A Contractual Risk Transfer Primer

"We will pay those sums that the insured becomes legally obligated to pay as damages because of 'bodily injury' or 'property damage' to which this insurance applies." So begins Coverage Part "A's" (Bodily Injury and Property Damage) insuring agreement in Insurance Services Office's (ISO's) commercial general liability (CGL) policy. That first sentence of "Section I - Coverages" also raises the first coverage question; how does an insured become "legally obligated to pay?" Legal obligation, or liability, can arise from intentional or unintentional torts (wrongs) and express or implied contracts; both are covered, in varying degrees, by the CGL. Of the two, contractually assumed liability may be the more difficult concept around which to design coverage or anticipate the breadth of protection offered by or available through the CGL. This post: 1) defines contractual risk transfer; 2) lists the three parties involved in risk transfer; 3) describes the three levels of transfer; and 4) discusses the basics of contractual risk transfer wording. The next article in this three-part series details the level of liability protection extended from the unendorsed CGL to the contractual "indemnitee" (defined later). The series ends with a detailed look at the level of protection extended to an additional insured under the CG 20 10. Surprisingly, the breadth of protection extended from the unendorsed CGL (in spite of the "contractual liability" exclusion) may be broader, in some respects, than the protection granted to the additional insured. Contractual Risk Transfer Contractual risk transfer is a non-insurance contract/agreement between two parties whereby one agrees to indemnify and hold another party harmless for specified actions, inactions, injuries or damages. Risk transfer accomplishes objectives found in both risk financing (finding a source to pay the cost of a claim) and risk control (developing a means to avoid or lessen the cost of a loss). The ideal use and true purpose 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(ies) directly and actively participating in the activity have the best opportunity to prevent or avoid the loss; thus they are contractully required to protect an "innocent" supervising or non-participating party from financial harm following injury or damage. However, some "transferors" (defined below) violate contractual risk transfer's use and purpose by contractually attempting to absolve themselves of responsibility for or avoid the financial consequences of, generally, non-transferable liability for injury or damage. Such broad risk transfer, sometimes thought of as exculpatory agreements, requires the "transferee" (lower tier contractor) to stand in the place of the transferor regardless of who caused the loss, even if the transferor was solely responsible for the injury or damage. Such broad wording may not be enforceable depending on the law of the jurisdiction (10 states allow such wording in construction contracts under specific circumstances) and the totality of the circumstances under which the contract was drawn and presented. Contracts, as a rule, cannot be used to transfer or avoid statutory requirements, common law duties, criminal penalties or sole negligence in tort. Wording that violates these rules of contract construction may be considered exculpatory. Whether a contract 1) contains exculpatory provisions; and 2) is ultimately enforceable is judged against four criteria:

• The existence of a duty to the public. The greater the duty owed to the public, the less likely the entity involved in the operation can transfer the legal liability to another party ("transferee"). For example, entities subject to strict (or absolute) liability, such as blasting contractors, cannot transfer their liability;
• The nature of the service performed. The higher the intrinsic hazard, the less likely liability for the results of the activity can be contractually transferred;
• Whether the contract was entered into fairly. Was the contract on a "take-it-or-leave-it" basis or was there room for negotiation? Was the contract unilaterally beneficial or bilaterally beneficial (did both parties gain something of value)? Was there time to review the contract? Was the contract signed before the work began? Did one party have an unfair advantage in the contracting process? These and other specific questions relate to the fairness of the contract; and
• Whether the intentions of the parties are expressed in clear, unambiguous language. Contracts considered ambiguous are generally interpreted in favor of the party that did not participate in or had very little participation in the development of the contract.

Historically courts avoid negating contracts and individual contract provisions (although that may change in the coming years) because the right to enter into a contract is considered a personal right and responsibility generally valued by the courts. But nearly any court that adjudicates a contract 1) which violates statute; 2) is considered unconscionable; or 3) is against public policy will likely strictly construe the contract against the party who produced it - if not voiding the contract or contractual transfer provision outright. Contractual Risk Transfer and the "Rule of Threes" There are three parties to and three levels of contractual risk transfer, thus the "rule of threes." Although not an actual rule, this is an easy way to remember these two important concepts surrounding contractual risk transfer. The three parties having a part in contractual risk transfer are:

• Transferors - The party transferring its risk of financial loss to another. This may include the owner, the project management firm, and/or the general contractor. Other common terms for the transferor include "indemnitee" and "promisee."
• Transferees - The party accepting the risk. This can include the general contractor and subcontractors. "Indemnitor" and "promisor" are other names for a transferee.
• Indemnitor/Financer - The party called on to respond financially. This can include the "transferee," an insurance carrier (as per insurance contract provisions) or some other financially responsible party (i.e. a sub-sub to whom financial responsibility has been contractually transferred). Be careful not to confuse this use of the term "indemnitor" with that of a "transferee;" this is better thought of as the "financer."

The three levels of contractual risk transfer are:

• Limited transfer: The transferee only accepts the financial consequences of loss resulting from his sole negligence. If the transferor or another party contributes to the loss, the transferee is not financially responsible for that part of the loss. Essentially, the transferor is only protected for its vicarious liability arising out of the actions of the transferee.
• Intermediate transfer: The transferee agrees to accept the financial consequences of occurrences caused in whole or in part by its negligence. This includes if the transferor or another entity contributes to the loss in some way.
• Broad transfer: Provides the greatest scope and requires the transferee to indemnify and hold harmless the transferor from all liability arising out of an incident, even if the act is committed solely by the transferor. This may qualify as an exculpatory contract in some jurisdictions because such broad transfer is considered "unconscionable." Approximately 10 states allow the use of broad transfer, with a general requirement being that the transfer intentions be clear and unambiguous.

Legal professionals familiar with a particular jurisdiction must be consulted when comparing the level of transfer with the applicable state law. Each state stipulates the acceptable amount of transfer allowed via contract. Because of the potential differences between the contract-requested and the legally-allowed level of transfer, transferor's often request additional insured status and a waiver of subrogation endorsement to assure they are protected should the contract violate the applicable law. Indemnification, Hold Harmless and Waiver: The Heart of Contractual Risk Transfer Effective contractual risk transfer requires specific wording in the contract between the transferor and the transferee. Commonly known as the "indemnity (or 'indemnification') agreement," many contracts contain some form of indemnification and hold harmless wording such as the following (only an example, not intended as legal advice): • "For and in exchange for fair and equitable consideration, [transferee] (name of the lower tier party) agrees to indemnify, hold harmless and waive any right of subrogation against [transferor] (name of the upper tier party) from any and all liability or cost arising from bodily injury or property damage caused in whole or in part by the (transferee)." Indemnity agreements are the heart of contractual risk transfer. "Indemnification" is the contractual obligation of one party (the transferee) to return another party (the transferor) to essentially the same financial condition enjoyed before the loss (without improvement or betterment). Hold harmless wording shields the transferor from the effcts of the legal liability that can be assigned to them as a result of the actions contractually transferred (based, to some extent, on the level of transfer jurisdictionally allowed). Indemnification and hold harmless wording is not necessarily affected by, nor do they affect, the transferee's insurance coverage; it is purely a contractual issue requiring one party to stand in place of another - regardless of the presence of insurance to finance the costs. When insurance is lacking, the transferee holds two places, transferee and indemnitor. Waiver of Subrogation is the third leg of many indemnification agreements (back to the rule of threes). Subrogation rights flow from the harmed party's right to be made whole by the party responsible for the loss. If the right to recover from the transferor (the upper tier party) is contractually waived by the transferee prior to an injury, the transferee's (lower tier party's) insurer also has no right to subrogate. Waiver of subrogation should be solely addressed in the contract rather than endorsed to the CGL. If a particular state's statute affects the level of indemnification allowed, waiver of subrogation wording may need to be addressed in a separate paragraph within the contract to lessen the chance that the provision will be voided if the level of transfer is outside of allowable transfer provisions. Since the disparate financing and control techniques of insurance and contractual risk transfer are ultimately intertwined, understanding how the CGL responds to contractual risk transfer language is paramount. Following Nearly every insured enters into a contractual risk transfer agreement and assumes some amount of risk from another party. Such assumption can be by lease agreement, a maintenance agreement or a construction-related contract (the most often reviewed contractual language). Regardless the source, contracts must be reviewed to ascertain the level of risk being transferred to the insured. The level of risk accepted must then be compared to the level of coverage provided by the CGL. If the contractually accepted risk is broader than the coverage provided by the CGL, the insured may be subject to a substantial out-of-pocket expense. Not every transfer is insurable. Transferors are extended unexpectedly broad protection by the unendorsed CGL, provided certain conditions are met; possibly even broader than the protection extended to an endorsed additional insured. However, most higher-tier transferors don't believe the unendorsed CGL's protection is adequate so they ask to be included as an additional insured on the lower-tier party's policy. The breadth of protection extended to the transferor under both protection methods is explored in the next two posts.

A Contractual Risk Transfer Series Series

1. A Contractual Risk Transfer Primer
2. Contractual Risk Transfer Coverage Extended from the Unendorsed CGL
3. Contractual Risk Transfer and Endorsements to the CGL

---