A contractual risk transfer is a non-insurance contract or an agreement between two parties in which one agrees to protect and hold another party harmless for specified actions, inactions, injuries or damages.
This sort of risk transfer enables a construction-company owner, for example, to find a source to pay the cost of a claim and to develop a means to avoid or lessen the cost of a loss. Because of highly complex and legalistic wording, contractual-risk-transfer agreements have become more confusing and difficult to manage over time.
Construction company owners can thus find themselves at risk because of misunderstandings. It’s also common for owners to mistakenly assume they’ll be protected by state law. In fact, the law usually honors the wording of contracts as it was agreed to. That is because nearly all of these agreements have the five elements that are required to have a legally binding contract. These are:
- Consideration: This refers to an exchange of value. Every person in a contract must give something of value to the others. One person is getting protection while the others are getting work.
- Legal purpose: This makes a contract valid, as long as it isn’t contrary to public policy.
- An offer: This is a proposal made by one of the potential parties to a contract, usually the one seeking protections from a loss.
- Acceptance: This must be unconditional and unqualified. If someone’s acceptance is qualified or conditional, no agreement will be in place.
- Competent parties: For a contract to be binding, both parties to it must have the legal capacity to make a contract, of legal age (usually 18), and be mentally competent
As the person offering or accepting a contractual risk transfer agreement, you’ll find it’s in your best interest to fully understand the details of any agreement you are considering. What you don’t know could harm you.
Use these 5 FAQs below to any answer questions you might have about contractual risk transfer agreements.
- How do insurance policies respond to contractual risk transfer?
Understand that insurance is at the mercy of your contract, since it will tell everyone how to cover a loss. Although an insurance policy provides financing, contracts provide rules. And although an insured party can contractually agree to almost anything, there won’t necessarily be coverage. Policies only respond when an injury or damage falls within the coverages granted to the insured. More on this later.
- Why should I indemnify someone who is partially responsible?
The short answer is that it’s the right thing to do. Someone’s policy is going to respond to a loss, and ultimately you and the other party agreed upon who should be responsible and whose policy should respond to a covered loss. The most important thing after a loss is to accelerate the claims process so the injured party is well served. Not only is this the right thing to do; it will pay off with branding and marketplace reputation.
- Does contractual risk transfer absolve me of all risk?
Although risk is pushed “downstream” to the next contractor, the risk assumed in a contract may not be covered by another’s policies. The reasons for this include coverage gaps and exclusions in policies. Responsibility for losses is determined according to contract language, but contracts don’t necessarily guarantee payment from the other party. If another party’s policy doesn’t respond to a loss, yours most likely would. Although your insurance company may seek subrogation from the other party in the contract, you should ask yourself if that company has enough assets or cash to pay for the loss. If not, you may be responsible for the loss. A solid broker, one with knowledge of the construction industry, may be able to help you determine if the proper coverages and policy wording is in place to fully protect you on the jobsite.
- We collect certificates of insurance and are listed as “additional insureds.” Isn’t that enough to protect us?
Collecting a certificate of insurance, or COI, in itself is the most dangerous way for you to run your contractual-risk-transfer program. First, you don’t know if the information is legitimate. Second, you don’t know if it gets cancelled 10 minutes later. Getting listed as an “additional insured” will help verify the accuracy of the information on a COI and ensure that you will be notified if a policy is cancelled. The risk in relying on this practice is that there may be no agreement in place stating how a loss should be handled or the minimum limits required. This could leave you scrambling, in the event of a loss, to protect yourself.
- What is the best way to write contracts?
First off, you should talk to a contract attorney for sound advice and representation. General contractors typically would want to keep indemnity separate from insurance requirements. Doing so ensures there is no assumption by others that indemnification is capped at the sub-contractor’s insurance limits. Subcontractors should review these contacts to ensure that they are not fully responsible for losses they had little to no control over.
Eric Messer is a construction-industry business and risk consultant in the Milwaukee office of Marsh & McLennan Agency LLC. He can be reached at (262) 797-6281 or [email protected]