Contractual Risk Transfer: An Overview – Part 1 of 3
January 5, 2015
One of the most confusing and misunderstood concepts in insurance and risk management is contractual risk transfer. However, it is one of the most important aspects of a sound risk management program. Every contract you sign likely contains some level of risk transfer, although there is no standard language to accomplish this feat. Some contracts are one-sided and all the risk transfers to the party with the least amount of leverage, while others are more balanced and attempt to assign liability squarely onto the responsible party. And some contracts accomplish nothing in the way of risk transfer despite having an exorbitant amount of words related to that topic. Knowing what risk is being transferred to you and what risk you are transferring to others is a critical consideration when negotiating a contract.
The purpose of this post is to provide a broad overview of contractual risk transfer. I will talk about the two separate doors of accomplishing this feat: indemnification and additional insured status. In the second and third post in this series I will go into great detail on each and lay out some of the important considerations contractors need to be aware of.
Door 1: Indemnification
The word “indemnify” means to make compensation to another for hurt, loss or damage. One of the biggest misconceptions about indemnification is that it is insurance. Indemnification is not insurance at all. Indemnity is an obligation that is placed purely onto another party through a contractual relationship. It is, however, likely that your insurance program will provide coverage for your indemnity obligation, but there are definite pitfalls related to this kind of insurance coverage. If required by contract, the obligation to indemnify another party exists even if insurance is available or not, so it is important to make sure that your insurance program backs up the indemnity obligations being placed upon you. This also requires striking the indemnity obligations from contracts in which insurance coverage is not available.
There are three levels of indemnification: Broad, Intermediate and Limited Form. Broad indemnification requires one party (indemnitor – party providing the indemnity) to assume the obligation to pay for another party’s liability even if that other party (indemnitee – party receiving the indemnity) is 100% at fault. Intermediate Form indemnification requires one party (indemnitor) to indemnify another party (indemnitee) for their negligence if the indemnitor is liable. The last form of indemnification, Limited Form, is not really indemnification at all, meaning it is the liability you would assume in the absence of any contract.
If you are in the position of power, the most advantageous form of indemnification you can receive from another party is Broad Form. If you are in the weaker position and required to provide indemnification to another party, you should attempt to limit your obligation to Limited Form. However, there are several other nuances to consider, which I’ll address in the second and third post in this series.
Door 2: Additional Insured Status
Completely separate and independent from indemnification is something called Additional Insured Coverage. Unlike indemnification, this is insurance. If you provide a third party Additional Insured status, you are giving them direct access to your insurance policies. Most often, Additional Insured Coverage must be endorsed onto the standard insurance policy because it is otherwise not included in the base form. Unfortunately today, it has gotten much more complicated to add another party as an Additional Insured. There are literally hundreds of Additional Insured endorsements, each with their own problems or shortcomings.
There are many similarities between Additional Insured Coverage and Indemnification. Just like indemnification, there are three levels of Additional Insured Coverage: Broad, Intermediate and Limited. However, you may recall that most states have adopted Anti-Indemnity Statutes which prohibit Broad Form Indemnity, but most often, these statutes don’t affect the level of Additional Insured Coverage that is required from one party to provide another.
Which Door is Better?
I often get asked by parties that are in the position of leverage, which is better – Indemnification or Additional Insured Coverage, and I am hesitant to provide an answer because the truth is you absolutely need both. In fact, a “belts and suspenders” approach is recommended. There was a time that Additional Insured Coverage was preferred over indemnification, because it gave an injured party direct access to an insurance policy instead on having to rely on being paid (indemnified). Because it has become so complicated to craft Additional Insured Coverage correctly, I no longer think that preference exists. The possibility that the Additional Insured Coverage is inadequate is too great with all the various endorsements that exist today.
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