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M&A and prior acts: Considerations for the design firm

By Dan Buelow | February 12, 2018

There are many reasons a design firm may decide to buy, sell or merge its practice with another firm; however, there are only a few available options when it comes to addressing the prior act exposures of the firm being acquired. This blog will provide an overview of the limited but critical issues to consider when addressing the professional liability (PL) prior acts exposures when an Architects and Engineers (A&E) firm merges with or is acquired by another firm.

Architect measuring blueprints with a protractor and a ruler

While there are a host of legal and accounting issues to consider with any M&A, I’ll only focus on the professional liability exposures and related insurance considerations. I’ll also note that even if you’re considering an asset-only purchase – you still must address the prior acts exposures as outlined in this post. If I can leave you with one take-away in all of this it’s this: Involve your insurance broker sooner rather than later so they can assist in providing you with all of your options and potential costs well in advance of closing any deal.

There are really only three options any A&E firm has when it comes to addressing the prior acts of the firm being acquired:

  1. Purchase an extended reporting period (ERP)
  2.  Add the selling firm to the acquiring firm’s PL policy
  3. Take a hybrid approach

1. Purchase an extended reporting period policy

The firm being acquired, the seller, typically will have the option to purchase an extended reporting period policy also known as ERP or a tail policy. For the purposes of this blog, I’ll refer to it as an ERP. Often the terms of the available ERP are built into your professional liability practice policy, including the premium that will be charged to purchase this policy. The ERP will extend the in-force PL practice policy terms currently in place at the time a tail policy is purchased. Both the cost and the available term of an ERP can and will vary from carrier to carrier. The available term will also vary from carrier to carrier, with some PL policies containing no ERP options at all, while others may offer a maximum ERP term of only three to five years.

Note: If your PL practice policy doesn’t contain an ERP option, you should ask your broker to request this option be added to your policy by endorsement. There should be no additional cost for adding an ERP option to a PL practice policy.

Cost for the available ERP options will also vary and is typically a percentage of the annual practice policy premium currently in force at the time the ERP is purchased. For example:

  1.  12 month ERP = 100% of annual premium
  2.  36 month ERP = 250% of annual premium
  3.  60 month ERP = 300% of annual premium

A premium charge of 300% of a firm’s current premium can be a significant expense that needs to be considered early in the negotiation process of any merger or acquisition. This is especially true given the ERP premium is fully earned and due in full when the ERP is bound. Nine issues to consider when purchasing an ERP policy are:

  1. An ERP is only available for a firm that’s ceasing to do business, or, if and when a firm is acquired by and/or merges with another firm.
  2. An ERP only extends the reporting period – not the policy period. There’s no coverage for work done after inception of the ERP, only for prior acts.
  3. The in-force practice policy terms and conditions at the time an ERP incepts, (including the available limits of coverage, deductible and retro date), would apply to any claims made during the extending reporting period.
  4. The available limits of an ERP can be eroded by any new claims made during the extended reporting period – as well as any open claims or pre-claims that had been previously reported to the original policy that’s being extended.
  5. If, for example, you bought a three-year ERP and the limits were eroded in year one of this three year extended policy period by any claim(s) 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.
  6. Limits typically cannot be increased or reinstated during the ERP policy period.
  7. You must decide up front what ERP option you want when you purchase it (i.e., one-, two- or three-year ERP), and you often may not get the option extend or renew an ERP.
  8. You should confirm if you have any contractual obligations that require you to continue your coverage for a specific period after substantial completion of any specific projects when considering the ERP option you might require.
  9. It’s a good idea to survey your staff on any claims or potential claims that should be reported to your PL practice policy prior to purchasing an ERP.

Note: If you’re purchasing an ERP and have open projects that would be assumed midstream by the buyer, you will want to clearly list those projects so they can be covered under the buyer’s PL practice policy – or excluded. This should be done by contract in the selling agreement between both parties – as well as by endorsement in both the seller’s and buyer’s professional liability practice policies.

Pros and cons of purchasing an ERP

The advantage of purchasing an ERP for a firm ceasing to do business is that it’s typically the only available option a firm will have to extend coverage when it closes its business. For the firm that’s selling and/or merging with another firm, there may be more attractive options as noted below. 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 PL practice policy. If a claim is made against the seller for any work that was done during the covered period of the in-force ERP, then the claim would be handled – up to the available limits and per the terms of the ERP. The buyer’s PL policy, and deductible, should not be exposed.

Note: If an ERP is purchased by the seller, it’s a good idea for the buyer to request an endorsement to be added to their PL practice policy. This will provide them a defense in the event they’re dragged into a claim made against the seller’s prior act exposures – regardless of whether it’s intended to be covered by the seller’s ERP.

The downside of purchasing an ERP, in addition to the significant up front cost, is that it may not provide the necessary coverage for the prior act exposures of the firm 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 extended reporting period of time – nor (typically) can the ERP be renewed. Considering the average statute of limitations and repose in the U.S. is over 10 years, this can be quite concerning for any current or former employees 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, this is something you most likely would want to avoid.

For these reasons, I typically would recommend adding the selling firm to the acquiring firm’s PL practice policy if and whenever possible versus purchasing an ERP. However,  there are certain pros and cons associated with this option that should be considered – along with possible hybrid options.

2. Add the selling firm to the acquiring firm’s professional liability policy

The acquiring firm can often add a firm to their professional liability policy to cover any prior act exposures of that firm. They would add the selling firm by endorsement – and typically any Additional Named Insureds currently listed on that firm’s in-force PL practice policy, as Additional Named Insured(s) to the acquiring firm’s PL practice policy. You should work with your broker to confirm this along with how much it would cost – and the possible impact on your PL practice policy going forward. Coverage and cost will depend on the risk profile of the firm being acquired. The Professional liability underwriter of the acquiring firm will generally require a copy of the in-force PL policy of the firm being acquired, along with its most recent application and five year loss history to determine what the cost would be to add the firm as an Additional Named Insured.

Pros and cons

The upside of adding the selling firm to the buying firm’s PL practice policy is that coverage for the seller’s prior acts will remain in place typically much longer than any available ERP – and, hopefully, beyond any statue of limitations and repose. Adding the selling firm to the buying firm’s PL practice policy is a significant benefit to all former and current staff of the selling firm in that they can rest assured their prior acts exposures will be covered by insurance for as long as the acquiring firm continues to purchase PL insurance (and continues to list the acquired firm on their PL practice policy as an Additional Named Insured). This arguably benefits the acquiring firm as well in that it will effectively mitigate the potential business distractions and personal risks of all the employees that will be joining their firm.

The downside, of course, is the buyer would be exposed to the seller’s prior act exposures. The buyer would likely incur out-of-pocket deductible expenses for any claims made against the acquired firm’s prior acts, which could be significant given the buyer may carry a higher deductible than the seller. In addition, the buyer’s future insurance costs could be impacted if these claims adversely impacted their loss ratio.

3. Hybrid approach

The objective of a hybrid approach would be to consider all viable options in an attempt to address the seller’s concerns of relying on a tail policy that would expire well before the statute of limitations and the buyer’s concern of covering the seller’s prior act exposures. As noted, it’s very important to work with your broker early in the process to explore all your options. Hopefully, your broker is a specialist in professional liability and has a good working relationship with the A&E marketplace to ensure you get the best available options. Carriers will vary in what they will or won’t do when it comes to covering the prior act exposures of another firm and what they might charge for these “hybrid” options.

4 hybrid options to consider:

  1. Rather than purchasing an ERP, add the seller to the buyer’s PL policy via an endorsement stipulating the seller’s current (and lower) deductible.
  2. Endorse the buyer’s PL policy to be excess of the seller’s extended reporting period.
  3. Endorse the buyer’s PL policy to drop down and cover the seller’s prior acts exposures at the expiration of any ERP.
  4. Add the selling firm to the buying firm’s PL policy and execute a side agreement to escrow the savings of not purchasing a tail policy to cover any premium and/or out-of-pocket deductible expenses the buyer may incur from covering the seller’s prior acts.

Issues to consider

These additional hybrid options should be considered and priced out. Often we find that adding the selling firm to the buyer’s PL policy makes the most sense for the reasons stated – and it’s often the most affordable. It’s always a good idea for the buyer to carefully review the seller’s loss history as part of their due diligence. If the seller’s loss history and/or prior acts are of any concern, a hybrid option including those listed above might be a viable alternative to adding seller’s firm to the buyer’s policy outright.

One experienced underwriter advised that in these situations it’s important to consider the past, present and future. Past is prior acts, present is projects not yet completed and future addresses whether the newly acquired firm will still provide services under the former name in the future? He goes on to say that sometimes it makes the most sense for the acquired firm to take care of past acts; however, there are some occasions in which it will be more prudent for the acquiring entity to take them on.

Whatever you decide, you’ll want to draft the appropriate endorsements (along with any necessary side agreements) and secure the necessary certificates – every year – to evidence that coverage is in place as agreed.

In closing

When it comes to any merger or acquisition the best advice I 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 provide invaluable guidance on your buy sale agreements and will work to ensure that whatever insurance solution is agreed to as respects covering prior acts exposures, it is not a contractual guarantee for blanket coverage for any and all claims. That ultimate will be determined by the terms and conditions of the in-force insurance coverage. When it comes to insurance and addressing the prior acts exposures to be covered, markets and underwriters can and will vary in their approach and flexibility as to available ERP options – and market conditions can and will change over time. By working closely with a broker that has expertise in managing A&E professional liability risk, has strong carrier relationships 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 — before signing the dotted line!

About the Author

Dan Buelow
Managing Director, Architects & Engineers practice

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