In an M&A deal, the seller’s professional liability insurance for legacy projects will likely come into play. Deal with it early on.
Among AEC firms in all parts of the country, M&A remains a hot topic; activity continues to be high with many firms being sellers or buyers. Some are even exploring both buying and selling as they look to expand in some areas and limit their business in others.
In recent months, there’s been a great deal written about the various risks associated with potential deals involving AEC firms, including those involving higher-risk disciplines or project types and how a firm’s claim history may impact a deal.
One issue associated with M&A transactions that’s received less attention, but remains a major challenge, is the disruption caused to both seller and buyer when issues involving tail coverage for the seller’s professional liability insurance gets pushed back to the last few days before closing.
Specifically, the most common roadblock to closing a deal involves the number of years tail coverage is to be in place and the associated cost – or, more precisely, who pays for the coverage. One recent M&A transaction, for example, involved a buyer who was in the process of finalizing the acquisition of a firm about one-fourth its firm’s size with a staff of 20 people.
In this case, a three-year tail policy from the seller’s insurance carrier would cost upwards of $185,000. This cost hadn’t yet been accounted for by either party to the transaction. Because it involved a relatively significant amount compared to the seller’s annual revenues, it wasn’t clear to either party whether the insurance cost might completely derail the pending agreement.
All of this last-minute controversy is not only avoidable; in some instances, a well-planned approach for insuring future liabilities associated with past work can be a positive factor for a buyer, distinguishing it from other buyers in the market.
Understanding professional liability tail coverage. Well before an A/E firm chooses to enter the M&A arena they should have a basic understanding of how their professional liability insurance works, including the protection it can provide against losses associated with legacy projects. The vast majority of design firms (certainly, those larger than one or two people) have professional liability insurance in place. This policy is often referred to as a “practice” policy as it technically covers the firm’s ongoing practice of architecture, engineering, etc. It is renewed on an annual basis, although some smaller firms may have a two-year policy term.
Most, but not all, of these insurance policies provide details of their tail policy options in the policy form itself or in the policy’s “declarations” page. With respect to duration, the most common options are for one-, two- or three-year policy terms. However, should you purchase a tail policy longer than one year, it is important to know that the limits of coverage are not reinstated annually; instead, they are spread over the policy’s entire duration. In other words, if you have a three-year tail policy with $1 million in limits and have a $1 million loss paid out in the first year of the policy, there is no limit left in the policy for the remaining two years.
Professional liability or “practice” policies also typically stipulate the pricing for each tail option as the cost is a function of the overall policy’s annual premium. Although not by any means universal, the typical pricing is: one year at 100 percent of the practice premium, two years at 150 percent, and three years at 185 percent. The premium is due in full at the time the tail policy is bound and typically cannot be financed as the entity involved often is in the process of ceasing operations – at least in its pre-sale/pre-tail form.
Here are some additional points to consider. As mentioned, the tail policy premium can be substantial. Nonetheless, it should not come as a surprise to either seller or buyer; the premium is set out in the practice policy.
Everything discussed up to this point assumes the firm is buying a tail with the identical coverage limits and deductible as the seller’s existing practice policy. Otherwise, there may be a problem for a buyer (or seller) if there is the desire for a tail policy with higher or lower limits (and/or deductible) than the existing practice policy. Another challenge arises if the buyer or seller wants a tail policy with a duration longer than three years.
These types of “options” are typically not addressed in any way in the practice policy. However, your insurance broker has the ability (at your instruction) to pursue them and other possible coverage options with your insurance carrier. That stated, there often is little willingness by the carrier to offer anything other than the tail terms stipulated in the practice policy.
For longer duration tails, you may be able to get an agreement from the insurer to confirm its willingness to offer a “renewal” tail policy at the expiration of the initial tail policy. In addition, keep in mind that tail policy options are typically only available from your current insurer; today, even in the current competitive professional liability marketplace, very few carriers are willing to consider offering tail quotes to non-insureds.
Even though the cost for tail coverage is typically a percentage of the overall premium for a design firm’s professional liability or “practice” policy, they can be substantial and may affect the terms of an M&A deal. By understanding the costs and coverage options early on, firms involved in these transactions can avoid delays and potentially difficult negotiations at closing. This will enable both buyer and seller to consummate the deal in a positive manner with a focus on realizing the benefits they initially envisioned from the combination.
Rob Hughes is senior vice president and partner at Ames & Gough. He can be reached at rhughes@amesgough.com.