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Contractual Risk Transfer: Basics and Best Practices

By Jacqueline Hawkins, esq, Sentinel’s General Counsel and Director of Risk Transfer

Contractual risk transfer provides the education enabling detailed discussions surrounding common (and not-so-common) contractually assumed risks.

The basis of contractual risk transfer is an agreement between two parties whereby one agrees to indemnify and hold another party harmless for specified actions, inactions, injuries or damages. The risk transfer accomplishes objectives found in both risk financing (how will the cost of a claim be paid) and risk control (developing a means to avoid or lessen the cost of a loss).

The overarching goal of contractual risk transfer is to place the financial burden of a loss on the party best able to control or prevent the incident leading to injury or damage. Presumably, the entity directly and actively participating in the activity has the best opportunity to prevent or avoid the loss; thus is contractually required to protect an innocent supervising party from financial harm.

Generally speaking, each party’s risk-related goals are to accept no more risk than it can reasonably insure or otherwise finance, and to transfer the balance of the risk to the other party.

Contractual risk transfer should generally be thought of as an effort to insulate the organization’s insurance or risk retention program from loss rather than as a replacement for that program. When losses are transferred to other parties, the organization’s long term insurance or risk retention costs should be lower than would be the case if the organization relied solely on its own insurance or other risk financing program to handle them.

Factors Affecting Contractual Risk

  • Control: Which party to the contract is in the best position to control the extent of the risk?
  • Knowledge: Does one party’s specialized knowledge of risk make it the more logical candidate to assume the risk?
  • Statutory or common law limitations on risk transfer
  • Custom and practice
  • Bargaining position: What are the relative strengths of the parties involved? Factors that may contribute are the size of the entities, reputation of the parties, and condition of the service market place.

Contractual Risk Transfer Process

Creating solid contracts are only one step to ensure successful risk transfer. To be effective and reliable, the parties must ensure they are complying with the contracts insurance requirements. If the transferee breaches its contractual obligations to protect the transferor with certain minimum levels of insurance, the transferor may unintentionally end up bearing the loss.

Provide analysis and strict protocols to assist from preparing a bid to include specifications (indemnity clause, insurance requirements) to commencing the work.

Performance Measures

  • Risks retained are appropriate and affordable
  • Risk is incorporated into the negotiations- proactive, not reactive.
  • Clear and unambiguous indemnity, insurance, and other risk associated provisions. (these provisions are not to hinder the negotiations but help!).
  • Insurance requirements are clear, using recognized terms that can be interpreted both at the time the contract is negotiated and in the future.
  • Insurance and other support for the indemnity is in place when the loss occurs.
  • A thorough insurance monitoring process keeps the transferee in compliance with the insurance requirements.
  • The performance of the contract process is monitored and regularly evaluated.

 Risk Transfer Checklist

Follow a set procedure each time you hire a subcontractor. Require written contracts with every subcontractor and do not allow them to enter a jobsite or start work until all contracts are signed and all risk transfer requirements are met. Risk transfer requirements include:

A written construction contract with each subcontractor that includes

☐   An indemnification agreement in your favor

☐   A hold harmless agreement

☐   A requirement that you be added as additional insured on the subcontractor’s policy

☐   A requirement that additional insured status be on a primary basis

☐   A requirement that the additional insured coverage includes both work in process (ongoing operations) and completed work (i.e. completed operations)

☐   A requirement that the additional insured coverage be maintained for a specified length of time

☐   A requirement that the subcontractor maintain adequate General Liability limits of insurance such as:

(higher umbrella limits, and pollution or professional liability may also be required based on contract work)

General Liability

$2,000,000 general aggregate

$2,000,000 products/completed aggregate

$1,000,000 each occurrence

$1,000,000 personal and advertising injury

Automobile

$1,000,000 combined single limit

Umbrella 

$1,000,000

Employers Liability

$500,000 each employee

$500,000 disease, per policy limit

$500,000 disease, per employee

☐   A requirement that you are given 30 days’ written notice if the subcontractor’s policy is canceled.

Obtain from every subcontractor a completed certificate of insurance that:

☐   Describes the type of insurance and limits of insurance in effect. Make sure limits shown meet your requirements.

☐   Names you as the Certificate Holder and indicates you are named as an Additional Insured. Request a copy of the Additional Insured Endorsement attached to the policy. Verify this endorsement provides coverage for work in process and completed work.

☐   States that you are given 30 days’ written notice if the subcontractor’s policy is canceled.

In addition:

☐   Maintain organized files that include the construction contracts, certificates of insurance and additional insured endorsements.

☐   Set up a suspense system that tracks certificates’ policy expiration dates.

 

Additional Tips and Tactics

Certificates of Insurance

Carefully examine certificates you receive from subcontractors. The certificate is your first evidence that your subcontractor’s coverage meets your insurance requirements and that you are named as an additional insured. It summarizes the subcontractor’s insurance coverage:

  • Named Insured (should match the contract)
  • Policy Numbers
  • Name of Insurance Agency who issued the Certificate
  • Name of Insurance Company showing NAICS code for each line of coverage
  • Type of Policies (General Liability, Automobile, Excess/Umbrella Liability, Workers Compensation)
  • Policy Effective and Expiration Dates
  • Limits of Insurance
  • Exclusions Added by Endorsement
  • Special Provisions
  • Terms under which you, the certificate holder, must be notified if the subcontractor’s policy is canceled

The certificate should name you as an additional insured. The certificate is presumed to be accurate only on the date the certificate was issued.

A certificate of insurance is not the same as an additional insured endorsement. A certificate of insurance does not change the terms of the insurance policy. Only an additional insured endorsement can make you an additional insured. Request a copy of the actual endorsement showing you have been added as an additional insured and be sure to get another copy at each renewal.

Using Uninsured Subcontractors

Using an uninsured subcontractor reduces the value of your indemnification agreement. If you hire an uninsured subcontractor you could be responsible for payment for injury or damage that should have been the responsibility of the subcontractor. While the subcontractor may also be sued, without insurance, they may be unable to pay for the injury of damage.

Additionally, your annual cost to hire subcontractors affects your premium. If you hire an uninsured subcontractor, your insurer will charge extra premium at the end of the policy period based on the subcontractor’s payroll. Essentially, you pay premium as if the subcontractor’s employees were on your payroll, and losses are paid under your policy.

When claims are paid under your policy that should have been paid under a subcontractor’s policy, your policy limits are unnecessarily reduced, your renewal premium is more likely to increase and many insurers overall are less willing to insure your business.