are negligent, and your customer decides to sue you for damages.
What happens if you make a claim on your PI Insurance?
As soon as you become aware that there’s a risk you might be subject to a claim (and certainly as soon as that much-dreaded “Letter before Action” lands on your desk, if an issue comes out of the blue!), the first thing you should do is speak to your insurance broker. Let them know there’s a potential issue, and seek their advice as to how best to resolve it.
If there’s a contractual obligation to mediate before seeking court action, this might be the next step – but if you want to be able to rely on your PI insurance to pay any damages that you might be liable for, it’s essential to let your insurers get involved in the process.
They will, not unreasonably, want to participate in the discussion (either directly or via their appointed law firm) to help you defend your position and avoid or minimise the amount of any damages paid out to the other party. They might do this by:
- making sure that a genuine contractual breach has occurred on your part;
- investigating the possibilities of settling, as a way of reducing their overall costs (it might be less expensive than defending the claim and paying damages, can result in a better outcome for your commercial relationship, and of course saves you from unsightly court action!);
- seeing if the other party contributed to the breach in any way;
- finding out whether the other party tried to mitigate their losses (i.e. keep them to a minimum);
- seeking objective evidence of the amount of the direct losses incurred by the other party; and
- doing their best to categorise all losses that are not incurred as an inevitable consequence of the breach, and that you could not have reasonably been aware of in advance, as being “indirect” losses, and therefore outside the scope of any direct damages they might have to pay.
While all of this might seem a bit time consuming and contentious, you can understand the rationale: the insurers want to limit their costs, and will do everything they can to keep them to a minimum. From your perspective, remember that a successfully defended claim has less impact on your business and subsequent insurance renewals and will hopefully deter future claims. So it’s in everyone’s interest to resolve such matters swiftly and cost effectively
What if you’ve given a contractual indemnity?
The idea of giving an indemnity is that you make a contractual commitment to the other party that, if a particular defined event occurs (often a specific kind of breach, such as breach of third party IPR, or delay in delivery), you will pay all of the other party’s costs and damages resulting from and associated with that event.
The scope of costs and damages that you’re on the line for will depend on the exact wording of the clause. We see many indemnity clauses in contracts drafted by a buyer that are, effectively, a blank cheque from the seller. They are uncapped and unlimited in every way, covering all losses linked to, or resulting (however remotely) from the breach.
While these are (in theory – see below) great for the buyer, they are very, very scary for the seller.
Worse still, the biggest culprits when it comes to asking for indemnities are huge organisations – government departments, local authorities, global companies, banks… the very organisations whose capacity for spending (and wasting) money is limitless!
So not only have you written a blank cheque, but you’ve written it to an entity that is quite capable of bleeding your business dry and not even slaking its thirst.
But that’s why I have Professional Indemnity Insurance!
You’d think so, wouldn’t you?
If you’ve got professional indemnity insurance, you’d naturally expect it to cover you for any indemnities you give in your contracts. But sadly, you’d be wrong!
In fact, in many cases, your insurance will not support you at all in a claim brought by your client under an indemnity provision in the contract. Check your policy (sorry, it’s time to read that small print…).
You should look under the ‘exclusions’ section. Here you will almost certainly find a provision stating that the insurers will not cover any claim for “your liability under any contract which is greater than the liability you would have at common law or statute without the contract” – or something similar.
If you have a good broker who understands these issues, they will be happy to talk you through the approach their underwriters take in respect of contractual indemnities. What’s more, they may be able to guide you to an alternative underwriter or policy that’s more appropriate to the risks you need to insure.
So what does that mean in practice?
Effectively, by insisting on being indemnified, your client is removing your ability to rely on the extensive funds that your insurers would otherwise place at your disposal, forcing you to self-insure.
So if your client brings a claim under the indemnity, and your insurers walk away from the claim, you’ll have to pay up for any damages out of the funds in the company coffers. And if they’re not deep enough to meet the bills, liquidation is the next step available – something that doesn’t really work for either you, or the client seeking to enforce the indemnity.
This means that while the buyer might have thought they were getting the ultimate protection by asking for an indemnity, in reality, they are limiting their cover to the cash you have in the bank and the value of your assets. Ouch.
But that’s not fair!
Isn’t it? Think about it – why would an insurer sign up to underwriting any blank cheque you volunteer to hand over to your client? How would they stay in business if they did?
When you think through the nuts and bolts, it makes perfect sense – but quite scary sense, as the safety net that you thought you had in place when you were merrily signing up to all those contractual indemnities doesn’t actually exist!
So what to do?
When faced with a demand for indemnities from your client, you have a number of options:
- say ‘no’, on the basis that the indemnity removes any real protection for the client and puts you at risk of liquidation; or
- say ‘yes’ on the basis that (a) the client is highly unlikely to ever make a claim on the indemnity, and (b) if they did, you’d be willing to liquidate and walk away; or
- say ‘yes’ and purchase additional specialist insurance to cover the specific indemnity you’re giving – and either swallow the cost yourself, or ask the client to pay the premium on your behalf.
And what not to do?
Whatever you do, don’t just sign up to an indemnity because it’s too much hassle to do something else. By all means accept the risk if it makes good business sense – that’s your prerogative as a negotiator. Let us help you understand the size of the risk beforehand, and take care to mitigate it to the best of your ability if you believe it’s a risk worth taking.
Founder and Managing Director, Devant