Entering into a contractual relationship can expose your organization to significant contract liability. Implementing standard safeguards indicates a well-rounded risk management program and guards against potential losses. An organization should require a contractor to assume liability arising out of the contractor’s negligent conduct, delivery of products, services or activities. This type of risk transfer is the most common, as the contractor is generally the party in the best position to prevent potential losses.
The first way to transfer risk is by requiring the other party of your contract to hold your organization harmless in what is known as an indemnification agreement. “Indemnity” is a protection against loss. In an agreement, one party agrees to protect the other against losses arising from their services, products, activities or use of facilities. Indemnification agreements should be used with all suppliers, contractors, tenants and facility users.
To ensure any potential claims are paid, contractors should also provide insurance appropriate for the services or activities involved. In addition to protecting the contractor, the insurance should also protect your organization or entity, and its officers, officials, employees and volunteers.
Clear language helps you avoid contract liability
Utilizing clear indemnification language and requiring insurance coverage in your contracts provide the following benefits:
- Protects you from being held liable for damages caused by your contractors
- Encourages safe practices on the part of the contractor by placing the responsibility on them
- Allows you to rely on the contractor’s expertise to do the job safely, because they are required to cover the consequences
- Places potential risk upon those best able to control the work (the contractor)
- Provides an alternate source of payment for losses against your organization that you did not cause and are not responsible for
- Helps to preserve your organization’s budget, assets and loss performance reputations with your insurers
When entering into contracts, keep the four following steps in mind.
4 considerations prior to signing a contract
- Review the Risks and Relationships
Start by analyzing the scope of work involved in the agreement, the contractor or persons completing the work and the relationship that they will have with your organization. Clearly defining and adequately describing these items is crucial for avoiding contract liability, especially if there are later disputes over exactly who was responsible for what.
Determine what objectives are to be accomplished. Vet out the project and contract with these questions:
- What could go wrong, and what potential losses could occur?
- What are the critical steps in completing the project or objective safely?
- Is the contractor or other party qualified and/or accountable?
The potential risks involved and your options for minimizing them will vary. Researching the work, the contractor or vendor, any additional parties and the potential risks will help determine the most effective ways to protect your organization. It’ll also save you time by allowing you to create a clear action plan for accomplishing any requirements.
- Utilize hold harmless language
All of your contracts should have hold harmless or indemnification language that includes an obligation for the contractor to defend your organization (including its employees, officials, agents, volunteers, etc.) in the event of a loss. Ideally, the language of the agreement should be able to be interpreted as broadly as possible in your favor. Hold harmless language shifts responsibility for loss or damage arising from the contract to the party providing services or acting on your behalf. Your contractor acts as your representative while performing services for you, provided they are within the scope of your agreement and damages caused to others by their performance on your behalf can be collected against you. Adequate indemnification language will allow your organization to tender claims to the contractor for defense and indemnity.
It is best to use your own contract form with language that has been drafted by your attorney, but at times you may have to accept the other party’s form or negotiate the terms of the hold harmless language with them. If you do have to make changes or accept another form, always have your attorney review and approve any language before executing the agreement, to avoid contract liability.
Related: Steps to prevent business fraud
- Require adequate insurance conditions
Requiring a contractor to carry insurance ensures that they will have sufficient resources to cover potential losses and protect your organization. Include the requirements in your initial bid or contract negotiation process so they are prepared in advance to secure coverage.
Your entity should request the following protections as part of the insurance requirements:
Additional Insured Endorsement: This will name your organization as an additional insured under the other party’s general liability policy for covered claims arising from their work or activities on your behalf. It provides you direct rights, access to recovery and increased opportunity for legal defense from their policy. Request that your entity and its officials, employees, and volunteers be added to the endorsement as additional insureds to all applicable liability policies, so that all parties potentially involved are covered too.
Primary Coverage: Requires the other party’s insurance to be the first to cover any claim, with your coverage applicable only after their limits are paid out. This language is generally included in general liability policies and does not require a separate endorsement. Be sure to check that the policy has this; if it is just stated in your contract and not included in the policy, the condition is not binding with the insurance company.
Waiver of Subrogation: A provision in contracts that requires one party to give up its right to subrogate, or recover damages, against another party. Subrogation usually occurs when an insured suffers loss from a third party. The insurer pays the insured the damages, which waives the insured’s right to sue and recover damages directly from the third party. The right to recover damages then transfers to the insurer, who can then sue to recover the damages they paid out as a claim. Requiring the contractor’s insurer to include a waiver of subrogation prevents them from pursuing a claim against the other contractual party involved (your organization) in an attempt to recover money they paid to resolve a covered claim.
High Deductibles or Self-Insured Retentions: Be aware of any high deductibles in the contractor’s insurance and make sure the contractor is capable of paying them. An insurance company has no obligation to pay for damages or defense until the deductible or retention is paid. Some entities choose a high deductible or retention as a cost-saving measure to save on premium, but you can require your contractor to obtain insurance with reasonable deductibles that they can afford.
Notice of Cancellation: Make sure your agreement with the contractor includes requirements to notify you immediately if their coverage has been cancelled so that you can cease the project or services being provided until coverage is replaced.
Verification of Coverage: Proof of insurance is usually provided on a Certificate of Insurance listing the types of coverage, the names of insurance companies, coverage period, limits and deductibles or self-insured retentions. The certificate will name your organization as the Certificate Holder. Be sure to receive a new certificate when coverage renews for ongoing agreements. To be named as Additional Insured requires an endorsement to the policy. Some policies issue a blanket endorsement that adds all contracted parties as an additional insured. Be sure to also obtain a copy of the endorsement or blanket policy language for your records.
Require Financially Sound Insurers: It is recommended to require insurance carriers that are A-rated by A.M. Best. However, you can deviate on the minimum financial size category or financial strength rating depending upon the size of the project or the type of risk based on the services being provided in the contract. You can check an insurer’s rating at www.ambest.com. If they have an insurer that is not rated, you may request other information that proves their financial ability to fulfill their claims payment obligations or check with your insurance broker for guidance on the acceptability of the insurer. Standard & Poor’s is also a common standard for measurement of insurer financial stability.
- Adjust the requirements to the risk
Being flexible during contract negotiations is acceptable, as long as you are obtaining enough protection for your entity based on the size of the project or activity. Analyzing the potential financial exposure to your organization and using your judgment or experience is key in minimizing your contract liability. If you are uncertain, contact your insurance broker for advice. They can provide guidance based on limits or contract requirements they are seeing in the insurance industry and their experience. A project or service may seem small, but take into account that there could be reputational damage and future loss of revenue to your organization if any incident occurs. Think of the long-term effects in addition to the damages that could result from contract liability when setting your required limits.
As a risk manager for your organization, you may determine that exceptions to the insurance limits are warranted after you’ve conducted your research and assessment of the risk. In cases where little or no risk is involved, your organization may decide that limits can be lowered or removed, if not applicable. Conversely, if you determine that more risk is involved, you should require additional types of coverage or raise the standard limits amount for adequate protection.
Contract liability can be easily avoided by implementing procedures with some forethought to the risks involved and putting the aforementioned safeguards in place.
This article originally posted on Arrowhead Tribal’s blog. It is used with permission and has been updated and modified to better fit the needs of ACM’s claims customers.