Insurance is at the mercy of contractual risk transfer. The contracts your insureds sign—generally before giving you the opportunity to review them—create requirements to which the insurance policy must respond, if possible.
Understanding contractual risk transfer is necessary for staying out of trouble when you insure contractor risks. But even if you don’t insure construction-type operations, you’re still guaranteed to face contractual risk transfer language at some point.
Here are seven of the most frequently asked questions related to contractual risk transfer.
What is contractual risk transfer? It’s a non-insurance risk transfer mechanism that accomplishes the goals of risk financing and risk control. Essentially, it allows the upper-tier or upstream contractor to tap into the finances of the lower-tier or downstream party. The lower tier can finance the requirements of the contract in one of two ways:
- They can pay some or all costs out of their own pocket, from savings or other accounts.
- They can purchase an insurance policy to finance that part of the contractually agreed to risk.
Sometimes, both methods come into play. From a risk control perspective, contractual risk transfer allows the upper tier to avoid the activities that could lead to injury to another party and make that party directly liable for the results. This dovetails with the risk transfer aspect of contractual risk transfer.
Why is contractual risk transfer necessary? The simplest answer is vicarious liability. The upper-tier contractor, which could be the general contractor or another contractor who subcontracts work to another party, can be held liable for the actions of the party to whom they subcontract the work. The general contractor is ultimately responsible for the entire job site. Responsibility for any injury or damage that occurs on the site or results from the construction activities falls on the general contractor. Contractual risk transfer allows the general contractor to transfer that burden to others.
What is the ideal use of contractual risk transfer? It places the financial burden on the party closest to and best able to control the chances that loss will occur. Who is better able to control the risks that could arise from wiring the building? Is it the electrician or the general contractor? Since the electrician is doing the work, they are better able to control the risks associated with the work. Thus, the electrician should pay for any injury resulting from the electrician’s work.
Is contractual risk transfer ever misused? Yes, in three key ways:
- Using exculpatory contracts. A contract is exculpatory when the upper tier attempts to use the contract to absolve themselves of all liability. Contracts cannot be used to transfer or avoid a statutory duty, criminal penalties or sole negligence in torts. However, some exculpatory clauses are allowed if they are reasonable and legal.
- The contractual provision violates the law. Statute or common law often limits the amount of responsibility contractually transferable to a lower tier.
- The transferor violates its own contract. Most construction contracts contain a provision stating that all contractually required insurance provisions must be proven prior to beginning operations. Such requirement is reasonable if the contract is signed before the work begins and the upper tier reviews all insurance requirements prior to work beginning. However, the contract often isn’t signed until work has already begun, violating the upper tier’s own contractual requirement.
Is contractual risk transfer enforceable? In short, yes. Courts generally prefer not to alter or overturn contracts because the right to contract is viewed as a private right. As long as the contract is written in compliance with state law and is not considered exculpatory, courts don’t interfere with them.
How does insurance respond to contractual risk transfer? Remember, insurance is at the mercy of the contract. The contract sets the course and the insurance policy provides the financing, if the policy covers what was agreed to. The insured can contractually agree to almost anything, but that does not mean the policy will or can respond. The policy only responds when the injury or damage transferred falls within the coverage grant.
What other areas are affected by contractual risk transfer requirements? Beyond triggering commercial general liability, business auto, workers comp and other insurance coverages, contractual risk transfer plays a major role in whom is shown as an additional insured. Additional insured status generally arises from the contract. Because of contractual risk transfer, agents have to fight the battle associated with long lists of additional insureds. Some requests are ridiculous, and some additional insured requirements cannot be met—and that becomes your fault, rather than the person who agreed to the contract.
Additionally, construction contracts often contain the requirement that coverage be provided on a primary and noncontributory basis. Although this is an antiquated requirement, it’s still a requirement with which you must contend. Contract wording also affects certificates—many if not most construction contracts attempt to dictate the information required in a certificate of insurance. Sometimes these requirements cannot be met due to statute or other reasons.
Contractual risk transfer can run and ruin your day if you let it—and it should scare you. For a more detailed analysis and discussion of contractual risk transfer, additional insureds and the primary and noncontributory requirement, don’t miss a Big “I” Virtual University (VU) webinar on Wednesday, July 19: Contractual Risk Transfer, Additional Insureds, and the Primary and Noncontributory Requirement. Attendees will receive a recording of the webinar and an accompanying transcript—which allows you to research the topic anytime without having to re-listen to the entire webinar to find the information you want.
Chris Boggs is executive director of the VU.