What Is Professional Indemnity Insurance and How Does It Affect Accounts

At Towerstone Accountants we provide specialist accountancy services for solicitors and law firms operating under SRA regulation. This article has been written to explain What is professional indemnity insurance and how does it affect accounts in clear practical terms so you understand how the rules apply in day to day practice. Our aim is to help you stay compliant protect client money and make informed financial decisions.

Professional indemnity insurance is one of those costs that most professionals accept as a fact of life without ever fully understanding how it works or how it should appear in the accounts. For solicitors in particular it is not just a commercial decision but a regulatory requirement and a financial consideration that affects cash flow profit reporting and compliance.

I regularly speak to firms who know they must have professional indemnity insurance but are unsure how premiums should be treated in the accounts what happens when policies span accounting periods or how claims and excesses affect their financial position. These uncertainties can lead to incorrect accounting and unnecessary stress when year end approaches.

In this article I will explain what professional indemnity insurance actually is why it is required how it works in practice and how it should be accounted for in a UK solicitor firm. I will also cover the impact on profit cash flow and balance sheets so firms can see the full picture rather than treating it as just another overhead.

What is professional indemnity insurance

Professional indemnity insurance commonly shortened to PII protects a business against claims made by clients or third parties for professional negligence errors or omissions.

For solicitors this might include:

• Incorrect legal advice
• Missed deadlines
• Drafting errors
• Breach of duty
• Professional mistakes that cause financial loss

If a claim is made the policy typically covers legal defence costs and compensation payable subject to policy limits and excesses.

The key point is that PII protects the firm rather than the client directly although clients benefit indirectly through the firm’s ability to meet claims.

Why professional indemnity insurance is mandatory for solicitors

Solicitors are required to hold professional indemnity insurance under rules set by the Solicitors Regulation Authority.

The purpose is to:

• Protect clients
• Maintain confidence in the profession
• Ensure firms can meet claims
• Reduce the risk of firm failure following litigation

Minimum cover levels are prescribed and vary depending on the structure of the firm. Failure to maintain adequate cover can lead to serious regulatory consequences including intervention.

How professional indemnity insurance policies work

Most solicitor PII policies operate on a claims made basis.

This means:

• The policy in force when the claim is made responds
• Not the policy in force when the work was done

This has important accounting and risk implications particularly when firms change insurers or close.

Policies usually run for a fixed period commonly 12 months with annual renewal.

Key components of a PII policy

Understanding the main components helps firms assess both risk and accounting impact.

These typically include:

• Policy period
• Limit of indemnity
• Excess or deductible
• Scope of cover
• Run off cover provisions

The excess is particularly relevant financially as it represents a potential cost the firm must bear if a claim arises.

How PII premiums are usually paid

PII premiums can be paid in different ways depending on the insurer and firm size.

Common arrangements include:

• Annual payment upfront
• Monthly instalments
• Combination of deposit and instalments

The payment method affects cash flow but not how the cost is recognised in the accounts.

How professional indemnity insurance should be treated in the accounts

From an accounting perspective PII is a business expense. However timing matters.

The key principle is matching. The cost should be recognised in the period to which it relates not simply when it is paid.

This is where many firms go wrong.

Accruals and prepayments explained simply

If a PII policy covers a period that spans the accounting year end the cost must be split.

For example:

• If a policy runs from October to September
• And the year end is 31 March

Only the portion relating to October to March should be charged as an expense in that year. The remainder is a prepayment carried forward.

This ensures profits are not understated or overstated.

Recording PII premiums in practice

In practical terms firms should:

• Record the full premium when invoiced
• Allocate the correct portion to the profit and loss
• Carry forward the balance as a prepayment

This applies regardless of whether the premium is paid monthly or annually.

Where PII appears in the financial statements

Professional indemnity insurance affects several areas of the accounts.

These include:

• Profit and loss account as an overhead
• Balance sheet as a prepayment where relevant
• Cash flow statement reflecting actual payments

Understanding these links helps partners interpret the numbers properly.

Impact on profit reporting

If PII is not accounted for correctly it can distort profit.

Common errors include:

• Expensing the full premium in one month
• Forgetting to include prepayments
• Misallocating costs between periods

These errors affect partner profit shares and tax calculations.

Impact on cash flow

While accounting spreads the cost cash flow reflects reality.

PII premiums are often one of the largest annual outgoings for a law firm.

This can create pressure particularly where:

• Premiums increase sharply
• Payment is required upfront
• Cash reserves are tight

Cash flow forecasting should always factor in PII renewal.

Excesses and claims in the accounts

When a claim arises the accounting treatment depends on circumstances.

If the firm pays an excess this is usually treated as an expense in the period it is incurred.

If legal costs or settlements are paid directly by the firm these may also be expenses unless reimbursed.

Provisioning may be required if a claim is probable and the amount can be estimated.

This is an area where professional judgement is essential.

Provisions for claims and contingencies

Accounting standards require firms to consider whether provisions should be made for known claims.

A provision may be required where:

• A claim has been made
• There is a present obligation
• An outflow of resources is probable
• The amount can be estimated

This can affect reported profits even before cash is paid.

Disclosure considerations

Significant claims or contingent liabilities may need to be disclosed in the accounts even if no provision is made.

Transparency is important particularly for incorporated firms.

Run off cover and firm closures

Run off cover is required when a firm closes or stops practising.

This cover protects against claims made after closure relating to past work.

The cost of run off cover can be substantial and must be planned for financially.

From an accounting perspective it may need to be recognised as a liability when the obligation arises.

How PII affects regulatory confidence

Beyond accounting PII is a key indicator of financial stability.

The SRA considers:

• Whether cover is in place
• Whether premiums are affordable
• Whether firms are at risk of non renewal

Difficulty obtaining or paying for PII can trigger regulatory scrutiny.

Relationship with accountants and brokers

Accountants and insurance brokers often work together to support firms.

Accountants help by:

• Forecasting affordability
• Ensuring correct accounting treatment
• Advising on profit impact
• Supporting disclosures

This ensures insurance decisions align with financial reality.

Common mistakes firms make with PII accounting

In practice I see recurring issues.

These include:

• Expensing premiums incorrectly
• Ignoring prepayments
• Failing to plan for renewal cash flow
• Not accounting for excesses properly
• Overlooking run off obligations

These mistakes are avoidable with proper advice.

Why PII costs are rising and why it matters

Many firms have seen PII premiums increase in recent years due to claims experience market conditions and insurer appetite.

Rising costs:

• Reduce profitability
• Increase cash flow pressure
• Influence firm structure decisions

Understanding the financial impact helps firms adapt rather than react.

My professional view

Professional indemnity insurance is not just a regulatory tick box. It is a significant financial commitment that deserves proper attention in the accounts.

When accounted for correctly it provides clarity. When handled poorly it distorts profits and creates unnecessary stress.

Solicitors should understand how PII affects their numbers not just their compliance status.

Final thoughts

Professional indemnity insurance protects solicitors clients and the profession as a whole. It is mandatory for good reason and its financial impact should never be underestimated.

From an accounting perspective premiums should be matched to the correct periods excesses and claims should be treated carefully and future obligations such as run off cover should be planned for in advance.

With proper accounting and forward planning PII becomes a manageable cost rather than a financial shock and allows solicitors to focus on delivering high quality legal services with confidence.

You may also find our guidance on What financial reports should solicitors review each month and What are common accounting mistakes made by law firms useful when reviewing related SRA and accounting obligations. For a broader overview of solicitor accounting and compliance topics you can visit our solicitors accounts rules hub which brings all related guidance together.