A Background to Insurance, Professional Indemnity & Risk Management for Architects

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1 A Background to Insurance, Professional Indemnity & Risk Management for Architects (Note: Several diagrams in the original are not reproduced here) History Modern living and business activities in general involve the risk of sustaining losses of varying type and degree. If risks to life, limb and capital weren t taken, there would have been little technological, economic or social advancement; e.g. Gothic architecture, aviation, hydro-dams, nuclear power generation, and medical / surgery techniques. The economic loss consequences of risk-taking can be substantial and sometimes ruinous. Insurance is a method of compensating for these losses. Insurance of a kind is known to have existed in Greek and Phoenician societies. Bottomry was an early form of shipping insurance wherein investors would place a deposit with a shipping owner, who agreed to refund the deposit plus a premium when the ship returned safely to port. If the ship failed to return, the deposit would be retained by the ship owner for the purpose of rebuilding another ship. Marine insurance was transacted in England in 1574; Fire insurance in At that time, as an alternative to intoxicating bars, a number of coffee-houses were established in London to cater for different clientele. Edward Lloyd was a coffeehouse proprietor who attempted to attract marine underwriters as customers by printing a weekly shipping news-sheet. It was from this background in 1696, that a group of marine underwriters formed an underwriting-exchange known as Lloyds, which has continued to become the world s specialist insurance underwriter. Companies formed to transact insurance, now operate globally as important commercial entities. Commercial Basis of Insurance Insurance is one of the more interesting and important transactions engaged in by individuals and business firms. It embraces two related interests - financial and legal.

2 A financial definition of insurance is a financial arrangement that distributes the cost of unexpected losses (losses which would have occurred irrespective of insurance). Predictability of losses in advance, is basic to an insurance system s operations. Because the insurance system allows the cost of losses to be predetermined, it allows the cost of losses to be financed and redistributed in advance. Insurance companies therefore rarely pay for losses; they merely provide the facility for the payment of losses from a pool of funds contributed by policyholders. Legally, insurance may be defined as a contractual arrangement wherein one party (Insurer) agrees to compensate another party (Insured) for losses. This contract (policy) specifies the particular loss and provides for the insured to pay a contribution (premium) to the insurer. The policy creates rights and corresponding obligations for both insurer and insured. The insurer cannot force the insured to pay the premium, but it can cancel the policy or deny a claim for payment. Insurance Principles When referred to in insurance, loss means an undesired, unplanned reduction in economic value. It may be direct: e.g. life, fire, structural collapse - or indirect: (consequential loss) e.g. accommodation costs incurred as a consequence of a house fire. Property insurance policies are very specific as to whether coverage is provided for either or both. The chance of loss (probability of loss) may or may not be known before a loss takes place, but it is the ratio of the number of losses (predicted or actual) to the number of exposure units. If there was no possibility of loss, or if loss was certain to occur, then insurance would not exist. In the first instance there would be no need to insure, and in the second the loss would be an expense. Hazards are conditions that serve to increase either the frequency or severity of losses e.g. poor street lighting may result in more burglaries, or storage of petrol in a garage may result in a greater loss if the garage caught fire. If an insured materially increases a hazard, the insurer may suspend the insurance coverage. If an individual causes a loss to collect the insurance (e.g. arson) this is know as a moral hazard - it increases the frequency of loss. Where an attitude of indifference to loss is created by the purchase of insurance, this is known as morale hazard. This why should I care attitude increases the severity of loss. Risk is subject to many definitions, but a convenient expression is the variation in possible outcomes of an event based upon chance i.e. the greater the variation around an average expected loss, the greater the risk. The degree of risk is a measure of the accuracy with which the outcome of an event based on chance can be predicted - the more accurate the prediction, the

3 lower the degree of risk. Because insurance companies keep accurate statistics on losses that have occurred, they are in a better position to predict losses that will occur. Additionally insurers, by accepting a large pool of risks, rely upon a mathematical principle known as the law of large numbers. For example, the greater the number of observations of an event based on chance, the more likely the actual result will approximate the expected result e.g. tossing a coin or rolling a dice. (Ironically, a calculated risk is something that cannot be calculated). Insurers however will pay regard to the following in order to arrive at an underwriting risk average. The probability of loss The possible severity of loss Types of Insurance The possible degree of variation in actual results. Insurance is a Special Kind of Contract Contracts normally assume an equal understanding of the terms by both parties e.g. A agrees to pay B for item C. Insurance is often concerned with unequal knowledge i.e. the insured has full knowledge of their risk circumstances which if unknown to the insurer could disadvantage the insurer. Insurance contracts therefore require the insured to disclose all information, which is material to the risk and which might influence a prudent insurer in accepting or declining the risk. Insurance contracts are required to be made with the utmost good faith (uberrimae fide) in which both parties deal honestly with each other. Additionally the insured is required to warrant that the information provided to the insurer is accurate. Failure to disclose accurate material information may invalidate the insurance policy in the event of a claim. Furthermore, if these material facts change during the term of the policy, the insurer must be advised. There are many types of commercial insurance, e.g. fire, accident, life are occurrence based. Professional Indemnity (Negligence) Insurance Professional indemnity (or professional negligence) insurance is a special type of legal liability insurance, which applies to professional services, so as to indemnify the insured for legal liability arising from their negligent acts or omissions. Professional negligence is failure to exercise reasonable knowledge, skill, care and diligence normally expected of a particular profession. This duty of care is owed contractually to the client, but also tortiously to the client and to other classes of person whom ought reasonably be contemplated as being likely to be affected by the negligent actions of the professional - e.g. new building owner,

4 together with subsequent owners or tenants or in some cases the financiers of the building. Professional indemnity policies are normally written on a claims made basis: i.e. for a policy to respond the policy must be in place when the claim is first notified, notwithstanding that the negligent act or omission which gave rise to the claim occurred before the policy was written. Often it may take many years for the negligence to fully manifest itself and then for claims to be settled. PI insurance policies are written on an annual basis i.e. a new contract is written each year. The policy terms can therefore change from year to year, conditions which apply this year may not next year. Writs for professional negligence typically allege breach of contract and also a breach of tortious duty of care. Such tortious claims are framed so as to sue the various co-defendants jointly and severally. The net effect of this is that where any of the joint-tortfeasors is found to be of little financial worth, the liability for payment of their uncollectable contribution falls upon the remaining solvent tortfeasors. In the case of building works, this is typically the professional (particularly the insured professional) and the territorial authority that issued the building consent and code compliance certificate. Professionals and territorial authorities are typically insured by PI policies, and accordingly provide a good deep-pocket for litigants to exploit. Clients, often erroneously, believe that the professional s PI policy is for their immediate benefit. It effectively provides a facility to indemnify the professional for legal liability arising from their negligence, increases the net-worth of the professional, and in doing so affords the client greater surety for recovery of losses when liability is proven. PI insurance does not protect a firm against risk occurring, it merely offers restoration after the eventual loss. Types of Risk Fundamental Fundamental risks affect entire communities and are uninsurable through private insurers - e.g. war, nuclear fission, and earthquake. Government assistance is involved e.g. EQC. Pure Pure risks can only result in a loss -e.g. death, fire, theft, and liability. These risks are insurable by private insurers. Speculative Speculative risks may result in a gain, loss or no change. These are uninsurable risks: cf. casino gambling, horse racing. Society may benefit from speculative risks, but always loses from pure risk loss.

5 Important Insurance Terms Actuary A statistician who solves insurance risk problems. Agent A person who sells insurance policies as an agent for the insurer. Agents may be employed by the insurer or commissioned to them. Broker A person who arranges insurance as an agent for the insured. Co-Insurer An insurer which accepts part of the risk along with the primary or lead insurer, for a share of the premium. Consequential Loss A secondary loss resulting from an insured peril. Claims Made Policy A form of insurance which responds when the events which might give rise to a claim under the policy are first notified to the insurer during the currency of the policy e.g. Professional Indemnity Insurance. Typically, notification and settlement of these claims may occur over many years after the claims notification. They are often referred to as being long-tailed. Estoppel Conduct of insurer or agent, which suggests that a policy waiver applies. Excess Sometimes called deductible. This is the initial loss-cost, which is borne by the insured. Group Insurance A pool of like-risks within one shared policy. It generally attracts a lower premium because of its lower administrative and marketing overheads. NZACS, CEAS, and PSBG each operate Group Insurance schemes. Indemnity Putting the insured in the same financial position after a loss as they were in before the insured event took place. It recognises depreciation, unlike replacement-cost insurance. Loss Adjuster An insurance investigator as agent for insurer, who checks if the loss claimed is covered by the policy, and negotiates the settlement of any Claim.

6 Loss Assessor A person who as agent for insurer assesses the value of loss. Occurrence Based Policy A form of insurance which responds to a claim, when the events which give rise to a claim under the policy occur during the currency of the policy e.g. accident and life insurance. The quantum of loss and claims settlement is often quickly resolved. Proximate Relationship First peril in a chain of events which results in a loss. Primary Insurer The insurer which contracts with the insured. Re-insurer A secondary insurer which contracts with the primary insurer to accept a specified portion of risk, normally at specified upper limits, for a share of the premium. Subrogation The substitution of one party (insurer) to another party s (insured) rights. This permits the insurer to recover from a third party who is responsible for the loss. Underwriter A person who selects and rates applications for insurance. The term is now synonymous with the word insurer. Waiver An intentional abandonment of insurance terms. Communique May 1998 Reviewed June 2009