Contractual Liability is a very important concept in the world of risk management and insurance. Yet, what is meant by contractual liability and how it actually works is not always well understood. This article is intended to clarify the concept of contractual liability with examples of risk transfer by contract as well as providing an explanation, with illustrations, as to how the contractual liability insurance, found in the commercial general liability (CGL) policy, applies.
In General. Outside the context of insurance, contractual liability (or liability because of a contract) has a very broad meaning – a promise that may be enforced by a court. Consider the following simple example. I agree to paint your house for $1,000 and collect $500 prior to the job. After I accept the $500, I obtain a more lucrative offer and never show up to paint your house. You can go to court and claim the $500 you paid me, as I have breached the contract. Your claim is a contractual liability claim.
An Agreement to Assume Liability. It is common for businesses or organizations to agree, usually in writing, to take on the liability of someone else – liability they would not have otherwise. This form of agreement, where one party takes on or assumes the liability of another by contract, is commonly called a “hold harmless” or “indemnity” agreement.
Hold Harmless or Indemnity Agreement. In an indemnity or hold harmless agreement, one party (the indemnitor) promises to reimburse, and in some cases defend, the other party (indemnitee) against claims or suits brought against the indemnitee by a third party. The purpose of the hold harmless or indemnity agreement is to transfer the risk of financial loss from one party (the indemnitee) to another party (the indemnitor). This transfer or shifting of financial consequences is often called non-insurance contractual risk transfer and is considered a risk financing technique.
Properly written hold harmless and indemnity agreements override common law and afford an indemnitee the right to collect from the indemnitor, in some cases even if liability arises out of the indemnitee’s sole negligence. While each state has its own statutes and case law that may restrict what may or may not be transferred, it is a mistake to conclude that all hold harmless and indemnity agreements are void and against public policy simply because the agreement assumes liability for the sole negligence of another.
One very important aspect of the hold harmless or indemnity agreement is that it does not relieve the indemnitee (the party with the benefit of the promise) from liability to the third party. The indemnitee may be found to be completely liable to the third party for its bodily injury or property damage. The hold harmless gives the indemnitee a legal right to collect from the indemnitor (to the extent included in the contract and allowed by law) for the damages paid to the third party. The purpose of contractual liability insurance is to pay, on behalf of the indemnitor, the damages to the third party.
Contractual Liability, hold harmless or indemnity agreement is almost always found, in a real estate lease agreement between tenant and landlord. A sample hold harmless and indemnity clause found in a real estate lease is:
The Lessee will save the Lessor harmless and keep it exonerated from all loss, damage, liability or expense occasioned or claimed by reasons of acts or neglects of the Lessee or his employees or visitors or of independent contractors engaged or paid by Lessee whether in the leased premises or elsewhere in the building or its approaches, unless proximately caused by the negligent acts of the Lessor.
As many indemnity or hold harmless clauses may be quite lengthy and difficult to read, it is often a challenge for risk managers to determine with any precision the scope of liability that has been assumed. The following example may prove helpful to explain how the above agreement might work.
Contractual Liability Insurance and the Commercial General Liability Policy
Contractual liability insurance has been automatically provided within the commercial general liability CGL) policy since 1986. The mechanics of how coverage is actually provided does merit some explanation.
The first mention of “Contractual Liability” in the 2001 CGL policy is as the title of an exclusion. Coverage is eliminated by this exclusion for assumption of liability in a contract or agreement. There are, however, two important exceptions:
· Liability of the insured that would be imposed without the contract or agreement
· Liability assumed in a contract or agreement that is an “insured contract.”
Breach of Contract Claims
On occasion, a policyholder will seek coverage under the CGL policy for a breach of contract claim. In other words, the damages being demanded do not arise from liability assumed in a hold harmless or indemnity agreement, but are due to failure to meet an agreed upon obligation. Avoiding coverage for breach of contract claims is the very reason the CGL first excludes all contractual coverage, then grants limited contractual liability coverage by an exception to the exclusion. Here is an example of what is intended to be excluded:
A contractor agrees in a construction contract to insure a building that is being built for the owner. Unfortunately, the contractor forgets to place the insurance on the building, which a tornado destroys shortly before its completion. The owner seeks payment from the contractor for the value of the building, asserting a breach of contract action for failing to purchase insurance. The contractor then makes claim under the contractual liability coverage of his or her CGL for the value of the building.
Assumption of Liability by Contract or Agreement. What is actually meant by “liability assumed by contract” has been the topic of a considerable amount of litigation, with varied outcomes. An Alaska case – Olympic, Inc. v. Providence Washington Insurance Company 648 P.2d 1008 (Alaska 1982), as quoted in Gibbs M. Smith v. United States Fidelity & Guaranty Co., 949 P.2d 337 (Utah 1997) provides this explanation, which reinforces the concept that coverage is not for breach of contract:
Liability assumed by the insured under contract refers to liability incurred when one promises to indemnify or hold harmless another, and does not refer to liability that results from breach of contract.
The court went on to explain the differences in the nature of the obligations:
Liability ordinarily occurs only after breach of contract. However, in the case of indemnification or hold harmless agreements, assumption of another’s liability constitutes performance of the contract.
Assuming a Duty versus Assuming a Liability
Assuming the liability of another (agreeing to be responsible for someone else’s legal obligation to pay damages to third parties) is sometimes confused with assuming a duty to others (an obligation to act or not to act that would not exist but for an agreement).
For example, I may enter into a maintenance contract whereby I agree to regularly service the machinery on your premises, creating a duty that I would not otherwise have had. But I carelessly fail to service a machine that later malfunctions, injuring your employee. It is subsequently found that my failure to service the machine caused the malfunction and employee’s injury. The employee brings suit against me for his or her injuries.
Some insurers have mistakenly denied CGL claims such as these, contending the claim is a breach of contract claim and thus excluded by the contractual liability exclusion of the CGL. A more careful analysis of this type of claim will reveal that it is in actuality a tort-based claim – specifically negligence. I breached a duty (to maintain the machinery), such breach being the proximate cause of the injury to the employee. The duty was assumed or created by the contract; no assumption of liability via a hold harmless or indemnity agreement was involved. The damages claimed were not by the other party to the contract and were not the cost to fulfill the contract, but rather damages resulting from injuries to an unrelated party, the injured employee.