As Peter Maguire reports, Y2K represents a very real dilemma for insurers underwriting professional indemnity business.
With only six months remaining to the Year 2000, the extent of the disruption which will be caused by the so-called Y2K problem remains unclear. Widely differing opinions have been expressed as to its likely severity, although what can be said with certainty is that, if it does give rise to widespread loss and disruption, many clients will seek to lay off their losses on their professional advisers.
In those circumstances, Y2K represents a very real dilemma for insurers underwriting professional indemnity business. The inherent uncertainty of the problem makes it difficult to try and quantify their aggregate exposure to this type of claim, while they must also have regard to their obligations to their shareholders, names, capital providers and reinsurers. Accordingly, certain insurers have taken a policy decision either not to offer cover for Y2K-related claims, or to offer cover on a restricted basis.
On the other hand, the current UK professional indemnity market is probably the softest in living memory; capacity abounds and competition is fierce. In those market conditions, a decision to exclude Y2K losses may lead to a substantial loss of business, particularly in circumstances where other insurers are prepared to underwrite the risk and brokers are anxious to obtain the broadest possible cover for their clients.
In this context, what practical steps have insurers taken to try and contain their exposure and how are Y2K claims likely to arise?
Potential sources of claims
Broadly speaking, claims are likely to arise in three ways, namely:
1. Own Y2K non-compliance
Where a firm's own office systems are not Y2K compliant and no paper back-up systems are available, important data may be lost. This may, in turn, give rise to claims arising out of a failure to act upon key dates, with important deadlines being missed. These deadlines may include:
• The dates by which tax reliefs are to be claimed or notices of appeals filed with the Revenue (accountants).
• Rent review dates and break dates for leases (surveyors).
• Actuarial calculations and pension projections (financial advisers).
• Policy renewal dates (insurance brokers).
• Dates of expiry of limitation periods or other important deadlines in the procedural timetable of an action, particularly following the recent introduction of the Civil Procedure Rules (solicitors).
2. Advice sought explicitly by clients in relation to Y2K issues
Examples where potential liabilities may arise include:
• Advice given by a surveyor as to whether the Y2K problem has the potential to affect the proper operation of a building or its value.
• Advice given by a surveyor or an accountant in relation to the formulation and implementation of a client's Y2K compliance project.
• The recommendation by a computer consultant of software which is said to be Y2K compliant, but which is not.
3. A failure to take into account the implicit impact of Y2K issues in the course of providing advice
The Y2K problem may also impact implicitly upon other advice provided by professionals. It is, therefore, imperative that its potential impact is understood if claims are to be avoided.
• Where a solicitor, acting in relation to the acquisition of a company, fails to seek appropriate disclosure and warranties in relation to the target company.
• Where an accountant, asked to value a company in connection with a merger or acquisition, fails to take into account the potential impact of Y2K.
• Where a surveyor values a commercial property without taking into account the potential impact of Y2K. In those circumstances, his valuation could be taken to state implicitly that all equipment, plant, and machinery and services are Y2K compliant, unless he has made it clear that his valuation is predicated upon an unverified assumption that this is the case.
Classes of professional exposed to Y2K claims
A number of professions are at risk, although the level of exposure varies considerably from class to class. They include:
Computer consultants (and, depending on their precise role, management consultants) represent the most obvious area of exposure and the market already faces a number of claims. The date upon which computer consultants became aware, or should have become aware, of the Y2K problem and then advised clients of its implications, will be of particular relevance in the resolution of these claims.
While the directors of a company have direct responsibility for ensuring that their businesses will not be adversely affected by Y2K, auditors have a responsibility to provide an opinion as to whether the financial statements of the company present a true and fair view. They are obliged to make enquiries to establish what steps a company has taken to deal with the problem and, where the auditor is not satisfied with the measures taken, it may be appropriate to qualify the audit report. Where no such qualification is provided, and the company subsequently suffers a business collapse because of a Y2K problem, the auditor's role is likely to be the subject of intense scrutiny.
The potential difficulties which they face may be exacerbated by the risk of material mistaken by a company's management or IT staff, whilst commercial pressure may be exerted by directors who are concerned at the adverse commercial impact of a qualification to the accounts.
Accountants in their advisory function
Accountants face potential exposures in relation to, inter alia, due diligence work on mergers work and acquisitions, as well as in relation to other valuations and the preparation of profit forecasts and projections. In addition to potential claims from clients and liquidators, accountants could face an exposure to third parties where there has been a voluntary assumption of responsibility on their part. In this regard, considerable pressure may be brought to bear to provide a measure of comfort to third parties, such as banks, on Y2K issues.
In addition to an exposure arising out of a failure of their own systems, brokers will be vulnerable where they recommend, on behalf of their clients, policies which limit or exclude Y2K related losses, where fuller cover is available elsewhere in the market and they have not provided clients with the advice necessary to enable them to make an informed decision in this regard. Claims may also arise where brokers negligently advise their clients in relation to Y2K issues generally, such as where they provide incorrect advice in connection with the scope of a Y2K exclusion.
Financial advisers are heavily reliant upon forward projections and will, accordingly, be particularly vulnerable to claims arising from errors in their calculations caused by defects in their own systems.
Areas of exposure include missed deadlines, merger and acquisition work, a failure to make appropriate preliminary enquiries in property transactions and negligent advice in relation to Y2K terms and warranties in computer contracts.
Claims may arise, inter alia, in the context of property management (which encompasses the potential problems arising out of embedded processors or “chips”), in building and quantity surveying and in valuation work. Problems may also arise in connection with the services of estate agents and auctioneers in the context of The Property Misdescriptions Act 1991.
Construction contracts will typically encompass contracts for the supply of works and materials, in consequence of which they are subject to the statutory implied terms as to fitness for purpose and satisfactory quality. Many of the products in question are likely to include components or embedded processors relating to, for example, security and access, fire detection and fire fighting systems and power supplies.
Options available to insurers
While the response of the market to Y2K has, to a significant degree, been dictated by the current soft market, insurers have generally sought to raise their insured's awareness of the issues and to encourage them to take steps to manage their exposure. They have also sought a measure of underwriting protection through both specially formulated proposal forms and in the application of certain terms and sub-limits in policies.
The professional indemnity market have responded to the Y2K problem in a number of ways, including:
• The exclusion of Y2K claims on a blanket basis.
• The exclusion of Y2K losses, but with a “buy-back” in respect of defined perils.
• The selective underwriting of different classes of professionals, who represent a greater, or lesser, risk in the context of Y2K. In this regard, the ICA Approved Wording has been amended to allow the selective incorporation of Y2K exclusion into accountants' policies and an exclusion can now be applied to surveyors' policies without constituting a breach of the RICS Regulations.
• Selective underwriting by “cherry-picking” individual firms who can demonstrate that they have taken a responsible attitude to the problem, both in terms of their own Y2K compliance and in relation to broader risk management issues.
• Writing the business in order to retain (and possibly increase) market share. Indeed, some insurers have developed initiative products to respond specifically to Y2K.
• The application of sub-limits for Y2K losses (including the use of aggregate limits).
The issue of fortuity has already been the subject of extensive consideration. Suffice it to say, for present purposes, that although the facts giving rise to any particular claim or loss will need to be carefully reviewed, it seems likely that many claims under professional indemnity policies will have the necessary element of fortuity. In this regard, and subject to any evidence of reckless conduct, it may be hard for an insurer to argue that the claim was bound to arise or, indeed, bound to arise at a certain time.
2. Non-disclosure, misrepresentation and breach of warranty
Most insurers have issued tailor-made questionnaires seeking information on the insured's own Y2K compliance, the type of advice being provided inter alia, and the steps which the insured have taken to identify, and manage, the risk.
Although a non-disclosure, misrepresentation and breach of warranty will, prima facie, entitle insurers to avoid the policy or be discharged from all further liability thereunder, many professional indemnity policies (for example, those of accountants, solicitors and surveyors) contain a waiver of insurers' rights in this respect, if the insured can demonstrate to their reasonable satisfaction that the non-disclosure, misrepresentation or breach of warranty was innocent and free of fraudulent conduct. Moreover, such policies are, on a proper construction, composite policies of insurance, containing separate contracts between each insured and insurers. It follows that the position of each insured needs to be considered separately and that “innocent” partners (and, indeed, other “innocent” insureds) will be entitled to indemnity.
So far as incorporated entities are concerned, in Arab Bank plc v Zurich Insurance Company (1998), the Court was asked to determine, on a preliminary issue, whether the alleged fraud of the director signing the proposal form vitiated the policy for the company (for the purposes of the application, the allegation was assumed to be true). Rix J held that a fraudulent misrepresentation by the director did not affect the rights of other insureds under the policy - including the company - and that the knowledge of the director was not to be inputed to them.
The decision is subject to appeal and, while the composite nature of such policies is a well established principle (as is the non-imputation of an agent's fraud to the principal), the key issue in all such cases will be whether or not the director signing the proposal form was the “mind and directing will” of the company for the purposes of seeking insurance cover.
3. Y2K exclusions
A number of insurers have chosen to apply tailor-made exclusions in relation to Y2K claims and losses. These will be construed contra proferentum and the clauses therefore need to be made as clear and unambiguous as possible, as well as being consistent with the remainder of the wording.
4. Y2K sub-limits (including aggregate limits)
A number of insurers are employing sub-limits which restrict any indemnity for Y2K losses. It will be for an insurer seeking to apply those sub-limits to demonstrate that the loss is Y2K-related which may, in turn, give rise to difficult issues of causation.
5. Blanket notifications
The requirements relating to the notification of circumstances differ as between various policies. Some, for example, require notification of circumstances “which may give rise to a claim”, whereas others require notification of circumstances which “are likely to give rise to a claim.”
If insurers intimate that they are intending to impose a Y2K exclusion or other restriction on cover at renewal, an insured may be tempted to make a blanket notification of circumstances in an attempt to engage the current policy. Each case will have to be looked at on its own facts and, in these circumstances, insurers will doubtless wish to press their insureds to particularise exactly what circumstances are being notified, or purportedly notified, (recognising that the absence of particularisation in relation to particular clients will not, of itself, be fatal to the notification).
In practical terms, the Courts are likely to give significant weight to the underlying purpose of the “deeming” clause (as per BNP Mortgages Ltd v Page & Wells (1994)) and to have more sympathy where an insured who has acted in good faith and made a genuine attempt to assess and identify the risk of claims against them. There will also be a lower burden upon an insured where his policy refers to the notification of circumstances which “may give rise to a claim”, particularly where any issue as to coverage will be resolved at a time when such a claim has, in fact, materialised. Thus, in Rothschild v Collyear (1998), Rix J held that:“I believe that it is legitimate to test the view of what the future may bring, where that view has been contemporaneously and prophetically expressed, against what happened in due course.”
He concluded that the test of materiality in that policy wording was weak and that there was not “any justification for demanding too much of the test that the notified circumstances “may” give rise to a claim.” He also commented that a narrow interpretation of the policy's requirements could well lead to a position that “by the time that a claim came to be made, it is quite likely that it would become impossible to obtain cover for it, either or at all or only on prohibitive terms.”The Rothschild judgment was driven, to a significant degree, by policy considerations in addition to which, the insured's solicitors had prepared a carefully drafted letter of notification in response to what was an industry-wide problem relating to pension mis-selling. In the Y2K context, each notification will need to be looked at on its own merits.
6. The aggregation of claims
The aggregation provisions of any policy will need to be considered in relation to its applicable limits of indemnity and excesses. The existing caselaw is fact-specific and heavily influenced by policy considerations although it is axiomatic that, where a policy refers to claims “arising out of the original cause or source” (or similar words), there will be a better prospect of aggregation. In this respect, Lord Mustill held in AXA v Field that the words “originating cause” open up the widest possible search for a unifying factor.
In the final analysis, the issue is ultimately one of factual causation and it will be necessary to investigate the background to any claims.
7. Reinsurance protection
The issue of aggregation also needs to be considered in the context of an insurer's reinsurance protection and the relevant provisions in their treaty wording.
Risk management issues for insureds
In addition to an ongoing dialogue between various firms, brokers and insurers, a number of professional bodies have provided specific guidance to their members in relation to Y2K. In October 1997, the ICA issued a technical release on the audit implications of the problem while, in January 1999, the RICS, in conjunction with Cameron McKenna, published detailed guidance for their 90,000 members, focusing upon issues arising from Y2K and how this impacts upon the advice and services which surveyors provide. The appendices to the booklet include, inter alia, sample draft wordings for inclusion in letters of engagement and reports, together with draft specimen clauses excluding or limiting liability.
Where insurers are prepared to underwrite Y2K losses on a selective basis, they are likely to seek evidence that:
• The insured has recognised and understood the problem, both in relation to their own compliance and the advice which they give.
• The insured has obtained appropriate professional advice.
• A practical risk management plan is being implemented.
• The insured has identified the areas of advice upon which Y2K may impact, whether explicitly or implicitly.
• There is an awareness of the problem throughout the firm, steps having been taken to make staff at the operational level aware of the key issues.
• The firm has taken steps to raise their client's awareness and understanding of the problem and to seek to agree an appropriate response to it.
• Steps have been taken to clarify the scope of the insured's retainers, including any relevant limitations, and that all relevant assumptions, qualifications and limitations are set out in reports and other advice to clients and third parties.
• That the insured recognises the need, in appropriate circumstances, for clients to seek independent advice (for example, IT, engineering or legal, as appropriate).
In certain circumstances, insured firms should also consider whether they could justify seeking to exclude or limit their liability, particularly where they will not have the benefit of any, or only limited, professional indemnity insurance. Such provisions will, in all cases, be subject to the reasonable test of The Unfair Contracts Act 1977.
These issues should now be addressed by all professionals, regardless of the extent to which - if at all - they have the benefit of professional indemnity cover. If practical steps are taken at this stage, they will be able to minimise the risks which they face in the event that some of the more pessimistic predictions about Y2K prove to be correct. The alternative may be for certain firms to find themselves involved in a multiple game of “pass the parcel” next year, as various parties try to shift the blame for any losses that do occur.
Peter Maguire is a partner in the Insurance and Reinsurance Group of Cameron McKenna and is co-author of the RICS Guidance on Y2K.