DAN BUELOW: Hello, and welcome to Talk to Me About A&E. I'm Dan Buelow, managing director for Willis A&E. And our topic today is on what design firms should consider if they are involved in buying or selling a firm when it comes to addressing their professional liability exposures and insurance coverage options.
We've seen a real uptick in M&A activity in the design sector over recent years, which has been driven primarily by the influx of private equity into this segment. Private equity is in fact buying up businesses across the United States at an incredible rate. And most people would be surprised to learn how pervasive private equity really is in this country.
If you considered each of the three largest private equity firms portfolios of companies, they would be the third, fourth, and fifth largest employers in America after only Walmart and Amazon. There has been a lot written on the topic of private equity. And the primary concerns often raised as respects the private equity model is that private equity firms tend to buy and hold companies only for a short period of time, typically, only a few years or so. And they tend to load up the companies they buy with a lot of debt.
Given this, my concern is as it pertains to the design profession is the question of these private equity firms will be making the same level of investments in quality controls and long-term risk management initiatives that design firms have traditionally made and arguably need to make. Another concern is that private equity groups themselves often are serviced by brokerage teams that are not specialists in A&E. When a private equity firm acquires an engineering firm, they will often roll that engineering firm into the private equity's master insurance program that will often be covering a wide range of businesses, some of which may very well not be designed professional firms.
This master program is managed by the private equity broker team who, again, are typically not specialists in A&E. This, I believe, is problematic for all concerned, including the private equity group when it comes to ensuring they not only have the right coverage in place for the unique and often complex professional liability-related risks of an engineering firm, but also quality risk management support specific to ongoing education for the design firm staff, contract review and negotiation support as well as claims advocacy. All of which is very important to mitigating risks to costly claims and client disputes.
WTW is unique, in that we are made up of what we refer to as industry verticals that are highly specialized, allowing a WTW team representing a private equity group to bring in the WTW A&E team to help them manage these unique A&E-related risks. It's important to note that not all private equity groups are the same, and also that some design firms have used private equity to fund their expansion objectives and have been successful in retaining the specialty brokered relationships as well as their commitment to quality controls and risk management practices.
Regardless of the model, my advice is that the firm being acquired and the private equity firm discuss up front as to how these important insurance and risk management considerations will be addressed in the future and to make certain have the right A&E insurance specialists on your team. So that's a recap on some issues to consider specific to M&A and private equity. Now, we will dig into what every firm needs to address on both sides of a buy-sell transaction regardless if private equity is involved or not when it comes to addressing your professional liability exposures, in particular, prior acts and insurance coverage options.
And to help me with this segment of our discussion, I have brought in a very special guest with over 40 years insuring architects and engineering firms, Mr. Doug Hamilton. Hello, Doug.
DOUG HAMILTON: Hi, Dan. How are you doing?
DAN BUELOW: Doug is vice president with Allied Worlds A&E division. Doug tell us a little bit about yourself and your background in A&E.
DOUG HAMILTON: Quite a bit of background in professional liability D&O, E&O, architects, engineers, so kind of a mixed bag. I worked for a number of companies, been with Allied Worlds for the last 10 years and helped to set up their primary A&E contractor professional liability program.
DAN BUELOW: And also, quite a stint with Lexington AIG's, a A&E program as well.
DOUG HAMILTON: Yeah, and a little involvement with environmental issues along the way, but 25 years with AIG, yeah.
DAN BUELOW: So Doug has incredible experience. And the Willis A&E team and I have always gone to Doug and always had the pleasure of working with him. But we go to Doug when we have some crazy complex risk or issue. He's usually on our top of our list to talk through some of these things that we get to.
So Doug, I mentioned that we've seen a real uptick in M&A activity. In your 40-plus years of experience in this niche of A&E, have you ever seen this level of M&A activity that we are experiencing?
DOUG HAMILTON: No, not the level we have seen. And I think that has to do a lot with the demographics and people retiring. But the other thing which I do find interesting is the firms that I talk to that are looking for acquiring entities say they can't compete with private equity. So there's quite a divergence there between firms buying firms and private equity buying the firms.
DAN BUELOW: Great point. And then when you're underwriting and assessing a design firm's risk profile, is it fair to say you may have a different view of those firms that have grown organically versus through M&A, regardless of if it's private equity or not?
DOUG HAMILTON: Yeah, we are always concerned over the relationships with the assets that have been sold, how they transfer to the new firm, how they do manage risk as a part of the process, and how they deal with the relationships, which is an underlying very subjective issue that needs to be dealt with.
DAN BUELOW: There really are challenges, aren't there? Whenever there is a merging of two businesses, differing areas of practices, people, cultures, and systems, as you noted, and even geography, all of which can create risk and heightened exposures to claims. As an underwriter, how do you assess the quality of the management of a firm to address these types of risks?
DOUG HAMILTON: First of all, it's important we do try to look at contracts for the sale of the firm to assess that. But I think more importantly is what's the capability of the staff of the purchasing firm that's our insured, how do they evaluate risk, what was their due diligence process, and where do they ultimately see the firm a year or two down the road? In other words, how long will that take to merge that new firm into their organization and be one, so to speak?
DAN BUELOW: And does it really matter if the sale is an asset-only purchase when it comes to addressing the prior acts exposure because we know it's a stock purchase or an asset only? But I tend to see primarily asset-only purchases.
DOUG HAMILTON: I think that's very accurate. Most of our sales, we do see our asset only. I don't think that takes you away from prior liability. You do have liability from work, generally speaking, under a contract that is sold. Sometimes they try to exclude that and only go forward, but that's not generally what I see today.
It's any work that was done under contract that was sold will go forward with the sale of the contract. And I do believe that prior liabilities can creep up to the firm. I've seen it happen before, where arguably at least successor in interest, this is really the new firm, they have been sued for completed prior work of the firm that sold them the assets.
DAN BUELOW: So when there's an acquisition, I would say that there really are three options if I tried to really boil it down, if you will, to consider when it comes to addressing the prior acts of the firm being acquired. And the first is to purchase an Extended Reporting Period or ERP, also known as a tail policy. The second would be adding the firm that is selling their business to the acquiring firm's professional liability policy. And the third, I would say, is hybrid approach or some additional issues to consider that I want to go through.
So I want to go through these three points, if you will, or considerations with Doug beginning with the ERP. So Doug, what is a tail policy?
DOUG HAMILTON: Extended reporting period to report claims up to a given date. It does not cover new incidents, new negligent act, error, or omission that would occur after that date, only up until that date for a limited period of time. One, three, or five years is generally the maximum you can get.
DAN BUELOW: So I have a number of bullets here in some of my notes. I'm looking at this. Let's walk through these a little bit and just add any comments to this, OK? So when you're thinking about an ERP, it really is only available for a firm that's ceasing to do business or when a firm is acquired by and/or merges with another firm, right?
DOUG HAMILTON: Correct.
DAN BUELOW: And an ERP only extends the reporting period, and this you noted, not the policy period. And that's really important, right? There's no coverage for work done after the inception of that ERP, only for the prior acts.
DOUG HAMILTON: That's correct.
DAN BUELOW: And that's why it really is important not to incept that ERP until you know you've got your deal closed and never cancel any insurance until you're sure that you have this all buttoned up pretty good, right?
DOUG HAMILTON: Yeah, and I think you got to-- you should always talk to your carrier, what's available, what are they willing to provide because ultimately, those assets that were purchased will need to be covered going forward or the purchaser's coverage won't sit excess of that tail coverage.
DOUG HAMILTON: Yeah, and I think you got to-- you should always talk to your carrier, what's available, what are they willing to provide because ultimately, those assets that were purchased will need to be covered going forward or the purchaser's coverage won't sit excess of that tail coverage.
DAN BUELOW: That's a great point. It really is. Involving your carrier and your partners early on in this process is, again, something we're going to keep coming back to. So another point here is in-force practice policy terms and conditions at the time that an ERP incepts, including the available limits of coverage, the deductible and the retro date, will apply to any claims made during the extended reporting period.
DOUG HAMILTON: Correct. And as you point out, limits that are used up because of prior losses, have been impaired because of prior losses would apply to the tail coverage going forward as well.
DAN BUELOW: Which is a very important point, right? So the available limits of an ERP can be eroded by any new claims made during that extended reporting period as well as any open claims or pre-claim matters that had been previously reported where that policy has been triggered, right?
DOUG HAMILTON: Yeah. On the carrier side, we would not reinstate additional limits at the purchase of the extended reporting period as a matter of practice.
DAN BUELOW: Yeah, and that's pretty consistent. While some carriers will vary here and there, I think that's pretty consistent, is that if you are going to purchase a tail policy, you're going to have an option. And it'll depend on the carrier, but let's say it's three or five years essentially. If you pick that three, you're not going to be able to extend it to five most likely after that third year.
DOUG HAMILTON: Correct, yeah.
DAN BUELOW: And if, for example, you bought a three-year ERP and the limits were eroded in year 1 of this three-year extended policy period by any claims made during the extended reporting period and/or by any open claims or pre-claims that had been made against the policy that's being extended, then you would have no more available limits of coverage under this policy.
DOUG HAMILTON: That is correct. And unlikely, you would get-- never say never, but unlikely, you'd get a carrier to increase those limits.
DAN BUELOW: Right, especially if there's been a bunch of claims on it, right?
DOUG HAMILTON: Yeah.
DAN BUELOW: So you must decide up front, again, what you want for that term. And you should confirm if you have any contractual obligations that require you to continue your coverage for a specific period after substantial completion, which is most the case of your contract. Usually, your clients are looking for-- and that's why we don't like these contracts that read that you'll-- evidence coverage for-- and keep coverage in place for 10 years after substantial completion. I think that's a hard one to meet.
DOUG HAMILTON: Yeah, meet the criteria to satisfy the contract yeah.
DAN BUELOW: Yeah, and it's a good idea as to prior to any expiration of your firm's PL coverage to survey your staff on any claims or potential claims that should be reported to your professional liability practice policy prior to the purchasing of that ERP, right? You are extending that policy which does give you that extension. But it is just a good practice in general, isn't it? Prior to every renewal.
DOUG HAMILTON: I think it's a good practice anyway. It's not just with regard to this. I think if there's one issue that is out there about-- is reporting of claims in prior knowledge. That's an underlying issue across other aspects of the coverage other than just buying a tail coverage. Surveying your people, is it a critical factor? I think appropriate risk management practices.
DAN BUELOW: Absolutely, OK. And so to recap the pros and cons of purchasing an ERP is the advantage of purchasing this ERP for a firm ceasing to do business is not being purchased by another firm is that it's typically the only available option a firm that will have to extend coverage when it closes its business. And so that certainly is a real advantage. For the buyer, the upside is that when the seller purchases a tail policy, the prior act exposures of the seller will not expose the buyer's professional liability practice policy.
And if a claim is made against the seller for any work that was done during the covered period of time in force ERP, then the claim would be handled up to the available limits and per the terms of the ERP. And the buyer's practice policy and deductible should not be exposed, right?
DOUG HAMILTON: And it minimizes the ultimate exposure, correct.
DAN BUELOW: Again, we're addressing the insurance aspects of this. You really do need good counsel certainly with that buy-sell agreement and ideally to coordinate that with your broker and your carrier to make sure that-- because you don't want the practice policy exposed unless that's what your intention is. And so it's good to have it, your buy-sell agreement. And as an underwriter, you say you're looking at that agreement often.
DOUG HAMILTON: Yeah, and I think a valid point, whether you're buying assets or whether you're buying equity stock, buying a tail coverage is favorable to the purchaser and is looked positively by the carriers to protect their current policy.
DAN BUELOW: So the big downside of purchasing a tail policy or an ERP, in addition to the significant upfront cost, is that it may not provide the necessary coverage for the prior act exposures of the firms that's being acquired. As noted, the typical ERP offers up to a maximum term of three to five years. And limits cannot be reinstated over this period of time, nor typically can the ERP be renewed as mentioned by Doug.
And so considering the average statute of limitation reposed in the United States over all the states really is over 10 years on average, this can be quite concerning for any current or former employee who provided any services on behalf of the selling firm, given they would be personally exposed to any claims made after the term of the ERP. Assuming you might consider these staff members as part of your corporate family and the distraction to your business in the event that they are dragged into a claim, this is something you would most likely want to avoid.
DOUG HAMILTON: Yeah, I would agree. I haven't seen personal liability come up a lot, but it certainly is a basis for actions to be pursued.
DAN BUELOW: Right, you do have that personal liability. I don't disagree that you don't see a lot of brought in. But there is a concern about, hey, I can only get a five-year tail. OK, hopefully, I'm not going to be out of meeting my contractual requirements. And that was a-- we touched on that. But also, you're potentially bear.
And lastly, as I referenced, is the cost is significant. And Doug, what we've seen, again, is-- and not every policy will list this. Some policies are going to list these right into the policy. Others are silent. So you may want to endorse your policy to go back and get something in there.
But typically, you'll see that it's going to be for 12 months, 100% of the annual premium that is expiring on that policy. 36 months would be 250%, and 60 months is 300%. So it can vary, but it's a lot of money. And it's fully earned, and it's upfront, right?
DOUG HAMILTON: Yeah, and I would suggest that you talk to your broker to get your insurance carrier to commit to that in writing. At the time of the need for the tail, depending on individual circumstances, may be very difficult to get the three or five-year term.
DAN BUELOW: So that's everything and more than you might want to know about the ERP option, which brings us to the second option that I raised here. And that is adding the selling firm to the acquiring firms professional liability policy. And because of those downsides we reviewed of an ERP, the limitations if you will, we'll typically recommend adding the selling firm to the acquiring firm's professional liability practice policy as an additional named insured covering that firms prior acts if and whenever possible versus purchasing an ERP.
And again, because in this case, it's important to note that the A&E PL insurance carriers can and will vary on what they may offer for this and at what price. They may very well charge additional premium. So again, I can't stress enough the importance of reviewing all of this with your broker and your carrier partners as early in the process as possible.
DOUG HAMILTON: Yeah, and as a matter of practice, obviously if you're buying the company and the equity and the stock of the company, we would name them as a named insured under our policy. Asset purchase is a little bit different, in that you aren't buying the company. You're buying the contracts.
So some markets, as we do, will schedule those contracts that are being bought. And we will cover liability arising out of those scheduled contracts and cover the purchaser for their liability arising out of the purchase of those contracts. Again, you can get drawn into litigation because you bought the contracts, even though in theory, it may have been work done by the seller prior to the purchase date.
DAN BUELOW: Right. And the upside of this option of adding them as additional named insured on the policy is that the acquired firm would have indefinite professional liability coverage into the future as long as the purchasing firm continues to purchase professional liability coverage, which you would assume is more than a tail policy, more than three to five years. So that's the real advantage.
The downside is that the purchasing firm, as you referenced there, Doug, is will be taking on the prior acts, the liabilities of the acquired firm, and thus exposing its balance sheet, if you will, to potential claims and deductible expense, which are derived from services that were rendered prior to the acquisition. And we've seen it where firms have bought other firms, and they've been tagged pretty good by that, right?
DOUG HAMILTON: It certainly is a possibility. And as you and I talked about before, maybe a set aside of dollar value to address contingencies that come up, that kind of thing is generally appropriate to try to address or minimize at least those kinds of issues.
DAN BUELOW: So Doug, if you were to consider adding this other entity onto your insurance policy, your policy, as an underwriter, you're going to want to look at certain things. And I would think that as anyone that's going to be doing their due diligence, would want to have this information anyway. But you're going to need, won't you? You're going to want to get a copy of the professional liability application that was on the current policy as well as-- what would you look for loss information?
DOUG HAMILTON: At minimum, five years. Maybe more, depending on what the nature of their services are, and possibly claim descriptions. I think we would want some background information on the due diligence that went through to survey people to find out what liabilities were transferred.
I think that's kind of the other issue, is it's critical that we have an understanding of what liabilities may be excluded. Are there claims that in particular aren't covered by the purchase agreement, that kind of thing? So we would want to look at the contract, to get back to my earlier comment.
DAN BUELOW: All right, makes a lot of sense. So that brings us to option 3, which I'm referring to as the hybrid approach or additional considerations. Again, you need to confirm all this with your current carrier. And you want to run this through and discuss this. And we would always encourage our clients to do this with us early in the process.
So we understand that there are confidential issues, and it's a sensitive time when everybody's really looking at this as a prospective opportunity. And we've entered into NDAs, but the importance, though, is that you want to make an informed decision. The worst-case scenario and one we've seen is where we are left out of the loop. And the insured comes to us and they're looking for something that we cannot get them in the market, and/or it's going to cost everyone a lot more than they anticipated.
And so they didn't contemplate that in the transaction. So why not get all the facts up, gather it up with your partners early in the process, right?
DOUG HAMILTON: Yeah, it's very difficult to backtrack, so to speak, once you've gone down that road a little bit.
DAN BUELOW: Right. So if you're purchasing-- and here, I'm going to list off some of these considerations, issues to consider. So if you're purchasing a tail policy and have any open projects that would be assumed midstream by the buyer-- so you are buying this firm, and you're going to be taking on work and working on some projects after the inception of the ERP. And therefore, you may have exposures that are not covered by that ERP policy.
You will want to address this by identifying those projects that should be covered under the buyer's PL policy. And this should be done by contract in the selling and the buy-sell agreement as well as in by endorsement in both the seller and the buyer's professional liability policies. Best you can to use those endorsements to clarify what you want to achieve here, that there may be additional premium charges for this for sure if you're going to be taking on additional exposure. And you touched on that, Doug. It's just like you're going to have often, and you're going to want to essentially list those projects out, right?
DOUG HAMILTON: Yeah, that would be our preferred method, especially on asset purchase. So you know exactly what was being bought, what wasn't being bought.
DAN BUELOW: OK, and another consideration-- and we've seen some-- again, the hybrid approach here, if you will, is often the purchasing firm will have a substantially higher deductible or SIR, Self-Insured Retention, than the firm that they are acquiring. And given this, you may want to consider when adding the firm to the seller's PL policy that you do so at the seller's current and lower deductible. This is done. We've seen it done.
And there's some pros and cons to that including you know what the terms of that and what the carrier will offer. We've seen some really carriers vary on this. I don't know what your thoughts are on that, Doug.
DOUG HAMILTON: I don't know if there's a universal approach to that. I think most underwriters would be hesitant to lower a retention if they can help it.
DAN BUELOW: Yeah, I've seen it done, but yeah. Another important consideration when an ERP is purchased is what you should do if and when that ERP expires or those limits are eroded. You may or may not be able to get the purchasing firms PL carrier to agree to this by endorsement or do anything up front.
You should discuss this. And at the very least, monitor this closely and diary in your own system as the insured to approach your PL carrier when that firm that you've acquired ERP expires if you want to cover them, right? So again, this is kind of that hybrid like, look, it I'm not going to name you as additional named insured now.
But when that ERP expires, we've had luck going back to the care that they currently are working with at the time and saying, hey, this ERP expired. We want to name this as an additional named insured to the policy. And usually, we don't have too much pushback on that if we're-- unless there's claim issues or if it turns out. But the buying firm is going to be taking on potential exposure there. That's the downside.
Hopefully, after three, five years, you've got out of the woods, so to speak, when it comes to that liability. The upside that if something does come up, you don't have anyone within your corporate family there that's exposed to potential uninsured claims.
DOUG HAMILTON: And I would agree with you. The hope is three to five years down the road that things have worked through. Any issues, if there are issues, that they have worked through themselves, and everything is going smoothly going forward.
DAN BUELOW: So Doug, we've had some firms also agree not to have the selling firm pay the significant upfront costs for the ERP, and that they will add them to their professional liability policy as an additional named insured. But then they work out-- and I think you touched on this a little bit, is they say, well, rather than incur that 300 or more percent of that premium charge, we're going to take that money that you would have spent. And we're going to escrow that to cover any out-of-pocket claims that might happen.
And we've seen that as well. And that's kind of-- I think it makes sense to have that conversation. Again, you would need to be doing all that upfront before you're signing the dotted line to make sure you got all your ducks in a row for that. But we've achieved that.
DOUG HAMILTON: Yeah, and I think that really kind of applies more to the larger firms where there's more dollars involved. It makes more financial sense in that respect. But that is a very viable tool for certain situations.
DAN BUELOW: Right. And whatever you decide, you're going to want to draft the appropriate endorsements along with the necessary side agreements and secure the necessary certificates every year to evidence that the coverage is in place as agreed, right?
DOUG HAMILTON: Yes.
DAN BUELOW: So in closing on this discussion here, is when it comes to any mergers or acquisition, the best advice we can offer is to work closely with your legal, accounting, and insurance consultants as early in the process as possible. Each deal is unique, and both parties must do their due diligence. A good attorney will be able to help provide invaluable guidance on your buy-sell agreements and will work to ensure that whatever insurance solutions is agreed to as respects covering prior acts exposures is not a contractual guarantee for blanket coverage for any and all claims. So you got to be careful that wording, like any other contract.
But when it comes to insurance and addressing the prior acts exposures to be covered, markets and underwriters can and will vary. Not everybody's as nice as Doug in their approach and flexibility to available ERP options and market conditions. So you really want to get out in front of this early by working closely with your broker that has the expertise in managing A&E professional liability risk and strong carrier relations and can effectively advocate on your behalf. You should be able to obtain and determine the best available options for both parties so that a fully informed decision can be made, again, before signing the dotted line.
DOUG HAMILTON: I would agree. And I think, as you pointed out, communication and providing information in a timely fashion is really critical, and keep everybody aware of what's going on. And company side, let them review the documents and make the decision. And most companies will-- it's a fact of life. So you got to deal with it. And most carriers are very good about dealing with the situation.
DAN BUELOW: Thanks, Doug. Great point. And Doug, before I let you go, any final comments or words of wisdom for us.
DOUG HAMILTON: No, I think you've given plenty already. I had a couple here myself as I did, but no, I appreciate the opportunity. It's always a good subject to talk about and to get everybody kind of know where we sit and what the options are. And again, communicate. So appreciate the opportunity.
DAN BUELOW: Well, thanks, Doug. And I heard a rumor that you might be retiring, and you're going to be fishing full time starting here sometime in the near future. Is that true?
DOUG HAMILTON: I don't know about fishing full time, but that is true. The other part of it's true. And I would like to fish full time. So we'll see what happens.
DAN BUELOW: Well, Doug, it'll be a loss to the industry, that's for sure. You've been really a true advocate for the design profession for years. And so it's been a pleasure to work with you. So thank you for joining us, Doug.
DOUG HAMILTON: Me as well. And thank you very much. Again, appreciate the opportunity to talk.
DAN BUELOW: We covered a lot of information here. And you may want to refer to our Willis A&E technical briefs on this topic that can be found in the education center of our website at www.wtwae.com. On our site, you can also find all of our Talk To Me About A&E podcasts and webinars in addition to these technical briefs.
So I want to thank Doug Hamilton, vice president of Allied Worlds A&E division, again, for sharing his insights and expertise. Thanks again for joining us for another Talk To Me About A&E. I'm Dan Buelow, and I will talk to you soon.
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