Understanding Professional Indemnity Insurance: The Average Provision

Professional Indemnity (PI) Insurance provides businesses and professionals with cover for their liability for compensation arising from errors and omissions in connection with the professional services they provide to their customers. It is important for brokers and their clients to understand the level of cover provided by the chosen PI Insurance policy.

The purpose of this article is to explain the Average Provision included in PI Insurance policies and assist you to better understand its relationship with the indemnity limit and how it deals with underinsurance.

Underinsurance in Professional Indemnity Insurance

Most insurance brokers and their clients may be familiar with the concept of underinsurance in the context of property insurance. However, they may be less familiar with how underinsurance is handled in the context of Professional Indemnity Insurance. This is where the operation of what is generally known as the Average Provision comes into play. 

When does the Average Provision apply?

The Average Provision only applies to PI Insurance policies that have a defence cost exclusive indemnity limit. As a quick refresher, an indemnity limit that is exclusive of defence costs means that any reasonable and necessary costs and expenses associated with defending, investigating, responding to, or settling the claim (including legal costs) are payable in addition to the indemnity limit by the insurer. Generally, costs and expenses paid in addition to the indemnity limit by the insurer are capped to the amount of the indemnity limit.

How does the Average Provision Apply?

Where the compensation payment to resolve a claim is greater than the indemnity limit, an Average Provision will apply to calculate the proportionate amount of defence costs to be paid by the insurer. It does this by limiting the amount available for the payment of defence costs to the same proportion that the indemnity limit bears to the compensation payment required to resolve the claim.  In other words, the insurer’s percentage (%) contribution to defence costs will reflect the same percentage (%) contribution the insurer makes towards the compensation payment.

Average Provision Claim Example

Let’s look at the operation of the Average Provision through a claim example. Assume an insured has a Professional Indemnity Insurance policy with a defence costs exclusive indemnity limit of $1M and an Average Provision. The insured makes a claim that is settled through a $2M compensation payment to the third party. In addition, legal costs incurred to defend and resolve the claim are $750,000.

The Professional Indemnity (PI) Insurance policy responds as follows:

• The insurer contributes $1M in relation to the compensation payment. This is the maximum amount available under the indemnity limit.
• The insurer contributes $375,000 (50%) towards legal costs. This is because the Average Provision applies where the compensation payment is more than the indemnity limit. As the indemnity limit ($1M) represents 50% of the compensation payment ($2M), the insurer’s contribution to defence costs is limited to 50%.

The insured is required to fund the underinsured amount of $1,375,000 (being $1M for the compensation payment plus $375,000 for legal costs).

Making Informed Professional Insurance Decisions

By being aware of the Average Provision applicable to the Professional Indemnity Insurance policy brokers can assist their clients to make informed decisions about the level of cover they should have and the financial implications if the level of cover is insufficient.

Related Articles

PI Policy Extensions

PI Reinstatement of Indemnity Limits

PI Cost Exclusive vs Cost Inclusive

PI Professional Services Description

Important Notice

Berkley Insurance Company (limited company incorporated in Delaware, USA) ABN 53 126 559 706 t/as Berkley Insurance Australia is an APRA authorised general insurer. Information provided is general only, intended for brokers and has been prepared without taking into account any person’s particular objectives, financial situation or needs. Insurance cover is subject to terms, conditions, limits, and exclusions. Underwriting criteria applies. When making a decision to buy or continue to hold a financial product, you should review the relevant Policy Wording.