Viewpoint: Back to Basics – Risk Transfer Through Contracts and Insurance

Along with analyzing risk, a risk manager’s core function is to offload as much risk as possible as cost-effectively as possible. While meeting this goal is generally thought of as assembling the right insurance portfolio at the best price, transferring risk by contract with a business partner or subcontractor is an often-overlooked alternative that can save a good deal of money and offer sound protection when done right.

Below, we consider the advantages—and some pitfalls—of transferring risk via traditional contract, vs. transferring risk via insurance.

Risk Transfer through Contract

An indemnity contract—or an indemnity provision within a more comprehensive contract—functions as one way in which a party can transfer its risk. To be sure, many insurance policies also qualify as indemnity contracts. However an indemnity agreement also may stand alone, apart from insurance. An indemnity agreement should do just what its name suggests—indemnify one (or both) parties to the contract. In practice, the agreement can take different forms—specifically broad form, intermediate, and limited indemnity agreements—and can work in conjunction with other contractual provisions to provide the parties the specific contractual parameters to which they have agreed.

The most comprehensive type of indemnification comes in the colloquially-termed broad form indemnity agreement. Here, an indemnitor assumes an unqualified obligation to hold the indemnitee harmless for all liability associated with the subject matter of the agreement, regardless of which party was actually at fault. In other words, this form of agreement seeks to indemnify a party fully for any and all negligence of either party in the performance of the contract.

Such an agreement may seem too good to be true to an indemnitee. And indeed, it does come with certain caveats. First, some jurisdictions do not allow a party to insulate itself from liability for its own gross negligence or intentional conduct. Second, additional public policy concerns may inform the interpretation of the broad form indemnity provision based on, for instance, the type of work to be performed under the contract. For these reasons, often indemnity provisions, regardless of their scope, will contain a “savings clause.” A savings clause functions, as the name suggests, to “save” a contractual provision from nullity should it be determined to be invalid. Standard savings language will contain language specifying that the clause shall be construed “to the fullest extent allowed by law…” In those cases, even if the indemnity provision itself were deemed invalid (because of statute, public policy, or any other reason), a court construing the agreement would interpret it to the extent that applicable statute or policy would allow it to be construed and still be enforceable. For broad-form indemnity agreements, which purport to transfer any and all risk to the indemnitor, this language can “save” the agreement from a judicial interpretation rendering it unenforceable – for instance in a jurisdiction that does not allow contractors to be indemnified for their own negligence.

Parties may not wish (or be able) to transfer all risk to another party. Whether the considerations that inform this decision are financial, business relationship, or otherwise, a party may wish to retain some of the risk that accompanies its contractual relationship. In these cases, contractual partners may agree to an intermediate indemnity agreement. Here, the indemnitor assumes all risk, with certain exceptions. In most circumstances, an indemnitor under an intermediate indemnity agreement assumes all risk both for its own negligence, as well as joint negligence. The only circumstances in which an indemnitee, then, would retain the risk would be where the indemnitee is solely negligent. Of course, this may lead to the begged question of liability and litigating fault. While parties should recognize that this type of agreement may necessitate a finding of fact, it does mitigate the risk of a judicial finding that the clause is unenforceable. For an indemnitee looking to avoid significant risk while at the same time maintaining peace of mind that a court will not strike the agreement, an intermediate indemnity agreement may make sense.

Finally, parties wishing to transfer risk may agree to a limited form indemnity agreement. An agreement like this generally incorporates an analysis of comparative fault. It may include qualifying language like “to the extent caused by…” The indemnitor agrees to indemnify its contractual partner, but only to the extent that certain conditions are met (or not met). For instance, the agreement may be only to the extent that the other party is not negligent, or to the extent that the other party is not involved in the loss. Again, wording like this could lead the parties into a factual dispute. But the language of the contract is designed to protect the indemnitee should they be found not entirely negligent.

Risk Transfer through Insurance

A party may also transfer its risk to another through insurance. Of course, an insurance policy is also a contract. But whereas an indemnity provision may form just a part of a larger contract, the express purpose of an insurance policy is risk transfer. As such, the policy offers a policyholder unique benefits geared toward the purpose of transferring and mitigating risk.

Most liability insurance policies provide a mechanism under which the insurance company must defend its policyholder against potentially covered claims. While this obligation can take different forms, the most common comes as a “duty to defend.” Here, the insurance companies agrees that it must defend its policyholder from claims seeking damages covered under the policy. A key benefit of the duty to defend lies in its breadth. Many jurisdictions require an insurance company to honor its contractual duty to defend if the allegations against the policyholder even potentially fall within the policy’s coverage. And often, courts will analyze this duty looking only to the insurance policy itself and the complaint against the policyholder. In other words, extraneous evidence, including evidence that would undo coverage for the allegations, is not considered. These broad defense parameters can protect a policyholder against even false or fraudulent allegations. A liability policy’s duty to defend provides a policyholder peace of mind that should it face liability, its insurance company should step up to defend.

Risk Transfer Via Another Party’s Insurance

Parties may also include an insurance requirement in a separate contract, under which one or both parties must buy and maintain insurance for general or specific potential liabilities. The logic behind this makes sense for both the potential indemnitor and the potential indemnitee. From an indemnitor’s perspective, maintaining insurance can mitigate any losses that it must pay to the indemnitee under the contract. On the flip side, requiring an indemnitor to obtain and keep insurance provides an indemnitee the comfort of knowing that should the indemnitor be unable to pay, the deep pockets of the insurance company are serving as a backstop.

An indemnitee may negotiate contract language that the indemnitor’s insurance policy name the indemnitee as an additional insured. Both parties would then enjoy the direct benefits of the insurance policy. Under this arrangement, however, an indemnitee would be wise to require either a copy of the policy, or the endorsement naming the indemnitee as an additional insured. While often the reciprocal party or its insurance company will provide a certificate of insurance, rarely will such a certificate be proof of the indemnitee’s additional insured status. Should push come to shove, a court likely will look to the policy itself to determine additional insured status. A putative additional insured does not want to find itself in the position of believing it has status under the insurance policy only to find that it does not.

Conclusion

Indemnity provisions and insurance policies can – and often should – work together to ensure that the party transferring risk does not later find gaps through which liability can slip. But both agreements can bring with them pitfalls for the unwary. Parties to such arrangements should carefully review both the applicable contract and insurance policy to confirm that they are obtaining the agreement that they bargained for. Contract language should be clear, simple, and consistent. Explicitly denominating the risk to be transferred can provide certainty in contracting, and greatly increase the bargained-for protection needed for your company or business.