What is Contractual Risk Transfer?
Examining and managing risk exposures is one of the keys to the long-term success for businesses of all sizes. However, when you work with partners and other parties such as contractors, renters, component suppliers and service providers, you may be held accountable for their actions or negligence. And because your regular risk management procedures and insurance policies generally don’t cover others, you could be found liable for huge losses. This is where contractual risk transfer can protect your business.
The best protection in these situations is to shift risk and liability away from your business and onto other parties. Thankfully, you can do this when you draft a formal business contract by including provisions, clauses and other text that determines exactly who is liable for specific scenarios and losses. This is generally referred to as contractual risk transfer and can include a wide range of provisions on liability. For example, a business could agree to be responsible for losses only when employees or customers are on the premises.
Protection and Risks
Because properly worded contracts are legally binding in court, they can help protect your business in the event of a loss or dispute. Additionally, contracts can contain insurance requirements, waivers and other types of risk transfer that give your business legal counsel or direct financial compensation. Although contractual risk transfer is an effective way to protect your bottom line when working with partners and other parties, the practice itself may expose your business to significant risks.
Many states have laws that require specific legal language in order to make contractual risk transfer enforceable, and some states have outlawed specific types of contractual risk transfer altogether.
This guide is meant to give a general overview of contractual risk transfer, including summaries of how and when specific types of risk transfer may be used. This guide should not be considered legal advice, and you should contact legal counsel for advice before you agree to a contract with other parties.
For more information on risk transfer and contracts, call GDI Insurance Agency, Inc. today 209-634-2929.
Legal Language Overview
Because contracts and all other legal documents may be read by many different people, it’s essential for them to be written in a way that ensures that they will be interpreted and enforced in a clear and consistent way. For this reason, words and phrases inc1luded in contracts are often interpreted literally, and their meaning can greatly differ from more informal, conversational language.
For example, think about the definition of the word “should.” When a manager tells an employee that they “should” be in the office before a certain time every day, the employee has a general understanding that this is a job expectation. However, because the literal definition of “should” states that the action is only probable and not guaranteed, including “should” in a legal document could cause readers to interpret its meaning in a number of different ways. Instead, most legal documents use clearer language to outline expectations, such as “must”, “will” and “shall.”
Here’s an overview of key terms that are essential to understanding contractual risk transfer.
The legal responsibility for a party’s acts or omissions. Legal proceedings involving liability focus on finding the party that was ultimately responsible for a loss, injury or other damage. Then, any relevant contracts are examined to see if any liability was transferred to another party, and if those risk transfer provisions are relevant to the situation.
It’s also important to note that courts often consider vicarious liability when investigating a case. Under this form of liability, a party can be responsible for a loss that they did not cause if they have a special legal relationship to the party who was ultimately at fault. For example, a person could sue an entire business if a single employee’s negligence leads to their injury.
A failure to exercise the care toward an individual or situation that a normal, responsible person would take. Although negligence is accidental in nature, a negligent party can still be held responsible for a loss or damage. Most states have laws that prohibit or limit the transfer of liability that results from one party’s own negligence.
Because negligence can involve the relationships between multiple parties’ actions and inactions, there are a few different types of negligence with important distinctions:
- Gross negligence: An extreme form of negligence that is still accidental in nature, but also shows a reckless disregard for the safety or lives of others. Many contractual risk transfer provisions contain exclusions for gross negligence.
- Sole negligence: Negligence that can be attributed entirely to a single person or party. Sole negligence is extremely difficult to prove, because any involvement whatsoever by another party would qualify as a separate type of negligence. Many states have outlawed contractual provisions that contain sole negligence exclusions in order to protect parties that don’t understand sole negligence and accept additional risk without their knowledge.
- Joint or contributory negligence: A situation where multiple people or parties are simultaneously negligent for a loss, injury or other damage. During a lawsuit, a court may find that multiple parties were negligent and assign different amounts of liability to each party. However, state laws concerning this form of negligence vary greatly.
The amount of reasonable care or attention that a normal, responsible person would take in any given situation. A party may attempt to avoid liability for a loss by proving that they were diligent and took reasonable steps to avoid damage or transfer responsibility for the situation to another reasonable person.
The act of one party agreeing to provide some form of compensation for the loss, damage or liability of another party under one or more specific circumstances. This is one of the most common and broadest forms of contractual risk transfer, as the party that compensates for a loss takes on some of the other party’s financial risk. Three additional terms are often used when discussing this process:
- Indemnity: The actual compensation that’s exchanged when one party indemnifies another. The form of compensation may vary depending on the specific wording used in different indemnity clauses.
- Indemnitor: The party that promises compensation through an indemnity provision. This party takes on additional risk by offering the reimbursement in a contract.
- Indemnitee: The party that will receive compensation through an indemnity provision. This party has transferred part of their risk elsewhere by getting a promise of reimbursement through the indemnity provision.
When used in a contract, the term hold harmless refers to
the act of one party protecting another party from losses and liability. Although
some experts believe that the terms indemnify and hold harmless can be used
interchangeably, not everyone agrees. Courts generally find that hold harmless
is a broader term that refers to protection against both liability and losses,
while indemnify only protects against losses by promising compensation after
damage has already occurred. However, both terms are often included in
indemnity provisions in order to offer more protection and avoid confusion.
Duty to Defend
The promise to provide for a legal defense or transfer funds to hire counsel. Many contracts include a duty to defend provision in which one party promises to accept responsibility for any costs or work related to lawsuits.
A term that’s used to provide partial or full exceptions to the contractual liability exclusion in most commercial general liability (CGL) insurance policies. Most CGL policies don’t provide coverage for damage that comes from one party’s agreement to take on extra liability, since this extra risk wasn’t considered during the insurance underwriting process. However, if the extra liability was a part of a contract, an insurer may label the extra liability as part of an insured contract and provide coverage.
Subrogation is the legal ability of a person or group to use the rights of another when resolving debt or an insurance claim. When talking about contracts, subrogation usually refers to an insurance company that’s trying to recover their losses from a loss that it paid out. For example, if an insurance company pays for one of its policyholder’s losses, it can legally use that person’s right to sue the at-fault party to try to recover the damages.
Waivers of subrogation are a common form of contractual risk transfer where the parties forming a contract deny this right to insurers. As a result, insurance premiums may go up.
The Common Types of Contractual Risk Transfer
Contracts are binding legal documents that outline the relationship between your business and another party, and the different sections included in a contract will detail how you operate together. In order to transfer liability from one party to another, contracts include dedicated sections—often called clauses or provisions— that describe the subject of risk and liability. Because contracts are a negotiated agreement, there are a number of ways to transfer liability during the drafting process. However, there are three main types of contractual risk transfer:
- Indemnity provisions
- Additional insured provisions
- Waivers of subrogation
Each type of contractual risk transfer has unique advantages and disadvantages, and you should examine each one to see what’s right for your business. For example, many states have laws that limit some of the types of contractual risk transfer, and some may be outlawed entirely.
When determining the type of risk transfer that’s best for you, you should consider the following questions:
- How can I establish the best working relationships with others?
- What types of risk transfer are most common in my area and industry?
- What type of risk transfer offers me the most financial protection in this scenario?
- Who will review my contract to ensure it’s both legal and in my best interest?
In order to help you answer these questions, the following pages will detail the three main types of risk transfer and provide you with an overview of their advantages, disadvantages and more.
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