Risk of loss may be transferred by one entity to another in a variety of ways. All methods of transfer fall into three basic categories,
- Insurance (transfer to an insurer under an insurance contract)
- Judicial (transfer to another party by virtue of a successful legal action)
- Contractual (transfer to another party under contracts other than insurance)
In this article, I will address the third category, contractual transfer, as a means to avoid the expense associated with the purchase of insurance and the expense and uncertainty inherent in legal actions.
NEED TO KNOW IS CRITICAL
In the Risk Identification and Measurement process, we need to review all contracts and lease arrangements in determining a given client’s exposures to loss.
In the course of the review, you will invariably find both “good news” and “bad”- risks transferred to others and risks of others assumed by you. Remember, it’s a two way street! While we are counseling you to pass your risks on to suppliers, tenants, etc., their advisors may be (or should be) advising them to add some of their risks of loss to your contractual woes.
The “victorious” party in contract negotiations (with respect to insurance and indemnification provisions) is usually determined by the nature of the business relationship involved. It’s often really a matter of who needs whom the most.
You are less concerned with who wins than knowing what has been “won” or “lost”-what risks have been transferred or assumed. You can’t structure a risk management program to cover unknown exposures and contracts are a commonsource of unpleasant, post-loss surprises.
STANDARD CONTRACTUAL LIABILITY EXCLUSIONS
When reviewing liability assumed under contract, you have to remember that your liability is insured only to the extent of the coverage provided by the policy. A standard Contractual Liability endorsement carries more than a dozen specific exclusions and usually won’t automatically apply to all contracts.
When you transfer your risk to another party, the same concern may be appropriate with respect to the adequacy of insurance protection carried by the other party. Unless the indemnitor is a very large, very profitable firm, its financial ability to assume the risk transferred will be dependent on whether it has insurance applicable to the type of loss involved. In the absence of adequate insurance coverage, the indemnification that you have received may not be worth the paper it’s printed on.
WHAT RISKS OF LOSS CAN BE TRANSFERRED?
CONSTRUCTION – A company anticipating the construction of a new plant or plant addition may wish to pass some or all of the risk involved on to a general contractor. The construction contract he signs will determine the degree to which risks of loss inherent in the venture will be retained or transferred. The transfer of the following risks should be considered:
- Damage to the building under construction
- Construction cost overruns
- Employee injuries
- Theft of building materials and equipment
- Third party injuries
- Lost income due to delay in building completion
Loss due to failure to comply with government regulation
LEASES – A lease agreement determines the apportionment (between lessor and lessee) of risks of loss arising out of:
- Damage to the real or personal property leased
- Consequential loss arising out of such damage
- Third party injuries
- Fluctuations in building (and rental) value
BAILEE AND CARRIER AGREEMENTS – Some risk of loss to property placed in the custody of a wide variety of bailees and carriers is almost always transferred. The extent to which it is transferred varies greatly, however. Bailees and carriers have specifically limited liability under law for property entrusted to them (this is especially true where carriers for hire are concerned). Their responsibility for loss varies greatly depending on the nature of the loss and the conditions under which loss occurs. Under these circumstances, it’s obvious that some knowledge of statutory terms and conditions must be acquired before you can determine what risks of loss exist and are subject to transfer in a given situation. Transfer of risk in the following areas might be considered under specially drawn contracts between involved parties.
- Responsibility for loss caused by acts of nature
- Responsibility for loss caused by enemy nations
- Responsibility for non-negligent loss
- Responsibility for loss of sale or decline in market value due to delayed delivery
- Responsibility for loss of profits due to damage to property involved
CONTRACTS OF SALE, SUPPLY AND SERVICE – Contracts relating to the distribution of goods and services offer innumerable opportunities for risk transfer. Any attempt to list them would simply duplicate transfer possibilities (or variations thereof) discussed previously in connection with other types of contracts.
Our comments concerning the potential for risk transfer under various general contract categories are by no means complete. They have been provided as examples of the process which should occur whenever you evaluate an impending contractual relationship. “Brainstorm” it. List all of the losses that might occur and then determine which risks can be profitably transferred. Every contractual relationship is unique and the question of risk transfer possibilities must be addressed with that basic premise in mind. It should be remembered that any transfer of risk should be basically equitable and reasonable. If a transfer is excessively one-sided, it could be voided in court.
After a decision is made to attempt to transfer given exposures to loss by contract, legal counsel should be consulted to evaluate any question of legality and recommend appropriate language for indemnification and hold harmless contract provisions.