Contractual risk transfer Featured

8:00pm EDT June 25, 2008

Keeping insurance costs to a minimum can be a challenge. One way to reduce long-term cost is by using the proper indemnification and insurance language in business contracts. By doing so, companies can limit their liability when working with outside parties and improve their risk to loss. Having strong contract administrative controls and a good loss picture ultimately leads to lower insurance premiums.

“Whenever there are two parties to a transaction you want to transfer your risk of loss (claims for bodily injuries, property damage, environmental loss, etc.) to the other party if you can,” says John Kurtz, vice president of The Graham Company. “By doing that you’re forcing the other party to assume liability.”

Smart Business asked Kurtz for more on how to take advantage of contractual risk transfer.

How does contractual risk transfer work?

It protects the company when you’re under contract by transferring responsibility for claims and loss and damages to the other party. So to the extent that you can transfer that risk to another party, you’re not responsible for it.

Can this be used in all forms of contracts?

In construction, it can be a subcontract or the contract that a construction manager has with an owner. Outside of construction, it could be a contract that you have with a major vendor, a major customer, a party in the product distribution chain or a financial institution. It could even be with a party sponsoring a special event.

Depending on which side of the transaction you’re on, you look to transfer that risk through contractual risk transfer anywhere you can. There are times when you may not have leverage in a transaction to transfer that risk, but at a minimum in those situations, you don’t want to be indemnifying the other party for their negligent acts.

Do companies still need insurance?

Regardless of whether you’re able to transfer the risk or not, you need to have insurance for the risk you assume. You’re going to have contractual liability insurance. But you still want to transfer the risk even if you have the insurance because it protects your loss experience. If your insurance company had to step up and pay a claim for a risk that you weren’t able to transfer to another party, you have that claim as part of your loss experience. If you’re able to transfer it, the broker is in a better position to negotiate lower premiums, and then also generate more interest among the insurance companies because you have strong contract administration in place and a favorable loss picture.

What should be included in a contract for effective risk transfer?

The business owner is going to want to have strong indemnification language shifting responsibility for claims and losses to the other party. So, again, even if you do not have the leverage in the transaction, you don’t want to indemnify the other party for their negligent acts. The most you want to be responsible for in that situation is your own negligence. If you have leverage in the transaction, you look to get that party to pick up as much as possible, including your negligence.

Who’s going to benefit the most in contractual risk transfer?

The party that benefits the most is clearly the party that’s able to transfer the most risk. It’s not a one-way street. I could sell you a product, and I might want indemnification and additional insured coverage from you. And you might say, ‘Why? I’m buying your product.’ The reason is that you’re going to buy my product and then make alterations to it and then re-sell it. So I want indemnification for that because I know you are going to make changes to my product. So there are all kinds of scenarios. Your broker needs to understand the nature of the transaction, how much leverage you have and how your policy coverage is structured.

What else should owners do to protect themselves when using contracts?

The other thing that the business owner wants in addition to the strong indemnification language is to be listed on the other party’s insurance as an additional insured on a primary and non-contributory basis.

There are two avenues for transferring the risk — the one is the indemnification language, and that transfers the risk to the other party. If you are sued, you point to the indemnification language that’s working in your favor. And then you show that you’re also listed as an additional insured so your coverage is also on that policy. Those are the two avenues of recovery under the other party’s insurance.

What else should a business owner understand before signing a contract?

The smart buyer has his broker look at anything before he signs it or before developing any subcontract language that he plans to use on a regular basis. Because in many cases it’s a couple of sentences or even a couple of words that can make a dramatic difference.

JOHN KURTZ is vice president of The Graham Company. Reach him at (215)701-5237 or jkurtz@grahamco.com.