With contracts, know what you’re agreeing to before you sign

“People think their insurance is always going to be there to back them up,” says Alan Pepoy, CPCU, ARM-P, risk technical specialist at Arthur J. Gallagher. “But in a broad form hold harmless agreement you can agree to accept risk that is essentially unlimited.”

Imagine this: One of your employees is substantially injured and puts in a sizable workers’ compensation claim. The injury resulted from a condition that was created by another company, let’s say ABC Corp. So, your employee — with the help of his or her attorney — sues ABC Corp. for “pain/suffering” based on the fact that it negligently created and allowed the condition to exist.

Your contract with ABC Corp., however, included a hold harmless or indemnity agreement that requires you to indemnify it for any and all claims. Your general liability insurance provides defense and coverage for ABC Corp. based on the hold harmless language, even though you didn’t create the negligent condition. But now you’re on the hook for a million dollar loss. Scenarios like this can happen because contracts open up your company to many potential exposures.

Typically there’s a conflict between obtaining business (sales) and managing risk. Sales may be pressured to get new business, even if it means accepting unreasonable risk. Instead, you want to balance sales with risk — not have your sales force promising anything and everything to get a deal.

Smart Business spoke with Pepoy about how to minimize the contract risk that can significantly affect your bottom line.

If a company doesn’t comprehensively manage its contract risks, what can happen?

You may be accepting risks that aren’t insured or diluting your coverage and limits because you’ve shared the value of that policy with third parties. Most policies are written on a ‘per occurrence’ basis subject to an aggregate limit, so after X number of claims, you could exhaust your limits and thereafter be uninsured.

In a worst-case scenario, you could jeopardize your company’s financial stability if you don’t have the wherewithal to pay a significant claim once a policy is diluted or you face an uninsured loss.

Which companies are the most affected?

Midsized companies that routinely enter contracts, such as construction, lease, service and vendor agreements, etc., are the most affected. You can sign a contract that has myriad requirements that doesn’t coincide with your insurance. You may even be extending your insurance to cover another party’s negligence.

Larger companies often have more stringent wording and won’t let you change the contract wording if you want their business. It’s important to attempt to negotiate. If that doesn’t work, at least be aware of the risk, so you’re not caught off guard.

How do you recommend business leaders manage contract risk?

Make sure all agreements — sales contracts, purchase orders, purchase agreements, etc. — are reviewed by your legal adviser, risk manager and insurance broker before you sign. They will point out areas of concern. Then, it becomes a business decision of whether the risk is acceptable or not.

You want a systematic process to transfer risk, via contracts, to third parties up and down the supply chain. If you’re dealing with a contractor that cannot pay the premium for the type of coverage you want them to have, it might be time to look at larger companies.

Make sure your organization not only reviews the documents and contracts but also the certificates of insurance.

It can be time consuming to set up the proper insurance coverage and wording. Once you’ve made the initial investment, especially if you have the right advisers, it’s not onerous. But it has to be done consistently. For years, nothing may happen; when it does, it’s usually a major claim.

If you do accept risk, consider how to avoid it. With loss control, you can increase the presence of safety to make an occurrence less likely. The problem is that when you accept risk from another company you may not have control.

It’s time to pull your sample contracts and get them to a competent risk adviser to have a discussion about what risks you’re actually taking on.

Insights Insurance/Risk Management is brought to you by Arthur J. Gallagher & Co.