Beyond contractually requiring “lower tier” contractors to maintain workers compensation coverage, “upper tier” contractors should consider incorporating other requirements into their contracts and agreements.
• “Upper tier” refers to the principal (owner) and primary general contractor;
• “Lower tier” contractors are the subcontractors and sub-subcontractors.
The previous articles focused on the definition of an employee, who is considered an employer and who could be held financially responsible for an injury. But insurance is not the only risk transfer mechanism available to protect upper tier contractors from the financial impact of an injury to someone who is not a direct employee. Contractual risk transfer’s contribution to upper tier contractor protection will be the focus of this commentary.
Basics of Contractual Risk Transfer
Effective contractual risk transfer requires specific transfer wording appear in the contract between the upper tier and lower tier contractors. Since these disparate financing techniques (insurance and contractual risk transfer) are ultimately intertwined, understanding how workers compensation policies and insurers respond to contractual risk transfer language is paramount.
Commonly known as the “indemnification agreement,” all contracts between upper and lower tier contractors should contain some form of indemnification and hold harmless wording. Provisions of such contractual wording may read as follows:
For and in exchange for fair and equitable consideration, transferee (name of the lower tier contractor) agrees to indemnify, hold harmless, and waive any right of subrogation against transferor (name of the upper tier contractor) from any and all loss or cost arising from bodily injury to (transferee’s) employees, subcontractors or subcontractor’s employees hired by (transferee).
This sample wording deals only with the exposure for injuries covered by workers compensation. More generalized wording can be used to cover other exposures such as bodily injury and property damage liability or liability arising out of completed operations.
Notice that there are three parties to contractual risk transfer; the transferor, the transferee and the indemnitor. Each is defined below:
• Transferors – The party from which risk is being transferred. 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, subcontractors and sub-subcontractors. Other common terms include indemnitor and promisor.
• Indemnitor – The party called on to respond financially. This can include the “Transferee” or an insurance company.
Indemnification and hold harmless agreement are the essence of effective contractual risk transfer. Indemnification is the contractual obligation of one party (the indemnitor) to return another party (the indemnitee) to essentially the same financial condition enjoyed before the loss with no improvement or betterment. Hold harmless wording provides protection from the legal process and any accompanying liability that may arise from an injury. Unlike contractual requirements to purchase workers’ compensation, indemnification wording is not necessarily affected by, nor does it affect, the transferee’s insurance coverage. It is purely a contractual issue requiring one party to stand in place of another.
There are three levels of contractual risk transfer found in contracts:
• Limited transfer: The transferee accepts only 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. This level is allowed in every state.
• 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. Only a few states allow this degree of transfer.
• 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 and is illegal in most jurisdictions because the wording is considered “unconscionable.” Unconscionable is defined as a contract that is unreasonable due to the unequal bargaining strength of the parties, or the result of undue influence or unfair tactics.
Regardless of which level of transfer chosen, consult with legal counsel familiar with the jurisdiction as any decision may be affected by statute.
Contractual Risk Transfer Done Right With Wrong Results
Contractual risk transfer’s importance cannot be underestimated; nor should its effectiveness be overestimated. A recounting of a recent claim will help explain the dichotomy of this statement.
Three parties were involved in this suit — the general contractor, the subcontractor, and a sub-subcontractor. The general contractor bid out all the work on a large commercial building project and awarded the contract for the structural steel to a subcontractor. The subcontractor only supplied the structural materials and coordinated the timing of delivery and installation at the construction site. The actual installation was contracted to a third party, the sub-subcontractor.
The subcontractor was required to contractually agree to indemnify and hold the general contractor harmless for any bodily injury or property damage resulting solely from the acts of the subcontractor or contributed to by the subcontractor (an intermediate transfer). In turn, the subcontractor required the sub-subcontractor to sign a contract containing the same risk transfer wording.
An employee of the sub-subcontractor fell and was injured. The injured worker sued the general contractor for gross negligence and reckless disregard for safety. The general contractor transferred the claim to the subcontractor to defend and indemnify, as was required by contract. Since the subcontractor contractually transferred its risk down to the sub-subcontractor, the direct employer of the injured worker was pulled into the suit and responsible to indemnify and hold the subcontractor harmless.
Had the general contractor not contractually required the subcontractor to indemnify and hold it harmless, it would have been wholly responsible for its own defense. Likewise, had the subcontractor not transferred its exposure to the sub-subcontractor, it may have become the sole party required to pay for any injury or damages. This is the main goal of contractual risk transfer, to make the entity closest to the activity (and thus with the most control over the situation) financially responsible for any injury that occurs.
So far the contractual risk transfer is operating as planned, but a few more facts must be known before the unveiling of the end of the story and the ultimate subjugation of the contractual risk transfer provisions.
The injured employee of the sub-subcontractor was tacking down a floor or roof from a height of about three stories – walking backwards; he physically lifted up the safety guards to get outside of them so he could complete the job. Continuing to tack while walking backwards he fell and was paralyzed. Drugs were found in his system upon required testing.
The subcontractor delivered the material and left the job site. Not returning for any reason. They were not charged with the supervision of the job, and they were not even on site in the days leading up to or on the day of the injury.
Contractual risk transfer had done its job, it placed the burden on the party closest to and best able to control the work methods and means, the sub-subcontractor. However, this is not how it ended. The case never made it to trial; it was settled by the insurance carriers involved. The sub-subcontractor paid $2 million, the subcontractor (who was not even there) paid $1 million and the general contractor got out paying only $200,000.
Had this case gone to trial and had the contractual provisions held up under state law the entire burden would likely have been borne by the sub-subcontractor. The general contractor may have had to ante-up if it were proven they failed to maintain a safe work environment (a requirement that cannot be transferred away); but the subcontractor would likely not have had to pay anything. If laws were upheld, the employee should have received nothing for violating safety rules and regulations and testing positive for drugs. But we will never know how it could have turned out had the court heard the case.
Waiver of Subrogation
Construction contracts of recent years have tried to require lower tier contractors endorse a “waiver of subrogation” onto its workers compensation policy in favor of the upper tier contractors. Many insurers have historically refused this request for reasons outside the scope of this article (although this trend is changing in some states). Waiver of subrogation endorsements should not be necessary if the contract between the parties already waives such rights.
Subrogation rights flow from the harmed party’s right to be made whole by the party responsible for the loss. If the right to subrogate against the upper tier contractor is waived by contract prior to an injury, the insurer of the injured worker’s employer (the transferee) has no right to subrogate either. Waiver of subrogation should be a part of the indemnification and hold harmless section of the contract, not provided by an endorsement to the policy.
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.
If a worker is injured, he or she likely will sue everyone within reach; this cannot be avoided. The goal of contractually required insurance and the use of contractual risk transfer are simply to place the ultimate financial burden on the party most directly related to and responsible for the injured party.
(Some information for this commentary sourced from “Knowing and Managing Your Workers’ Compensation Risk for Employees, Independent Contractors and Subcontractors” by Christopher J. Boggs published in the Fall 2006 edition (Volume 16 No. 1) of The Journal of Workers Compensation published by Standard Publishing Corp., Boston, MA. www.spcpub.com.)
All terms in this glossary and the glossary itself is taken from the book “The Insurance Professional’s Practical Guide to Workers’ Compensation: From History through Audit.” The book is available now to add to your insurance library.