Contractual Risk Transfer 101

When signing a contract with a vendor or supplier, you are most likely agreeing to terms that are either bringing on risk or passing on risk.  Almost every company doing business has partaken in this for years.  But have you ever examined what is actually written in your contracts and how your company is affected or exposed?  Let’s start by understanding the process.

A product will be “handled” by multiple parties throughout its life cycle while moving through the entire supply chain, manufacturing chain and distribution chain. Sound business relationships are vital for smooth functioning and for getting the product out to market quickly.  So how do you handle mishaps that inevitably occur, while still avoiding potentially contentious situations with suppliers and vendors?  The best way is to clearly spell out each party’s responsibilities in advance through various contractual agreements, which are typically required.  Since injury and liability can be created at any point along the product’s path to the end consumer, it is extremely important to create language that shifts the burden of responsibility to the party that has the greatest ability to mitigate the risk.  The portion of the contract that deals with risk transfer is critical, and below are the most commonly used provisions to accomplish contractual risk transfer.  Keep in mind that contractual laws vary from state to state, and your attorney can and should advise you on those nuances. Also, remember that every contractual agreement should be looked at under a case by case situation and one “generic” agreement is not recommended as relationships with vendors and suppliers can vary and can create their own challenges.

  • Indemnity provisions. This section may include one or more of the following obligations:
    • 1) Indemnify – To reimburse the other in the event of a loss.
    • 2) Defend – To pay for legal defense if a third-party brings a claim.
    • 3) Hold Harmless – To exempt a party from any responsibilities in the event of damages.

As an example, a manufacturer may agree to indemnify, defend and hold harmless the vendor who is selling the product from any claim that arises from a third party in connection with the product.

Keep in mind that before agreeing to an indemnification provision in a contract, it will be important to check the wording against the coverage provided by your insurance policy, as many times the indemnification section in the contract is broader than the coverage in the policy.  In that case, you would be responsible for the uninsured liability.  For example, many policies will not cover the other party’s sole negligence yet many contracts have this wording in them.

  • Exculpatory provisions. Exculpatory provisions act as a way to eliminate a company’s liability stemming from its own wrongful acts. It may be a simple statement requiring the other party to waive any and all claims against you that result from the business being transacted.  In theory this provision is a convenient way to be shielded from potential lawsuits; however, courts may not enforce it.  Companies should be very wary of accepting this type of provision in contracts.

  • Additional Insured provisions. Another way to transfer risk is by requiring the other party to list you on their insurance policy as an Additional insured and vice versa.  This obligates their insurance carrier to defend and indemnify you as an Additional Insured, even though you pay no premium. Within this provision, other insurance requirements may also be stated, such as the limits, the type of policy form and what type of insurance is required.

It is not enough to simply get an e-mail stating you were “added” as an Additional Insured or receiving a certificate of insurance that shows you were added. You need to see the actual endorsement as coverage for an Additional Insured can be drastically reduced to limit the insurance carrier’s exposure.  This can lead you to being majorly underinsured without even knowing it. The endorsement will spell out how you are covered and if there are restrictions or sub-limits for you as an Additional Insured.

If you are adding companies to you insurance policy to gain their business you really need to be careful as well. One very good risk management tactic to follow is to do an annual aggregate contractual liability exposure analysis with your broker.  This will help you understand and see all the liability that you have taken on.  For example, if you add 10 companies as Additional Insureds throughout the year and you only have $1,000,000 in liability coverage, is that enough in the event of a claim? Or if you have a $900,000 claim then that means you only have $100,000 left for all the other additional insureds to tap in to.  A bit scary if you ask me.

  • Waiver of Subrogation provisions. Subrogation is the process of one party’s insurance carrier seeking reimbursement from the other party for money spent if they believe that other party was at fault.  If your insurance carrier is seeking reimbursement from one of your business partners, it has the potential to severely damage that business relationship. In order to avoid deteriorating partnerships, one or both parties can agree to waive their right of subrogation against the other party before a loss occurs. As with the exculpatory provision, the waiver of subrogation may not hold up in court in the case of gross negligence or willful misconduct.  Additionally, your insurance company will want to know if you are doing this and in some cases be the final say because they are the one paying for the claim in the end and/or trying to recover monies.

Shifting the burden of liability through contract language is one method companies have to manage their risk. Keep in mind that just because you sign a contract, it doesn’t mean that your insurance company will agree to the terms and cover a claim. Understanding these terms and provisions as well as how to properly transfer risk is a step towards limiting your company’s overall liability landscape.

NOTE:  We are not attorneys and are not recommending any legal advice.  All contracts and the information below should be discussed with your counsel before implementing.

 

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