Author: Chris Boggs
Insurance is the slave 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 it can.
Understanding contractual risk transfer is a key requirement for staying out of trouble when you insure contractor risks. But even if you don't insure construction-type operations, you will be subject to contractual risk transfer language at some point, you can count on it.
Following are seven of the most frequently asked questions related to contractual risk transfer. Though brief, the answers give us a glimpse at the complicated issues emanating from contractual risk transfer.
What is contractual risk transfer? Contractual risk transfer (CRT) is a non-insurance risk transfer mechanism that accomplishes the goals of risk financing and risk control. In essence, CRT allows the upper tier / upstream contractor to tap into the finances of the lower tier / downstream party. The lower tier can finance the requirements of the contract in one of two ways: 1) some or all costs can be paid out of their own pocket (from savings or other accounts; or 2) the lower tier can purchase an insurance policy to finance that part of the contractually agreed to risk. Sometimes both sources are in play.
From a risk control perspective, CRT 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 CRT.
Why is contractual risk transfer necessary? The most simplistic answer is vicarious liability. The upper tier contractor (could be the GC or another contractor who subcontracts work to another party) can be held liable for the actions of the party to whom they subcontracted the work. The GC is ultimately responsible for the entire job site. Responsibility for any injury or damage occurring on the site or resulting from the construction activities falls on the GC. CRT allows the GC to transfer that burden to others resulting in the ideal use of CRT.
What is the ideal use of contractual risk transfer? CRT 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, it is better able to control the risks associated with the work; thus, any injury resulting from the electrician's work should be paid for by the electrician.
Is contractual risk transfer ever misused? Without a doubt CRT is ripe for misuse. Three key areas of CRT misuse include:
1. The use of an exculpatory contract. 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.
2. The contractual provision violates the law. The amount of responsibility contractually transferable to a lower tier is often limited by statute or common law. The three levels of allowable contractual transfer are:
a. Limited transfer: only the upper tier's vicarious liability for the work of the lower tier can be transferred to the lower tier;
b. Intermediate transfer: joint liability of the upper and lower tier can be contractually transferred to the lower tier; and
c. Broad transfer: the lower tier can be contractually responsible for all liability arising out of its own actions, the actions of the upper and lower tier jointly, or the actions of the upper tier acting alone.
If state law allows only limited transfer but the contract is broad transfer, the contract violates the law.
3. 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 all insurance requirements are reviewed by the upper tier prior to work beginning. However, many times the contract isn't signed until after work has already begun, violating the upper tier's own contractual requirement.
A common example is the angry Friday afternoon phone call from your subcontractor client stating that they are trying to get paid but can't until you provide a certificate of insurance (COI) stating that the policy contains all manner of requirements that can't be done and certainly can't be completed that afternoon. Suddenly, it's your fault.
When you dig deeper you discover that the project was a little behind schedule and the GC subcontracted your insured to do whatever it is they do and put them on the job site the next day. Two weeks later the contract is finally signed. When the sub submits his first invoice, the GC refuses payment until the contractually-required COI can be produced.
Based on the concept of estoppel and the application of equitable estoppel, the GC legally waived its right to hold the sub to the insurance requirements. The contract required proof and evidence of insurance prior to beginning work, the upper tier waived this requirement by putting them to work before asking for, requiring and reviewing such proof, thus they are legally estopped from requiring it later – and especially from holding up payment for lack of proof.
The problem is, few if any subcontractors want to challenge this in court because of money and the fear of losing other contracts with this GC. It's all about the economics.
Is contractual risk transfer enforceable? In short, yes. Courts generally prefer to not alter or overturn contracts because the right to contract is viewed as a private right valued by the courts. 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 a slave to the contract. The contract sets the course and the insurance policy provides the financing, if what was agreed to is covered by the policy. 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 the commercial general liability, business auto, work comp and other insurance coverages, CRT plays a major role in who is shown as an additional insured. Additional insured status generally arises from the contract. Because of CRT, 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.
Certificates are also affected by contract wording. 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. Unfortunately, you are forced to deal with it if you want to write contractor risks.
This is but a high-level review of CRT. You can learn more at this link.
Last Updated: November 4, 2024
_____________________________________________________________________________________________________________________________________
Copyright © 2024, Big “I" Virtual University. All rights reserved. No part of this material may be used or reproduced in any manner without the prior written permission from Big “I" Virtual University. For further information, contact jamie.behymer@iiaba.net.