What it means
The principle of indemnity is that insurance compensates for actual loss and no more, so a policyholder should not profit from a claim. That is why an indemnity settlement on an older asset reflects its depreciated value rather than the cost of a brand new replacement.
Policies that pay replacement cost instead are the exception and are priced accordingly. Professional indemnity, sometimes called errors and omissions cover, applies the same idea to services rather than property.
It responds when a client alleges that negligent advice, a design error or a missed deadline caused them financial harm, and it is compulsory for many regulated professions. Architects, accountants, surveyors, consultants and IT contractors all commonly carry it.
Almost all professional indemnity policies are written on a claims-made basis, which is the single most misunderstood feature of the product. Cover responds to claims notified during the policy period, regardless of when the work was done, so allowing a policy to lapse leaves past work unprotected.
The retroactive date on the schedule shows how far back the cover reaches. The commercial mechanics come down to the limit, the excess and the basis of aggregation.
A limit stated as each and every claim gives far more protection than the same figure stated in the aggregate for the year, and the excess is the amount the insured pays on every claim before the insurer contributes. Contracts with large clients frequently specify minimum limits, so cover becomes a condition of winning work.
The final nuance is that an indemnity policy pays defence costs, which are often the larger part of a claim. Many claims are eventually settled or dropped, but the legal work to reach that point can run into six figures.
That protection, rather than the damages themselves, is what many firms are actually buying.
In practice
Real-world examples.
Example
An architect is sued after a drainage design fails and the ground floor of a new house floods. Rectification is agreed at $180,000, and with a $10,000 excess the professional indemnity policy pays $170,000. The practice would not have survived the claim without cover.
Example
An accountancy firm bidding for a corporate client is told the contract requires at least $1,000,000 of professional indemnity cover. The firm increases its limit at a premium of $6,500 a year and wins a $240,000 engagement. Cover here is a cost of doing business rather than only a protection.
Example
A bakery's 12-year-old dough mixer is destroyed by a fire, and a replacement costs $90,000. Because the policy is written on an indemnity basis, the settlement reflects the machine's depreciated value of $38,000, leaving the owner $52,000 short. The following year the business switches to reinstatement cover.
Formula
Calculation
Insurer payment = The lower of (loss + defence costs) and the policy limit, minus the excess borne by the insured.
A design consultancy holds professional indemnity cover with a limit of $2,000,000 for each and every claim, inclusive of defence costs, an excess of $25,000 and an annual premium of $18,000. A client claims $410,000 for a specification error that required remedial work, and the legal defence costs come to $90,000, so the total claim is $410,000 + $90,000 = $500,000. Because $500,000 is below the $2,000,000 limit, the insurer pays $500,000 - $25,000 = $475,000 and the firm pays the $25,000 excess. That single recovery is more than 26 times the annual premium, since $475,000 / $18,000 is just over 26. Had the firm bought only a $250,000 limit to save money, the insurer would have paid $250,000 and the firm would have carried $500,000 - $250,000 = $250,000 of the claim plus the $25,000 excess, a total of $275,000.Case study
Seen in the real world.
Marlowe Surveying Partners is an illustrative, fictional firm of five surveyors used here to show how indemnity cover behaves in practice. It carried professional indemnity insurance with a $1,000,000 limit, a $20,000 excess and a premium of $14,500. A lender claimed that a valuation had been overstated and sought $340,000, and defending the claim over two years cost a further $110,000, giving a total of $340,000 + $110,000 = $450,000. The insurer paid $450,000 - $20,000 = $430,000, and the partners paid the excess.
Two details nearly cost the firm everything. Three years earlier the partners had left the policy lapsed for two months while switching brokers, and because the cover was claims-made, any claim notified in that window against past work would have fallen on them personally. They had also considered halving the limit to $500,000 to save around $4,000 of premium, which would have covered this claim with only $500,000 - $450,000 = $50,000 to spare.
After the claim the premium rose by 40% to $14,500 x 1.4 = $20,300, which the partners accepted without argument. They put continuous cover on a diary reminder, raised the limit rather than lowering it, and budgeted for run-off cover to protect the partners for six years after eventual retirement.
Watch out
Common mistakes.
- Letting a claims-made policy lapse between insurers, which leaves every piece of past work without protection.
- Assuming an indemnity settlement will buy a new replacement, when indemnity means depreciated value unless reinstatement cover was purchased.
- Choosing an aggregate limit to save premium without realising a second claim in the same year may find the limit already exhausted.
Questions
People also ask.
Does professional indemnity cover deliberate wrongdoing?
No, cover responds to negligence and honest error, and deliberate dishonest acts are excluded from every standard policy.
What is run-off cover?
It is a policy that keeps claims-made protection alive after a firm stops trading or a professional retires, typically for six years, so late claims about old work are still covered.
Should I notify my insurer about a complaint that has not become a claim?
Yes, almost all policies require notification of circumstances that might give rise to a claim, and failing to notify can void cover for that matter.
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