What Is Professional Indemnity Insurance and How Does It Affect Accounts

Professional indemnity insurance (PII) is a type of business insurance that protects professionals against claims arising from errors, omissions, or negligence in the course of their work. If a client suffers financial loss because of a professional’s mistake or poor advice, the insurance covers the cost of compensation, legal defence, and associated expenses.

For law firms, PII is mandatory under SRA regulations. Every authorised law firm must maintain insurance with an approved insurer that meets the SRA’s Minimum Terms and Conditions.

Typical claims covered by PII include:

• Giving incorrect legal advice or missing deadlines.

• Failing to file documents or complete transactions correctly.

• Breaching confidentiality or data protection laws.

• Misplacing client documents or funds.

• Conflicts of interest that lead to client loss.

Without adequate cover, a single claim could financially cripple a firm or lead to closure.

Why professional indemnity insurance is important for law firms

Professional indemnity insurance is more than a regulatory requirement; it provides crucial protection for both the firm and its clients.

Key benefits include:

• Financial protection: Covers the cost of legal defence, settlements, and compensation claims.

• Client confidence: Demonstrates that the firm takes risk management seriously.

• Regulatory compliance: Required by the SRA to maintain practising status.

• Business continuity: Prevents large claims from disrupting the firm’s operations or cash flow.

The SRA requires firms to carry a minimum level of cover, usually £2 million for partnerships and £3 million for incorporated practices. Many firms choose higher limits depending on their client base and work type.

How professional indemnity insurance affects accounts

Although PII is an insurance policy, it also influences how law firms record their finances. The cost of premiums, potential claims, and accounting treatment of reimbursements all have implications for the firm’s accounts.

1. Recording premiums as business expenses

PII premiums are a legitimate business expense. In accounting terms, the cost of professional indemnity insurance is recorded in the firm’s profit and loss account under administrative or professional expenses.

For tax purposes, these premiums are deductible because they are incurred wholly and exclusively for business purposes. The deduction reduces taxable profits, lowering the firm’s overall tax liability.

Accountants usually spread the cost of annual premiums evenly over the policy period to match the expense with the relevant accounting year.

2. Accruals for unpaid premiums

If a firm’s PII policy is renewed shortly before the year-end but payment is due after the balance sheet date, an accrual may be required. This ensures the expense is recognised in the correct accounting period even if the invoice has not yet been paid.

Accurate accruals are particularly important for law firms preparing statutory accounts or LLP statements, as they affect reported profits and partner drawings.

3. Provisions for claims and excess payments

If a firm faces a potential claim, accountants must assess whether it creates a liability or contingent liability in the accounts.

• If the claim is likely to result in a payment and the amount can be estimated, a provision should be made in the accounts.

• If the claim is possible but not probable, or the amount cannot be reliably estimated, it should be disclosed as a contingent liability in the notes to the financial statements.

Any excess payable under the firm’s policy (the amount the firm must contribute to a claim) should also be recorded as an expense when the liability arises.

4. Treatment of reimbursements from insurers

If an insurer agrees to cover a claim, the reimbursement should be recognised as income in the firm’s accounts, matching it to the related expense or liability.

Accountants ensure that the reimbursement and related costs are reported in the same accounting period to present an accurate picture of the firm’s financial position.

5. Cash flow impact

Professional indemnity insurance premiums can be substantial, particularly for law firms handling high-risk areas such as conveyancing or corporate law. Accountants help firms budget for these annual costs, often spreading payments through instalments or finance agreements.

Effective cash flow planning ensures that premium payments do not disrupt day-to-day operations.

6. Impact on partner drawings and profit allocation

In partnerships and LLPs, PII expenses reduce the firm’s distributable profits. This means partners receive smaller profit shares after accounting for the insurance costs.

Accountants may recommend including PII as a fixed overhead when calculating partners’ drawings to ensure fairness and transparency.

PII and regulatory reporting requirements

The SRA requires firms to maintain records of their professional indemnity insurance, including:

• The policy number and insurer details.

• The level of cover and renewal date.

• Evidence of compliance with the SRA’s minimum terms.

These details must be available for inspection and included in the firm’s authorisation documents. If a firm changes insurers or fails to renew its policy, it must notify the SRA immediately.

In addition, accountants preparing the SRA Accountant’s Report will review the firm’s insurance arrangements to ensure that client money is adequately protected and that the firm maintains appropriate cover at all times.

Managing insurance costs effectively

PII is often one of the largest overheads for law firms, so managing the cost is a key part of financial strategy. Accountants can help by:

• Reviewing the firm’s risk profile to ensure appropriate cover levels.

• Advising on premium budgeting and renewal timing.

• Comparing quotes from multiple insurers to find the best value.

• Identifying areas where risk reduction could lower premiums, such as improved internal controls or better file management.

Reducing risk through training, quality assurance, and compliance monitoring can often lead to lower premiums over time.

How accountants support compliance and claims management

When a potential claim arises, accountants play an important role in managing the financial implications. They can:

• Quantify the likely financial exposure.

• Ensure that all related costs are recorded correctly.

• Work with the firm’s insurer to align accounting treatment with the claim’s resolution.

• Review whether provisions or disclosures are needed in the financial statements.

They also support ongoing compliance by ensuring that insurance expenses are properly accounted for and that financial reporting reflects the firm’s true risk position.

Final thoughts

Professional indemnity insurance is essential protection for law firms, safeguarding both their finances and their clients’ trust. It is also a significant accounting consideration, influencing expense recognition, cash flow, and profit allocation.

By working closely with an accountant who understands legal sector regulations, law firms can ensure that their insurance costs are managed efficiently, claims are accounted for correctly, and their financial statements remain compliant and transparent.

Ultimately, effective management of professional indemnity insurance is not just about protection it is about maintaining financial stability and professional credibility.