The Basics of Risk Allocation

The Basics of Risk Allocation

Understanding Contractual Indemnity and Insurance Provisions

Contractual Indemnity

Shifting risk of loss from one party to another in a contract is recognized in many industries as a vital and necessary risk management tool.  Usually, the transfer of risk is carried out via an indemnity or hold harmless provision in the contract. For example, the Indemnitor (Party B) agrees to “indemnify or hold harmless” the Indemnitee (Party A) against certain liabilities arising out of the activity that is the subject of the contract.

Such provisions are typical in construction and service contracts in which Party A requires Party B to indemnify it for liability to a third party arising from Party B’s scope of work.  For example, a general contractor (Party B) might agree to indemnify the owner of a project (Party A) for liability to an injured third party arising from the owner’s or general contractor’s negligence.  Should the injured third party file suit against the owner, the owner can point to the indemnity provision in the contract and assert that the general contractor must indemnify it.  Typically, if the general contractor’s general liability insurance carrier determines that there is coverage, it will pay to defend the suit against the owner and any awarded damages, subject to the general contractor’s insurance policy limits

There are generally three types of Indemnity provisions:

1. Broad Form – provides that the Indemnitor (Party B) must indemnify the Indemnitee (Party A) for all liability and risk irrespective of which party was actually at fault.
2. Intermediate Form – provides that the Indemnitor (Party B) must indemnify the Indemnitee (Party A) for all liability and risk except where the injury or damage is caused by the Indemnitee’s (Party A) sole negligence.
3. Limited Form – provides that the Indemnitor (Party B) must indemnify the Indemnitee (Party A) for all liability and risk only to the extent of the Indemnitor’s (Party B) fault.

Limitations of Indemnity Provisions in Construction Contracts

It is important to understand that many states have imposed restrictions on the types of risk that can be transferred to another party in construction contracts.  For example, many states prohibit the transfer of one party’s own negligence to another party as a matter of public policy while others prohibit only the transfer of one party party’s sole negligence.

Anti-Indemnity Statutes in TBH&E’s Practice Jurisdictions

Maryland	By statute, prohibits contractual indemnification of one party’s sole negligence.  Md. Code. Ann., Cits & Jud. Proc. 5-401.
D.C.	No statute.
Pennsylvania	No statute prohibiting contractual indemnification if the intent of the parties to do so is clearly and unequivocally stated in the contract.  Otherwise, PA Courts have deemed broad form indemnity provisions unenforceable.  See Perry v. Payne, 217 Pa. 252, 66 A. 553 (Pa. 1907); Ruzzi v. Butler Petroleum Co., 527 Pa. 1, 588 A.2d 1 (Pa. 1991).
New Jersey	By statute, prohibits contractual indemnification of one party’s sole negligence. N.J. Stat. Ann. § 2A:40A-1.
Virginia	By statute, prohibits contractual indemnification of one party’s sole negligence. Va. Code Ann. § 11-4.1.

When a contractual indemnity provision is deemed unenforceable by statute or by the Courts, the legal obligation of Party B to indemnify Party A is not triggered.  Thus, Party A will be responsible for its defense costs and any award against it despite the fact that the contract may have stated otherwise.  To protect against this possibility, Indemnitees (Party A) will frequently require that it be named as an additional insured under the Indemnitor’s (Party B) insurance policy.

Additional Insured

Generally speaking, an Indemnitee (Party A), pursuant to a contractual indemnity provision, is not considered an insured under the Indemnitor’s (Party B) insurance policy.  As such, an Indemnitee (Party A) does not enjoy the same rights and protections that the Indemnitor (Party B) does under Party B’s policy.  However, if Party A is named as an additional insured under Party B’s policy, it would have a direct right to defense coverage and/or indemnification for insured claims under Party B’s policy, independent of the enforceability of the indemnity provision in the contract.  It, therefore, is preferable for Party A to not only incorporate an indemnity provision into the contract but to also require in the contract that Party B name it as an additional insured under Party B’s policy.

 Strategies for Allocating Risk as the Indemnitee (Party A)

1. Do not ignore your state’s Anti-Indemnity laws, if applicable, and make sure that your contract’s indemnity provision is clear and unequivocal.
2. Remember that any ambiguity of contractual terms will be construed by courts against the drafter of the contract.  Accordingly, if you are using your contract, make sure that the terms incorporated therein are clear and unambiguous. 
3. If your state prohibits contractual indemnification of your sole negligence, require that the other party name your company as an additional insured under its general liability insurance policy.
4. Require that the other party maintain adequate insurance coverage.
5. Verify compliance with your insurance requirements by requiring the other party to provide a Certificate of Insurance, confirming coverage limits and your status as an additional insured.
6. Be advised that a Certificate of Insurance provides only limited information regarding the other party’s insurance policy.  It does not bind coverage.  Therefore, you should confirm to the best of your ability that the other party’s policy of insurance does, in fact, name your company as an additional insured. Moreover, follow up with the insurance carrier monthly to be sure the policy is still in effect. Occasionally, dubious subcontractors will provide the COI during the bidding process then, after getting the job, will not pay the premium in an effort to increase profit.
7. Require that the other party immediately notify you, in writing, of any changes in insurance including the existence of other claims made against the applicable policy that would reduce the amount of coverage available to you.

Strategies for Accepting Risk as the Indemnitor (Party B)

1. Read the entire contract.  Before signing any agreement, it is paramount that you understand what you are signing.
2. Understand that if you execute a contract that contains a broad form indemnity provision, you are agreeing to indemnify the other party even if it is 100% at fault for causing the injury or damage.
3. Negotiate indemnity and insurance provisions.  Often times, you will be handed a “standard” contract that has not been modified to reflect the specific nature of your company’s scope of work.  Rather than simply accepting the contract as is, you should take an active role in negotiating reasonable terms.
4. If you are required by the contract to name the other party as an additional insured under your policy, make sure that you do so.  Upon executing the contract, contact your insurance agent/broker and confirm that the other party has, in fact, been named as an additional insured under your policy.  Failure to do so may constitute a breach of contract and leave your company personally liable for the other party’s defense and/or indemnification.
5. Be advised that a Certificate of Insurance provides only limited information regarding your insurance policy.  It does not bind coverage.  Therefore, you should obtain a copy of your insurance policy and confirm that the other party is, in fact, a named additional insured under the policy.
6. If your company routinely enters into contracts requiring it to name others as additional insureds under your policy, consider adding a Blanket Additional Insured Endorsement to your policy.  A typical blanket endorsement will automatically provide additional insured status to any party that your company agrees to name as such in an executed contract or agreement.

 

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 About the Author

Mike Hinkle is a founding partner of Timmerman, Beaulieu, Hinkle & Esworthy, LLC.  Mike’s practice focuses on complex business and insurance defense litigation in the federal and state courts of Maryland, New Jersey and Pennsylvania.  He can be contacted at (410) 649-4440 in Maryland, (717) 698-1428 in Pennsylvania or via email at mjh@tbhelaw.com.

 

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