Ensuring or Insuring indemnity coverage?

Allocation of liability using an indemnity structure is a well-established concept of contracting for energy projects. Typically, indemnity regimes have always been separate from any insurance obtained, this is to avoid any issues relating to caps, limitations of coverage or even loss of coverage.

As costs are rising, contracting parties continually look for ways in which to reduce exposure or to limit potential liability. When negotiating allocation of liability, is it acceptable to allow the indemnifying party to connect their liability to insurance?

Indemnity versus Insurance

Where a party provides an indemnity they are agreeing to accept the transference of responsibility for a specified loss and that they will keep the indemnified party whole against such loss. However, where they agree to provide insurance for certain types of loss, any coverage in respect of that loss will be limited by the terms and value of the insurance policy obtained. While insurance itself is a form of indemnity, it is caveated and limited in various ways and, notwithstanding a contractual obligation to procure the insurance, is only effective once the policy is in place.

A contractual indemnity, where the party takes on the liability directly themselves, does not require any further steps and, other than solvency, is not subject to any caveats.

Insuring indemnities

It is becoming more common for parties giving contractual indemnities to seek to limit their liability to, or offset it against, any insurance coverage that either they obtain or that the indemnified party may already hold themselves.

The intended benefit of an indemnity is that it is an absolute obligation to make payment up to the agreed amount where losses of the type specified are incurred. It remains subject to some credit risk depending on the financial capability of the party providing the indemnity but again, this can be mitigated through careful diligence and ongoing consideration of the indemnifying party's financial position during the life of the underlying agreement. Indemnities can also be backed by security where the financial position is deemed too risky, however, the ultimate risk that the indemnifying party, or the wider group it is part of, becomes insolvent will always remain.

Where an indemnity is capped at the insurance coverage available there is always a risk to the indemnified party that the policy will not pay out or will be invalidated in some way. While this can be mitigated to a certain extent by having sight of the policy and being named as an additional assured, the risk remains that the payment available may not be aligned to the value of the loss incurred or the policy may become invalidated.

Alternatively, permitting an indemnifying party to offset their risk against insurance that is either obtained or already held by the indemnified party still comes with risks. Where an offset right is included, it may imply a requirement on the indemnified party to actively obtain that insurance. Moreover, depending on the terms of the policy obtained, it may not be valid to allow the indemnifying party to rely on offsetting its liability against that policy so the indemnity could be at risk of becoming ambiguous.

Ensure insurance is correctly handled

Indemnities and insurance are each intended to address specific risks but the nature of each is markedly different. Linking insurance to indemnities risks devaluing the benefit of the indemnity structure and leaving the indemnified party exposed to greater risk. The starting position should always be that indemnities are requested for specific areas of concern or significant risk and this is decoupled from any requirement to obtain insurance.