Transferring risk through the use of indemnity or hold harmless clauses in a contract is common for large corporations with attorneys on staff, but owners of small and midsize businesses need to spend time on this, too.
“It’s become a much larger topic, both from an underwriting and risk management standpoint. People don’t always understand the importance of risk transfer. But there’s a greater emphasis being placed on it by the insurance companies. Taking the approach, ‘that’s why I have insurance’ is not something insurance companies want to hear,” says Chris Zito, president of Zito Insurance Agency Inc.
Because there is no direct revenue tied to it, business leaders tend to view risk transfer as an administrative burden. What they don’t realize is it reduces their overall cost of risk.
“Every day we see companies executing contracts that have not been read thoroughly,” Zito says. “This results in the unintentional assumption of risk.”
Smart Business spoke with Zito about the importance of risk transfer in business contracts.
How does risk transfer work? What are some examples?
When it comes to risk transfer, construction companies are an easy example. General contractors hire subcontractors and pass the risk down; a lower tier of subcontractor indemnifies the tier above it. The intent is that the party responsible for any damage or injury is held accountable for its actions, while protecting the people it is working on behalf of. A company takes the risk and pushes it back to the people who created it.
A retail store, distributor, wholesaler or a manufacturer’s rep might sell a product made by somebody else. If that product causes injury or damage, the way the legal system works, everyone in the supply chain can be named in the litigation — from the end seller to the manufacturer, even if they had nothing to do with the product’s design, manufacturing or packaging.
Say for example, a manufacturer outsources a portion of its manufacturing process, such as plating, grinding, heat- treating, etc., to a third party. If the work wasn’t done properly or to the specification required, it might have an adverse impact on the end product. As a part of its risk transfer process, the manufacturer should ensure the proper insurance and indemnity provisions are in place.
Ideally, how do companies use contracts to move risk away?
In a perfect world, the company has contractual hold harmless language in place, along with the proper insurance for the people who supply it goods and/or services. In some cases, a buyer of a product might be named as an additional insured. The ability to do that varies based upon the industry and type of services being provided.
The hold harmless or indemnity clauses range in length. If you’re trying to transfer the risk, you want the scope of that indemnity language to be as broad as possible. If you’re the entity assuming the risk, you want the language to be narrow. Like anything else in business, it becomes a negotiation.
In addition, risk transfer is a negotiating tool for purchasing insurance. Companies that demonstrate the best risk transfer practices are more attractive to insurance companies. The best businesses spend time on risk transfer practices, which helps their rates and lowers their risk profile.
What role does an insurance agent play?
Your insurance agent can educate you about risk transfer tools, and possibly help facilitate the process — becoming your back room, so to speak. If your insurance agent reviews contracts before you execute them, he or she can alert you to red flags or help you push the risk back to the people who ultimately create it.
Prudent businesses have a system in place where they make sure they’ve got current information on all vendors, suppliers and subcontractors, because those relationships have the ability to create and pass down risk to the people who are purchasing their goods and services.
In some cases — particularly when doing business with large corporations — implementing risk transfer can be difficult. However, at the very least, companies can quantify the risk they are assuming at the time of the transaction.
Insights Business Insurance is brought to you by Zito Insurance Agency Inc.