Every day at Protexure we provide premium price quotes to lawyers looking to purchase malpractice insurance policies. Those prices vary from lawyer to lawyer and firm to firm. We know it can be confusing for lawyers when they see premium prices change year to year or vary from carrier to carrier. And we know that the confusion can make it that much more difficult to feel good about your insurance purchase decision, making this necessary yearly purchase feel more like a necessary evil to be endured.
To help allay some of that discomfort, we offer this primer on legal malpractice insurance pricing. We hope it will shed some light on this “mysterious” process and provide you with a basis for making better decisions--and for feeling better about those decisions--when buying malpractice insurance.
Insurance companies, like any other business, set their prices so that they can ultimately make a profit on the product that they are selling.
For companies that make tangible goods, like shoes, the equation is pretty straightforward: calculate the costs of the materials that go into the pair of shoes, add the costs of the shoe-making process (including things like labor and allocated overhead) and the costs of distribution and you know exactly how much you spent making that pair of shoes. Then, calculate your desired profit margin in light of what you think the shoe market will bear, and set your price.
For companies that sell insurance, however, the calculation isn’t as straightforward.
First, their “production” costs are intangible and often quite variable, making them much more difficult to measure. An insurer has to calculate the price based on predictions it makes about the likelihood that certain events will happen in the future (a car crash, a fire, a health problem) and how much it may cost to deal with the effects of that event (is the car a total loss or only slightly dented? Did the fire damage irreplaceable artifacts? Will the health issue require specialized care or easily-obtained medication?).
Second, an insurance carrier also must factor in predictions about its ability to make income on the premium dollars it invests while holding enough liquidity to be able to pay out claims as they arise. It takes these predictions, adds in other costs like marketing, human resources, and other overhead, and sets a price for its policies.
For legal malpractice insurers, the calculation is complicated further by the fact that legal malpractice insurance policies are issued on a “claims-made basis.” This means that coverage arises from the policy that is in force at the time a claim is brought to the insurer’s attention, which might not be the same period as when the underlying representation giving rise to the potential liability took place. Claims made insurance coverage presents a tricky underwriting formula for actuaries who have to estimate potential future losses based on past--and, often, unknown at the time of pricing--actions.
This is particularly challenging because actual claims frequently do not ripen until long after the alleged error or omission. The result of a missed piece of evidence may not be truly known until the litigation is finally concluded. A drafting error in a will or property transfer may not come to light until years later. Even the effect of missed deadlines may not be fully realized or understood for a long period. So a legal malpractice insurance carrier is making even more difficult predictions about what its costs might be when it is setting its prices.
Additionally, lawyers, professional liability policies provide coverage not only for actual damages but for the costs associated with defending the claim, which are also unknown at the time the policy is purchased and which are variable and difficult to predict with specificity even after the malpractice allegations come to light.
So, what can an insurance company do to determine pricing in a way that allows for them to be profitable and allows the coverage to be affordable?
The insurance company has to rely on knowledge accumulated through its own experience and that of other insurers over the years. Actuaries and underwriters look at data to develop formulae they then use to make predictions about the likelihood that claims will arise and about how much those claims will likely ultimately cost to defend and indemnify.
They also factor in how much money they can make through the investment in the premiums that their customers pay them. While this is not nearly as precise a calculation as the one the shoe manufacturer can make, insurance carriers have gotten pretty good at making predictions they can feel comfortable with.
This, then, begs the question: what is that magic formula, and how can lawyers looking for malpractice insurance expect it to be applied to their practice?
Put simply, the greater risk you present to a carrier, the higher price they will charge you for your insurance. This basic calculation is made up of many factors, some more complicated or important than others.
The three dominant determinants are firm headcount, location, and the type of work--or Areas of Practice (AOP)--an applicant lawyer or firm does. Other factors that come into play include time in practice, practice management procedures employed, industry standards, claims history, and various selected policy features including types and sizes of deductibles and limits.
The first firm characteristic that impacts premium price is the number of attorneys in your firm. The principle is simple: the more attorneys in the firm, the more matters, and clients the firm can handle; more work equals more risk, and more risk equals higher price. All else being equal then, a solo attorney is less expensive to insure than a two-attorney firm.
Having said that, though, experience shows that the curve does eventually flatten. So, if your firm grows from a sole practitioner to two attorneys, you can anticipate your premium to double, but if you add a third attorney to the roster, the next percentage increase may not be as large. Indeed, firms with more than two attorneys could actually receive a size of firm discount or credit ranging from 3-10% for a 3-5 attorney firm up to 30-40% for firms with over 20 employed attorneys.
The rating--i.e. pricing--for the number of attorneys is also affected by the hours each attorney works. Annual hours worked or billed is considered an indicator of risk because it speaks to the volume of matters the attorney handles. Many carriers will have a standard rating for full-time attorneys (usually measured at 1000 hours or more per year) and lower rates for those who work reduced hours.
The Protexure Lawyers program, for example, regularly provides a discount of 50% for attorneys working between 500-1,000 hours per year and an 80% discount for attorneys working less than 500 hours per year. Under that rate scheme, a firm that has two attorneys working 2,000 hours, one attorney working 800 hours, and one working 400 hours will be rated based on 2.7 full-time equivalent attorneys.
The balance of hours worked to premium rate is complicated, however, demonstrated by the fact that different carriers treat part-time attorneys differently. Indeed, while some carriers will cover part-timers for less or even for free as an add on to a policy covering full-timers, others are not willing to ensure part-timers at all, figuring that their reduction in hours or matters is potentially counterbalanced by an increased risk that the attorney’s practice skills will erode when practicing fewer hours or on an inconsistent basis.
Carriers will also evaluate the number of support staff you have compared to your firm’s annual revenue and case volume to determine if the number of attorneys in the firm is appropriate for the level of business handled. Firms out of balance will see pricing adjusted accordingly.
A firm’s location will always have an impact on the cost of a policy. Rates can vary significantly from state to state as they reflect the insurance company’s assessment of the litigiousness and cost of handling losses in a given jurisdiction.
In larger states, there may also be rate differences by county, or rural vs. urban influences on the cost of claims. If claims activity is historically high in a particular area, that location will be rated higher for risk, resulting in a higher premium. Area of Practice rates can also vary by state.
Further, insurance rates can change annually as more claims are filed and the insurance carrier gets a better snapshot of the risks associated with the location and area of practice. Unfortunately then, your premium might increase from one year to the next even if you have not made an error or had a claim filed against you, simply because of the number of claims your carrier experienced in your state the prior year.
The underlying costs of handling and resolving claims--including attorneys’ fees charged by insurance defense firms in the state--are also a factor. These costs and experience can vary so widely that a firm in a highly litigious state may pay twice as much as an attorney with a very similar practice working in a state considered to be far less litigious.
The third significant factor used to determine the premium is in many ways the most influential: the make-up of a firm’s practice areas.
Legal malpractice insurance carriers use years of historical claims data to determine the risks presented by various areas of practice. Risk is determined by the nature of the practice and/or historical claim history for that type of practice. Each area of practice has a specific rating modifier determined by the risk associated with it. Similar to the rating modifiers for location, the riskier the AOP, the higher the modifier. A higher modifier will result in higher premiums.
When considering the risk presented by any particular area of practice, carriers look at both frequency and severity: how often lawyers practicing in those areas have claims brought against them (or how often mistakes tend to occur); and how big the stakes are when a claim is made (how much money is usually at stake in the representations they undertake).
Practice areas with a high frequency of high-cost claims get the highest rate and so on down the line, with low-frequency/low-severity areas being the least expensive to insure. For example, criminal defense and workers' compensation both have lower expected frequency and severity and will be rated at a discounted rate. On the other end of the spectrum, the plaintiff’s personal injury and real estate both have higher expected frequency and severity of loss and therefore will be rated higher.
The low end of the risk spectrum includes most areas of defense-related work including criminal defense, insurance defense, and corporate or commercial litigation defense. Also included is alternative dispute resolution and workers' compensation services. Claims arising from these practice areas typically have low frequency and low severity resulting in a lower expected loss cost, leading to rate discount factors ranging from 25% to 50%.
Moderate risk areas of practice include bankruptcy, civil rights or discrimination, family law, commercial or corporate plaintiff services, and immigration. While these areas of practice can have high stakes for the covered attorney’s clients, the cost to defend claims in these areas is generally moderate and controlled, and claim frequency is neither significantly high nor low.
High-risk areas of practice include real estate; plaintiff’s personal injury; and wills, trusts, and estates; with patent, mass tort, product liability litigation, and securities law viewed as the riskiest of all. Highly complex litigation practice also presents severity risk because of the high cost to litigate the “case within the (malpractice) case” when defending a claim. The primary driver of risk in these categories is their above-average claim size. Firms practicing in these practice areas can see rates 50-150% higher than firms practicing in the low to moderate practice areas.
Companies writing lawyers malpractice insurance establish their own rating formulas including how they will differentiate by area of practice. That means premiums can be different from insured to insured depending on the firms’ practice mix, even if the firms are the same size.
For example, if you are a solo practitioner providing only criminal and other defense-related services and want to purchase a $1,000,000 limit policy, you might pay a premium of $1,500, while another solo down the street specializing in real estate might pay closer to $4,000. Note, though, that practicing in many different or unrelated areas of practice, even if each is generally considered to be lower risk, can be riskier in the aggregate.
The less focused a firm, the more it appears that the attorneys may be dabbling in areas where they may have little to no experience, causing an increase in the likelihood of a claim. Sometimes, though, having a mix is helpful when it is appropriately balanced between a few high and low-risk areas. For example, a solo practitioner who practices 100% real estate will be considered a significantly higher risk than another solo practitioner who practices 50% real estate and 50% criminal defense.
Carriers analyze not only the risk the individual law firms they cover present, they also consider how much risk they themselves are carrying in their own books of business to make decisions about who and what they are willing to cover year to year.
For instance, many carriers have tight internal restrictions on work related to intellectual property, securities, and environmental law, and so may decline your application for insurance if you regularly handle such matters. Or they might just set an extra-high premium price to account for the increased risk they are taking on if they do choose to insure you.
Insurers also consider various individual characteristics of a particular firm as well as attorneys’ individual experiences and history when setting prices. They gather this information primarily from your answers on their yearly application. These factors include claims history, practice management choices, industry rating structures, choices about limits and deductibles, and your particular insurance coverage history.
As with any type of insurance, lawyers malpractice insurance underwriters consider an applicant’s loss history when determining premium price. If you experience a costly claim that leads to a large payout by your carrier, you may very well see an increase in your premium going forward--and most carriers do have some specified loss threshold at which they will not renew a firm or offer terms on a new application.
At the same time, legal malpractice insurance carriers recognize that all claims are not created equal. Unlike auto or homeowners insurance where a reported claim is typically the result of an accident or property damage, professional liability damages usually are unknown at the time a claim is first reported. If a claim is reported but nothing is paid out, it likely will not trigger a premium increase.
Indeed, most carriers appreciate when you report potential claims so that there is time for them to intervene early and potentially keep losses low, or avoid them together. Moreover, when insurers are made aware of potential claims, their underwriting can be more accurate, which leads to better pricing for everyone.
Many lawyers don’t seem to realize how much their general practice management systems and procedures factor into their premium calculation. But a quick look at any legal malpractice insurance application reveals the actions and systems insurers feel make the most difference in avoiding the most common mistakes.
For example, because missed deadlines are one of the most common errors leading to claims, every application asks about what type of calendaring system a firm has in place. Along these same lines, carriers want to know if you regularly use engagement and disengagement letters—which are helpful in resolving disputes before they blossom into claims—and how often you sue clients for unpaid fees, because such actions almost invariably trigger malpractice claims as defense tactics.
Insurance carriers often reward good risk management with a reduction in premium, which is a win/win for an insured law firm: the firm saves some money on its premium and significantly reduces the likelihood it will face a malpractice suit.
Step rating is an industry-wide standard of yearly premium increases reflecting the corresponding increase in risk associated with each additional year an attorney is initially in practice, or for each of the first several years, an attorney is covered by that insurer. Because legal malpractice insurance policies are, in essence, covering every representation the attorney has undertaken prior to any given policy’s inception, every year in practice expands that attorney’s potential pool of claims risk.
Thus, at the inception of a law firm's first year in practice, the insurance carrier has no risk or exposure because the firm has not offered any services in the past. But, for each following yearly renewal, the insurance carrier assumes more risk as the coverage now relates back to all of the work the lawyer performed leading up to the next policy’s start date. Actuarial data shows that this yearly increase in risk is statistically significant through only the first five years of coverage, and on a declining basis. Consequently, while your premium rate will go up each of those first five years of coverage, the step-up will be smaller each time, until the firm is considered mature after the five-year mark.
To illustrate: a start-up firm might see a 40% step-up in rate from year one to year two, a 25% increase going into year three, all the way down to only 6% for the year five premium.
In the United States, most legal malpractice insurance is distributed, or offered for sale, through agency relationships. This means that the company a purchaser deals with is often not the actual insurer or “carrier” itself, but rather someone representing the insurer as an agent or contracted seller. For example, Protexure Insurance Agency Inc. is an insurance agency providing coverage through an insurance carrier. Each layer of the distribution chain can add to your ultimate out-of-pocket cost.
Many legal malpractice insurance brokers tack on additional fees to the carrier’s calculated policy premium. Such fees may be avoided by working with an online-only provider. Also, premium payment and financing options can increase your ultimate cost: paying in one lump sum payment avoids interest or finance charges that may be assessed on monthly or quarterly payment schedules.
When it comes to insurance, the premium is directly correlated to the limits and policy additions you select (i.e. the “amount” of insurance purchased). The lower the policy limit you choose, the lower the premium will be. The chosen deductible will also impact the premium, but in an inverse relationship: the higher the deductible, the lower the premium will be.
The type or function of the deductible you choose will also affect out-of-pocket premium cost. An aggregate deductible (which is a gross deductible that caps out of pocket expenses regardless of the number of claims reported during the policy period) is more expensive than a per claim deductible (which applies to both defense expenses and indemnification for each claim made and reported during the policy period), adding usually around 5% to your base premium.
First Dollar Defense deductibles are even more costly, adding about 10% to your base premium. This kind of deductible applies only to the damages—or indemnification—portion of coverage, meaning insureds pay out of pocket only in the event they are required to pay actual damages (in the form of judgment or settlement), while the carrier pays all other defense expenses. This higher price option might be worth it if your practice involves complicated representations that would be challenging and time-consuming to defend in a malpractice action.
Because claims-made insurance is taking on the risk of work you have done in the past, if you have carried insurance continuously and without any gap throughout your preceding years of practice, for any yearly renewal, an underwriter reviewing your application can feel more comfortable than another underwriter before they has assessed the risks of the work you already performed in those prior years. This is true even when the coverage has come from more than one carrier. This translates into better premium pricing for the purchaser because they can more accurately calculate the risk you pose to them.
If you switch carriers without a gap in coverage, your earlier policies will speak to work done before the new date through mechanisms like extended reporting periods and tail coverage. Or, the new carrier will agree to accept your original inception date from the prior carrier. But if you have a gap in coverage, your new carrier will essentially treat you as having started practicing on the inception date of the policy and will not cover claims arising from work performed before that retroactive date, even when the claim is made against you during the new policy’s in-force period.
Understanding what goes into the calculation of premium can help you figure out how to save on the cost of legal malpractice insurance.
Shopping around for a new insurance provider every once in a while can be helpful in this regard, as carriers’ pricing can change as their experience in a location or a general book of business changes. Likewise, if you have significant changes in your practice, you might benefit by having a different carrier give you a new review. One advantage of starting with a new carrier is that you could be treated as a first-year attorney for step-rating purposes, which could mean a slightly lower premium in your first years with the new carrier.
Another way to potentially save on premium is to search for a carrier with a book of business that generally mirrors your own firm’s. Small firms and solo practitioners insured by insurance companies also ensure large firms are absorbing some of the large firms’ loss experience by paying premium rates based on the insurer’s overall claims experience, which includes the severity and frequency of those large firms’ claims experience. Unless a smaller firm’s areas of practice are mostly high risk, it may end up paying a higher premium than it would otherwise if purchasing from a carrier whose book is made up of mostly lower volume--and thus lower risk--practices. Conversely, if you are a smaller firm buying insurance from a legal malpractice insurer that specializes in covering smaller firms, your premium price is likely to be smaller, too, reflecting the lower risk of that insurer’s overall book of business.
Finally, it is important to remember to compare the premium cost to the full value of what you are purchasing in order to calculate the true “cost” of your insurance. There is a difference between cost and affordability. The actual out-of-pocket price of paying your yearly premium is a cost. But its actual effect on your bottom line needs to take into account what an uncovered loss could do to your ability to continue in practice or meet your personal financial obligations in the future: i.e. affordability. They are not the same.
Like buying shoes, buying lawyers' malpractice insurance is something every lawyer must do. And, like with shoes, every lawyer wants to find insurance that fits them properly and fits their budget, while providing value for money. The information in this primer should help any lawyer accomplish that goal confidently.