Professional indemnity: contractual liability and cover for liquidated damages

Professional indemnity insurance covers the policyholder for claims brought against it alleging that it has breached its “professional duty”. The indemnity available under the policy includes legal costs and expenses (for the costs of defending the claim) and ‘civil liability’ (which may extend to damages, compensatory penalties and claimant’s costs).

As the insurance market “hardens” (see our article here) policy coverage is narrowing. Some insurers are returning to the requirement for “negligence” or a specified “act, error or omission” to enliven cover.

Claims brought against professionals are likely to be formulated as causes of action in contract, negligence or otherwise under Statute (such as the Australian Consumer Law, ASIC Act and other legislation).
Limitations to cover contractually assumed liabilities

Professional indemnity insurance policies generally include a “contractual liability exclusion”. The intention is to exclude express liabilities the policyholder has assumed under its contracts. Insurers apply this clause to manage their exposure in circumstances where their insured has provided unreasonable contractual undertakings.

Contractually assumed liabilities in contracts may include express warranties or guarantees, indemnities, hold-harmless provisions, waivers, assuming liability for others work, contracting out of legislation and offering an “extended duty of care”. Liquidated damages are also contractual undertakings. The question we are most commonly asked is whether there is any cover for such loss.

In cases where liquidated damages are not specifically excluded by the policy, a question arises as to the extent that insurance cover may be excluded by such a clause where the parties to a contract of insurance have agreed to pay liquidated damages. In such a case, the insurer may contend that an agreement to pay liquidated damages is a “liability assumed under contract”.

What is a liquidated damages clause?

A liquidated damages clause specifies a sum that a party will pay in the event of a breach of its contractual obligations. The purpose of liquidated damages in such a clause is to avoid the need to the parties to spend a considerable amount of time and money quantifying their actual loss. Such clauses are often included in construction contracts given that quantification of loss caused by delay can be complex and expensive.

The traditionally accepted view is that a liquidated damages clause must not be for an amount that is inequitably higher than a “genuine pre-estimate of loss[1] or more recently, for an amount that is “out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation”.[2]

Onerous clauses deemed penalties

If a liquidated damages clause does not meet those tests, then it will likely be struck down by a Court and will not be enforceable on the basis the clause is unconscionable. This is grounded in the principles of equity which prevent a party imposing a penalty upon the other party for breach of contract in the sense that the sum designated, or to be determined as payable on breach, is greater, and unreasonably or inequitably so, than the true damage reasonably assessed at the time of contract as being the damage which the innocent party might suffer.[3]

Where a clause is held to be so unreasonable by a Court, it will be deemed a “penalty” rather than a claim for liquidated damages. In that case the insurer will have a level of protection against claims that are far in excess of what would otherwise be recoverable at law. It is relevant that policies will in the ordinary course, exclude penalties, and or otherwise, expressly, liquidated damages.

What coverage then is available under a professional indemnity policy?

It is relevant to restate that the intention of cover under a professional indemnity policy is to indemnify the insured for breach of professional duty. Quantifying that loss, once liability is established, is often a costly exercise and can cause delay in finalising a coverage opinion, or a claims settlement.

The conclusion we draw is that it is more likely in a case of a claim for professional negligence that a Court will not conclude that the amount stated in a liquidated damages clause is a liability that is “assumed under contract” that goes beyond the liability that will otherwise have existed at law. Accordingly, the contractual liability exclusion is unlikely to have any effect.

The commercial purpose of the exclusion is not served by applying it in a case where the insured’s liability would have existed anyway, as where the insured is liable in tort as well as contract. In such a case, the insurer should be regarded as being in breach of its duty of utmost good faith in relying on the exclusion.

Further, insurers ought not to be particularly concerned that a liquidated damages clause will result in a greater claim than would otherwise be payable to the insured and are likely to save costs of quantifying and disputing a liquidated amount by accepting the amount stated in the liquidated damages clause as a genuine pre-estimate of loss. However, if the amount is not accepted, it will be open for an insurer to bring an action contending that a claim for liquidated damages is a penalty.

For insureds

Ensure that a liquidated damages clause is for an amount that is a genuine pre-estimate of loss. By doing so it will assist in avoiding unnecessary coverage disputes with your insurer and contractual party, including any commensurate litigation costs.

Insured’s should also be weary that professional indemnity policies are very different. Cover varies by insurer. Indeed, some insurers have different policy wordings. Legal advice should always be sought when formulating liquidated damages clauses (and during contract negotiations) and that should dovetail with advice from your broker and policy coverage.

[1] Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1914] UKHL 1

[2] Andrews v Australia New Zealand Banking Group Ltd [2012] HCA 30, (2012) 247 CLR 205 at [32]; Paciocco v Australia New Zealand Banking Group Ltd [2016] HCA 28, (2016) 258 CLR 525.

[3] Multiplex v Abgarus (1992) 33 NSWLR 504, 519