Opting for the open market
20 January 1998
As the Law Society announces its plans for a shake-up of the Solicitors Indemnity Fund, Wendy Gray argues the case for getting rid of a mutual fund altogether. Wendy Gray is a sole practitioner. She is challenging the Law Society for the right to seek private indemnity insurance.
In late 1996 the Solicitors Indemnity Fund (SIF) disclosed to the profession that the fund had an accumulated deficit of approximately £454m. The profession has begun to feel the financial consequences at this year's renewal. There are projections about further financial levies next year. But have we been told the full story?
A year after the enormous shortfall was revealed, the profession is still waiting for a full explanation. Robin Hobbs, a risk consultant and self-insurance expert at Global Risk Initiatives, goes some way to shedding light on the situation.
He says there are several other groups in industry and commerce that have made collective arrangements as an alternative to insuring individually in the market.
However, most of these arrangements are run on a more formalised basis, whether established as a true mutual company or group insurance company (commonly referred to as 'captives') and are required to comply with the strict solvency requirements of the Department of Trade and Industry.
SIF is different because it is compulsory and it is a fund guaranteed by the profession which is why it attracts VAT at 17.5 per cent rather than the Insurance Premium Tax at only 4 per cent. But Hobbs argues that it would have been sensible to follow prudent commercial practice in underwriting SIF.
The majority of proposals for group schemes do not get implemented because of the perceived disparity of risks within the group.
In the SIF scenario, the major firms are reported as feeling that they subsidise the smaller practices' poor experience. Firms with three partners or fewer account for almost 55 per cent of the claims by value although they provide only 30 per cent of the contributions. On the other hand, those smaller practices not involved in the poor risk area of conveyancing, rightly feel that they are paying for other people's bad claims experience.
Hobbs says this problem can be solved by good underwriting. He explains: 'If you go to the insurance market for professional indemnity cover, the proposal form will include questions on the type of work undertaken and whether there is any international income, particularly US based.'
Until this year, the contribution calculation form did not ask these basic underwriting questions. There is comment in both the 1995 and the 1996 annual reports on 'risk banding', although still deferring action until three years' information has been collected.
According to Hobbs, the risk banding should have been part of the original underwriting structure of SIF or should, at the very least, have been brought in as soon as the extent of conveyancing claims became evident in the early 1990s (currently 66 per cent, according to the recent SIF newsletter).
'As soon as adverse trends in claims experience are identified action needs to be swift,' says Hobbs.
'You cannot afford to wait several years, as SIF appears to have done, and rely on future claims penalty loadings. Underwriting must be a dynamic process not a static one.'
He thinks that emphasis on the quality of risks is essential to a good group scheme. Much has already been done by SIF on risk improvement, and the imposition of penalty deductibles for missed time limits is a good start.
But any solution, whether within SIF or the open market, will need to encompass strict risk improvement requirements for consistent offenders, backed by tough action for non-compliance, says Hobbs.
Both the administration (apparently costing the fund about £3m) and claims handling (approximately £4.8m) of the fund should be reviewed by competitive tender.
There has been much comment on the loss forecasts used as the basis for underwriting the scheme and Hobbs assumes that when SIF was initially set up the claims experience of the master policy was available and used in formulating the contribution. The Ward report states that SIF's policy is to give the profession the credit of all potential investment income in advance. Consequently, it is even more important to get the base figure right.
But loss forecasting is not an exact science. In light of experience, particularly the three bad years of 1989/90, 1990/91 and 1991/92, it is generally accepted that too optimistic a view was taken in assessing the contribution needed to meet liabilities.
External specialists have recently become involved and will continue to be used on a regular basis. This makes good commercial sense.
SIF also appears to make no IBNR provisions. These provisions relate to claims which, for a particular year, have been 'Incurred But Not Reported' yet to SIF. The annual report mentions that the majority of claims are known by the end of 36 months, hence the three-year accounting period. One of the suggestions from SIF in response to the Ward Report is to adopt a one-year accounting period. If this is done then IBNR provisions will be essential. This is normal underwriting practice in the insurance market.
Given the problems with SIF, the question arises of whether it would still be running if it had not been compulsory to have it to obtain a solicitor's practising certificate, or if it had been administered by an independent professional management company rather than a company which is a virtual extension of the Law Society. The two issues going forward are how to deal with the shortfall in as painless a way as possible and how matters should be arranged for future cover.
The two solutions, according to Hobbs, are either to close the fund or to try to trade out of a loss-making position. The open insurance market is extremely competitive at the moment and likely to remain so in the short term. It could be possible to find an insurance solution that takes advantage of these market conditions but also uses the remaining time before the insurance cycle turns to collect funds towards the shortfall.
Hobbs believes the market can gear up with an appropriate solution because solicitors' professional indemnity business represents substantial income potential. The immediate action should be to explore all the alternatives using an independent professional insurance broker as an intermediary with the market. It would examine such options as using a panel of approved insurers in conjunction with a pooling arrangement for the poorer risks. This has worked well for other professions.
The obvious downside to using the open market is the control of claims handling because insurers are likely to take a more commercial approach than an internal insurance fund. These types of issues should be part of the market investigation together with proposals for dealing with the shortfall.
The other disadvantage with the open market is the insurance cycle but this, surely, is preferable to the unexpected and sizeable increases experienced by the profession for the current contribution period.
An insurance solution would also ensure that the profession is no longer facing unlimited liability and the threat of unknown future levies.
At the end of the day, solicitors deserve the freedom to choose between the various commercial options available in the professional insurance market. It is hard to justify compelling the profession to support SIF or any mutual fund.
There is a commercial problem with SIF which requires a commercial solution. Strip away the privilege of the unlimited guarantee of solvency given to SIF by the Law Society and SIF would be insolvent.
Indeed, it is arguable that SIF could have been insolvent for some years and that it has already tried, unsuccessfully in my view, to trade out of the shortfall. The situation is not unique it has happened many times before with these types of schemes and the solution, as we have seen, is clear.
If we act now while the market is still soft, we may be about to take advantage of insurance solutions to help pay for the existing shortfall.