Accountants' malpractice insurance is in state of flux

The CPA professional liability market is in a transitory period.

"We're coming off a hard market, where prices were increasing," said Ric Rosario, vice president of Redwood City, Calif.-based carrier Camico. "We're in transition at this point - I'm not sure what will happen. It could kick back into a hard market or erode into a soft market. A transition market has potential pitfalls, so buyers have to be careful."

Rosario explained that in a hard market, there are fewer competitors, so carriers are in a position to raise rates.

"A soft market is just the opposite - too many are in the market, carriers start underpricing each other and put each other out of business, and suddenly choices of coverage are limited. It's a vicious cycle. The cycles can be short or long depending on the type of business, but the accountants' cycle tends to be shorter."

One closely watched area is the cascade effect of Sarbanes-Oxley, according to Joe Wolfe, assistant vice president for risk control at CNA, the underwriter for the American Institute of CPAs' professional liability insurance program.

"In order to serve public audit clients, the Big Four have been cutting both public and private clients, because they need so many more resources to service their public audit clients under SOX," he said. "Businesses are cascading around the market - public clients are cascading down to second-tier and regional CPA firms. We're seeing some public audit clients cascade down to even smaller firms."

"Many CPA firms are being faced with new engagements with much larger clients than they were used to dealing with in the past," he added. "We won't know how this will play out for a few years. If there is additional claim experience, it will take time to develop."

Dave Sukert, senior vice president of underwriting at Aon Insurance Services, the administrator for the AICPA's professional liability insurance program, agreed. "Some clients have trickled down from the Big Four to regional and even smaller firms. It's not necessarily good or bad, but it's happening, and it is something we monitor closely."

Wolfe offered some advice for that: "Firms need to do some pretty active screening of new clients, especially if someone is coming to them cold. Some clients are actually cold-calling CPA firms to ask if they are interested in bidding on an audit engagement."

"The most frequent claims are still for tax services, and audit claims are the highest in terms of severity," said Wolfe.

However, he noted that most of the audit claims arise from the private sector. "Notwithstanding the amount of press given to high-profile public audit failures, the vast majority of audit malpractice claims don't involve public clients - they involve private clients. Our seminars go into some detail on the causes of those kinds of claims, especially financial fraud and embezzlement."

"The highest claims on average are still audit," echoed Tom Herendeen, vice president of the specialty lines division of Philadelphia Indemnity Insurance Co. "We haven't seen any major changes in that respect. Tax work still has the highest frequency of claims."

Herendeen noted that some private companies are taking on Sarbanes-Oxley initiatives on their own. "This is especially true of some of the larger private companies - they're frequently under pressure to comply with SOX if they want to be acquisition candidates. They need a structure in place to line up for that kind of transaction."

More clients desire to have an interactive relationship with the company, according to Herendeen. "They want more contact with us. A lot more are interested in loss control tools and other risk-management features we offer," he said.

Camico's Rosario noted a higher demand in Section 404-related work with non-public companies. "They're starting to require comparable type services. It's related to enhanced internal control. It's a huge burst of opportunity, but it also creates risk exposures, and it will continue to grow in the non-public sector," he said.

"Given that the rules and regulations are so new, we haven't seen any adverse claim experience from this area of practice," said Sukert. "To successfully undertake 404 work, or any new area of practice, firms need to determine whether or not they have the right people, and if they have enough of those people, to enable them to pursue this type of work and to do it well. Firms also need to determine whether or not 404 work is merely a means to enhance revenue in the short term, or if the area of practice is going to be a substantive part of the firm's platform for growth, succession and success. Firms tend to have problems when they decide to go into a new area first and then try to figure out how to do it later."

Rosario noted a similar tendency. "The most problematic area is when CPAs extend to areas in which they have little or no experience. For example, a CPA's existing client gets into a sell situation, and the CPA becomes too heavily involved in drafting and reviewing the agreement. Or where he doesn't have understanding of the tax implications of a complicated transaction, because he's been doing 1040s all his life."

He said that another concern stems from when CPAs promote an investment vehicle and take a commission. "A good example is tax shelters. Doing the return is one level of risk, but if they promote a shelter to the client and take a fee, that raises the risk to a much higher level. It's like the claim related to limited partnerships in the 1990s - when there was a fee involved in addition to getting in the deal, the exposures went through the roof."

Michael Warshany, account executive with the Jamison Insurance Group, said that rates have gone down over the past year. "They had increased because of the fallout from Enron, but that's in the past," he said. "People are looking for the best price, and all are lowering their rates to be more competitive."

Warshany said that professional liability programs would start offering endorsements on top of accountants' malpractice insurance to cover investment activities. "Many accounting firms are diversifying, and getting more into security planning activities," he said. "As we head into the next five years, the carriers that include this will have an edge over the others."

More firms are making the decision to fish or cut bait with regard to performing Securities and Exchange Commission services, according to Bill Thompson, vice president and comptroller of CPA Mutual Insurance Co. of America. "An increasing number of our clients are performing SEC engagement services," he said. "Either they're getting out of the business completely or they're making a decent commitment. You don't see many just doing one SEC client anymore."

"We've seen several get out of the business altogether, while others are picking up additional clients. We're also seeing a continuation of the mergers among firms - not as much as a few years ago, but it's still going on," he added.