09 Mar Things to consider when using indemnification agreements to allocate risk
By Anita Byer, Setnor Byer Insurance & Risk
Indemnification agreements are commonly used in business transactions to allocate risk. Risk allocation involves identifying who is responsible for what and for how much. In some cases, a contract requires one party to assume the liability of another party. These risk transfers are commonly found in construction and landlord/tenant agreements, and are becoming common practice in other industries as well.
Assuming responsibility for the acts of another is obviously a big deal. So, it’s important to know the nature and extent of the risk being assumed, and to have a plan to pay in the event of a loss. At a minimum, this requires an understanding of indemnification and Additional Insured status.
Indemnification
An indemnification agreement generally requires one party (the indemnitor) to assume the liability of another party (the indemnitee). In the event of a loss that is specified in the contract, the indemnitor agrees to compensate the indemnitee for their loss. It is important to understand that these provisions commonly require the indemnitor to assume liability that would not otherwise exist.
For example, construction contracts routinely include broad indemnification provisions that transfer liability for not only bodily injury or property damage, but also for pollution, design flaws, delays and other perils not typically understood or contemplated by the indemnitor. Therefore, the indemnitor must understand all the risks being assumed.
Additional Insured Status
Fortunately, insurance coverage is available to cover assumed (or transferred) risks, so indemnitors can use insurance to finance some of their assumed risks. But indemnitees often request or require their indemnitors to not only purchase insurance, but to also name them as an Additional Insured so they can directly access benefits under the indemnitor’s policy.
Though Additional Insured status can be used to finance indemnification obligations, it is important to know that there are limitations. For example,
- Additional Insured status only protects against losses covered by the insurance policy, regardless of what the indemnification agreement requires.
- Indemnitees must satisfy the policy’s conditions, such as meeting the definition of an Additional Insured or having a written contract, if required.
- An indemnitee’s protection may be compromised by shared coverage limits and a lack of control over the terms and conditions of an indemnitor’s policy.
- Certificates of Insurance cannot be used to create or modify coverage under an insurance policy, regardless of what they say.
Perhaps the most common and potentially costly problem occurs when an indemnitor assumes a risk that is not covered by their insurance. For example, a plumber agrees to indemnify a general contractor for economic damages caused by the plumber’s delay in completing the work. The plumber takes a week longer than expected to finish the job. The general contractor hires additional workers to make up for the lost week and sends the bill for the extra labor to the plumber. Under the indemnification agreement, the plumber must pay for the extra workers. Unfortunately, since there was no bodily injury or property damage to trigger coverage under the plumber’s general liability insurance policy, the plumber must pay the cost himself. Remember that Additional Insured status cannot be used to cover indemnification obligations that are broader than the insurance coverage.
Before signing on the dotted line, ask the following questions:
- What are the terms and implications of the indemnification provision?
- Is the indemnitor required to obtain additional insured status for another?
- Is the language of the additional insured endorsement adequate, covering the indemnitor’s responsibilities or must additional measures be taken to ensure that contractual obligations are properly financed?
When used properly, indemnification agreements and various insurance coverages can be combined to effectively allocate and finance assumed risks. Since the process of allocating and transferring risk in any business transaction is always significant and often complex, businesses should consult an experienced and licensed professional before signing on the dotted line. Please contact us to learn more about allocating and transferring risk effectively and affordably.