There is no doubt that times have been hard for legal firms in recent years, with many smaller firms closing. The profession has also seen some high profile casualties such as Cobbetts, Blakemores, Challinors, Halliwells and Davenport Lyons and that has caused insurers to focus more than ever on the solvency of law firms.
Significant levels of merger activity reflect the need for at least some firms to find a suitable partner to make cost savings and try to improve their financial position. For others, mergers have been more positive and strategic moves.
We have also seen the legal press focus on the levels of debt that firms are carrying. Two schools of thought have emerged from this analysis – either debt is good (evidence of ambition and investment) or debt is bad (a declining business). Only the finance directors of those firms who are carrying significant debts will know the truth.
However, for insurers, this is a serious issue with which to grapple. A firm that is financially unstable presents, arguably, a higher risk. At a very basic level, the ability to meet large excesses on claims reduces but, on a more fundamental level, risk management will come under pressure as those leading the business may have their attention focussed elsewhere. Also, it is likely that there will be a higher staff/partner turnover which is not conducive to the ‘steady ship’ that insurers want to insure. This is contrary to what insurers want to see with their insured firms, which is continued investment in quality infrastructure, systems and people. This can all lead to a long-term and profitable relationship for insurers.
Given the exposure to run-off, a firm that faces closure has a long tail cost for those insurers ‘last on the hook’. It is perhaps this element that makes the closer scrutiny of a firm’s accounts all the more vital from an underwriting perspective – the legal profession’s equivalent to Solvency I and II may follow.
“There are lies, damned lies and statistics”. An old adage, but it holds true. As noted at the beginning, debt is not necessarily a bad thing. However, perhaps what is key is to be able to show that any high level debt is nothing more than a short-term event. The longer it continues, the less likely the ambition is being realised and so getting under the bonnet of law firms on renewal is critical. For example, a simple understanding of how the debt has grown over the last 3 years, as well as an understanding of the plans for reducing it, will enable more balanced decisions to be made. All areas of business have seen margins reduce during the recession, and what is important is what has been done to off-set that.
There is no right or wrong way to run a legal practice. Some firms have chosen a route of debt for now, often under-pinning valid strategic investment decisions, while others like Mills & Reeve have decided zero debt is preferable. The Lawyer (7 April 2014) ran an analysis of a number of law firms and it was interesting to see the varied attitude to debt across the board, which emphasised the need for insurers to understand, as far as possible, what the strategic direction is.
While the outright failure of law firms remains relatively uncommon, the potential for insurers to be left holding a lengthy period of run-off (with limited prospects of receiving a premium for that), following the cessation of a practice, will continue to be a significant factor on renewal. Of course, no firm ever expects to fail but it is also true that no firm will tell the world in advance that it is about to.