Contractual Risk Transfer: The Devil in the Details

The increasing reliance of organizations on business-to-business service providers, especially in the information technology sphere, has helped small and mid-sized companies remain current and competitive, without having to allocate excessive resources for in-house capabilities.  However, this third-party reliance does not come without its own substantial share of risk – many small and independent contractors may not have the same physical and procedural controls as their more sophisticated counterparts.  Undoubtedly, the best tool to mitigate the residual risk associated with third-party contractors and service providers is a contractual risk transfer.

What is a Contractual Risk Transfer?

Once thought to be a tool exclusively utilized by large corporations with aggressive legal counsel, contractual risk transfers (CRT’s) are far simpler and more widely available than many would expect.  As the name implies, CRT’s are a means for strategically shifting risk to another party by contract.  An insurance policy is a ubiquitous example of this: a contract between the insured and an insurer to exchange the uncertain (possibility and extent of loss) for the certain (policy premium and deductible).

Most Common Types of Contractual Risk Transfers

• Hold Harmless Agreements: A legally binding contract in which another party agrees to hold your organization harmless for any liability that may arise out of their work or product, including liability for claims that would not ordinarily be covered by insurance.  Different degrees of hold harmless exist, including some contracts that require the third party to indemnify against acts of sole negligence (those for which you are solely responsible) – however, these types of broad agreements are typically viewed unfavorably by the courts, as risk ownership never truly rests with the third party.

• Indemnification Agreements: Similar in form and function to hold harmless agreements, but require indemnification against liability, meaning that no actual damages need be suffered before the agreement becomes active – in other words, such an agreement would require the indemnifying party to provide funds for legal defense and other incurred court costs.

• Certificates of Insurance: Best practices stipulate obtaining a third party contractor’s proof of liability (and often times workers compensation) insurance.  However, many individuals are unaware that they can require third parties to name their organization as an “additional insured” or “additional named insured”; the benefit of the latter being identical rights to those of the original policyholder, versus more limited coverage of liabilities with the former.  In essence, this provides a coverage “buffer” between your policy and that of your vendors.  It should be noted that coverage only applies to work performed at your behest or on your behalf.

• Waivers of Liability: As the name suggests, individuals, participants, or attendees can agree to a sponsoring party’s (nonbinding) waiver of its liability while performing a particular act or service. These are typical for activities or services that are inherently dangerous, and serve more to acknowledgement of the assumption of risk. However, courts tend to negate waivers of liability in instances of clear negligence by the sponsoring organization.

When is it Appropriate to Use a CRT?

It is imperative to understand that risk should be transferred to the “risk owner,” that is, to the party with direct control or influence over the cause of loss and associated preventative measures.  In the case of a construction project, the General Contractor or Project Manager typically requires that the party with direct responsibility and oversight for a specific function (a subcontractor) hold them harmless for any losses that may arise from – in whole or in part – their work. CRT’s are most effective when used as a component of an overarching risk management program.  CRT’s can and should be used by an organization that:

• Uses third party vendors, contractors, and service providers to perform functions with moderate to high potential of loss and/or litigation – including internal functions like accounting, IT, and human resources.
• Leases space to an individual, individuals, or a commercial organization
• Is hosting an event or gathering with a significant number of attendees, presence of alcohol, or the potential for a liability loss. In these instances, multiple CRT’s can be used in conjunction with one another, for example: have vendors sign Hold Harmless Agreements, and require guests or participants to sign a waiver of liability.
• Manufactures or wholesales products- A hold harmless or indemnity agreement can be signed by the preceding or subsequent party within a particular supply or distribution chain, in an effort to limit liability from those actions or circumstances outside the organization’s sphere of control.

Who Can Benefit from CRT’s?

While most prevalent in the construction sector, CRT’s have many applications across industry and function.  At the ideological level, CRT’s are a tool to more efficiently distribute risk – that is, to assign responsibility for a risk to the party that is able to exercise the greatest degree of control over that particular cause of loss.  While the extent to which CRT’s prevent losses is hard to measure, its appeal stems from resulting efficiencies in the allocation of risk control resources, and improved accuracy in the assignment of responsibility for losses that do occur.  Other considerations that play an important role in the feasibility of CRT’s include: distribution of leverage among parties, and the legal environment in which the contract would be adjudicated.  If a larger, more sophisticated party is determined to have taken advantage of a smaller party by shifting a disproportionate burden, the contract will often times be nullified by a court of law.