Contractual Risk Management

Paul Koziatek

Organizations choose to self-insure particular exposures because they believe it is more cost-effective to do so over time. For reasonable losses, with a small likelihood of deviation from year to year, it makes more sense to retain the risk rather than pay overpriced premiums to transfer the risk to an insurance company.

Advanced risk financing software tools and techniques are assisting firms in generating scenarios that evidence the long-term value that can be created from retaining a specific amount of loss exposures.

An important technique resulting from increased self-insured retentions and larger deductibles is the need to transfer those risks to responsible parties. This technique, identified as contractual risk transfer, should be implemented within organizations that make large out-of-pocket payments for losses before true insurance is triggered within their coverage portfolio. Contractual risk transfer is the risk management technique of allocating the risk among contracting parties.

Every organization enters into contracts. These business agreements encompass many risk-related provisions. These provisions specify which contracting party is responsible for loss or damage and what insurance is required of the responsible party. The parties to a contract negotiate and agree on risk transfer terms that become the governing law for the particular business transaction. If performed effectively, placing responsibility for risk on the parties is consistent with their ability to control and insure against that risk.

During the audit phase of identifying, analyzing, evaluating loss exposures, and implementing a risk management technique, a firm should consider all of its contractual obligations with outside vendors and contractors. The inherent risks in the agreements with these customers can create a substantial financial impact for an organization in the event of a loss in which the company makes payments for losses not under its control.

Contractual risk transfer is generally considered a risk financing technique. When financing risk, a risk manager decides whether to retain or transfer the risk. If transfer is the chosen technique, the risk manager must decide whether to shift losses to an insurance company or another party through contractual provisions. The indemnification, hold harmless and insurance provisions affect the allocation of risk in a transaction. Indemnity clauses alter the way liability is allocated between contracting parties by requiring one party to indemnify the other for liability to third parties. The overall intent of the indemnification clause is really to protect the company from loss of funds.

A hold-harmless agreement is a form of an indemnity provision in that one party is agreeing to assume the responsibility of another. In the hold-harmless arrangement, the indemnifying party, the indemnitor, agrees to reimburse the indemnitee for all losses, no matter who is at fault.

The insurance coverage required in a contract is another key provision found in contractual risk transfer. The coverages act as the backup to the indemnification language. By requiring that a contractor or vendor is properly insured, the company can be assured the contractor will have sufficient funds to pay for a claim. It is important to note the types and amounts of insurance, and most importantly an additional insured endorsement will coincide with the indemnification provision. Again, the insurance should reinforce the terms of the indemnity clause.

As mentioned earlier, the basic premise behind the indemnification clause is to pass the responsibility of loss to the negligent party. In most cases, independent contractors are not working under the direction and control of the company that hired them to perform the work. Therefore, if the contractor is involved in serious loss resulting in high bodily injury or property damage expenses, the company should not have the responsibility of paying for claims that could arise. The company expects the contractor to step in and cover costs the company might incur as a result of the contractor’s actions.

profound effect on which indemnification language is chosen. A company hiring a contractor to enter their facility and perform asbestos abatement may want to require an indemnification agreement in which the indemnitee has extremely little potential for out-of-pocket expenses, given the fact that any claim resulting from asbestos abatement is most likely going to be a costly piece of litigation.

The second most important aspect of contractual risk transfer involves the requirement of insurance coverages from the indemnitor. Without true loss transfer to an insurer, a company may not be certain that the indemnitor will have sufficient funds to pay for a loss. Indemnity agreements and other risk transfer techniques are only as good as the indemnitor’s financial ability to meet its contractual obligation to indemnify.

Although the transfer of risk is completely independent of insurance coverage, the indemnitor’s inability to fulfill its indemnity obligations does not relieve the indemnitee of its liability to a third party. For that reason, indemnities should take reasonable steps to assure the needed funds will be available when a loss occurs. Reviewing an indemnitor’s financial records is not practical, so insurance becomes a necessary obligation for contracts.

The overall goal when drafting insurance requirements is to differentiate between the types and levels of coverage that are carried out by the contracting parties. Current insurance language should be used rather than obscure or outdated terminology. The requirements should also reflect common industry practices and approaches to providing commercial line insurance.

Every organization enters into contracts to conduct business. A written contract describes the purpose of a business relationship, the responsibilities of each party to the contract, the number of funds exchanged, length, and other key terms and conditions.

By focusing on the key contract provisions of hold harmless/indemnity provisions and insurance requirements, a firm can reduce its overall exposure by transferring the financial impacts of claims to third parties. Today’s world of high-cost litigation demands that companies reduce their insolvency risk as much as possible.

Paul Koziatek is a Senior Vice President currently serving in our Marsh Tampa office. He is responsible for client service delivery including placement and development of strategic risk management initiatives and outcomes. Paul provides advice to both Marsh and client executive leadership across all lines of coverage with a specialization in alternative risk solutions.