Part of the risk manager’s job is teaching the rest of the company about the field. Part of this is educating the managers who are responsible for negotiating contracts on the insurance implications of these signed agreements.
Contracts and Insurance
There are all kinds of contracts: leases, service agreements, purchase orders, construction agreements and, of course, insurance policies. For each kind, it is critically important to get them right before they are signed. Although negotiating the contract may be difficult, it is ten times more difficult to enforce it when there is room for interpretation in the language. After an incident, the position of a comma can become the battleground of a law suit.
Of all aspects of a contract, the insurance provisions can be the most arcane and least understood section. This introductory article was developed for plant managers with no risk management or legal background, and may be of assistance for employees at your organization as they struggle through contract negotiations.
The General Approach to Risk and Insurance in Contracts
Keep the risk of loss on the back of the party responsible for causing the loss. You need to anticipate what losses are likely to happen and then demand that the contractor has the financial ability to indemnify your company for losses that he causes.
You can never totally avoid risk, but you should not allow other companies to dump their liability for losses on your company. Contracting partners cannot be let off the hook because they claim they cannot afford insurance or surety bonds. Large contractors have insurance and self-insurance schemes and can afford to make restitution for mistakes they make. Small contractors usually cannot self insure, but generally use insurance mechanisms to secure their financial responsibility—unless you let them contractually skip out of their responsibility.
Insurance that contractors have in place already covers most of the risks that you would want covered. If you limit the contractors liability by concessions in your contract, you then relinquish your ability to collect on that insurance. You should never release contingent liability or loss of income in contracts, since this is covered in virtually all liability insurance policies that your contracting partners should hold.
You should also make sure that the limits that a contractor has are high enough to cover any loss that it could generate. It is not just the immediate property damage a contractor can do, it is the resulting injury, down time and lost revenue that ensues that could have a significant impact on your company. The financial responsibility for loss should remain with the party causing a loss. Just because a contract price is small, does not mean the party could not cause a huge loss. Never limit the contractors liability by some multiple of the contract price; gear it to the maximum likely loss.
What Limits Are Adequate?
There is no stock answer nor are there any minimum limits lists. The likelihood of loss is different depending on the scope a project. For example, building a new plant on a “green field” is very different from refitting the cramped confines of an existing plant.
The only right answer is a high enough limit so the company will not feel the financial effect of a loss. Case by case and project by project analysis is the only way to set adequate limits.
One thing to watch out for it selecting the least expensive contractor. This may become a grotesque example of false economy, if the contractor causes a catastrophic loss. Even of it has adequate insurance protection, can your company afford the down time and project delays? If the contractor cannot afford adequate insurance coverage, you need to know why. Insurance companies are really pretty good at judging risk of their prospective insureds. A really bad risk will get no coverage at all or stripped down coverage at very high premiums. When a contractor balks at requirements for insurance: Is its loss history so bad that it cannot afford the premium? Has it been declined by underwriters? Is it just too small? Is it sandbagging, i.e., admitting to lower limits than what it may already have and just trying to shield his insurance program?
Responsible contractors will have good insurance programs and surely have the right coverages. These contractually shield them from loss exposure, so you should tap them. The more a contractor resists what you think are adequate limits, the more it is telling you how risky it probably is.
Specific Limits
Property (Construction) Exposures—Set limits to pay for all the value that is at risk; e.g., for a building, it is the full replacement cost of the finished building; for equipment, it is the replacement cost. Builders risk policies cover projects on that basis. You should insist on all risk coverage, with replacement cost valuation and advance loss of profits which will pay for lost profits if the project has a loss and start up is delayed. For transit coverage make the limits high enough for the largest concentration of values on any one conveyance or storage location.
Liability Exposures—Demand limits from contractors so that your company will not have to pay for a loss caused by someone else. Limits should be high enough to cover the worst likely catastrophe that the contractor or one of his sub-contractors can cause. It is not just the damage to the project, but the plant facilities beyond the project, injury to your employees and other contractors on your site, to the public outside your plant and lost revenues while your company is shut down.
Deductibles—Sometimes called retention or self-insured retention is the amount that an insured (your company) is responsible to eat. In property or first party claims, it is the threshold before the insurer pays the policyholder for his loss. In liability or workers’ compensation policies, it is the amount that will be charged back to the policyholder after the insurer pays the damaged party.
Small contractors generally have deductibles in the low hundreds, while big contractors may self-insure the first $5 million. The important fact is, the contractor must be able to afford the size of the stated deductible after the loss.
Terms of Insurance
-Liability Insurance is third party insurance. It deals with legal obligations to others. It has everything to do with negligence. When you perform some negligent act or omission and someone is harmed or someone else’s property is damaged by that negligence; legally you company owes for the damages. That is what liability insurance does. It pays for the company’s negligent acts. Negligence to others is the trigger.
Liability insurance is also called casualty insurance. There are many names for these policies, including: general liability, auto liability, umbrella liability, excess liability, employers liability, products liability, commercial liability and workers’ compensation. The key is that “liability” will probably appear in the title.
-Property Insurance is first party insurance. It has nothing to do with negligence. It responds to losses you have to your assets. It does not matter if your company was responsible for its own damage; property insurance pays regardless, unless it is excluded for some other reason (such as intentional damage). The company’s negligence is never an exclusion. Loss to company assets is the trigger.
Names for property insurance policies are endless but generally depend on the class of property they cover and the basis on which they indemnify for a loss. Examples include: all risk property, boiler and machinery and equipment, stock throughput, builder’s risk, cargo, inland marine, marine transit and equipment floaters.
-Combination or Package Policies combine a number of liability coverages and property coverages under one policy. Smaller and less sophisticated companies tend to get these package policies to cover their whole spectrum of risk. They only buy what they can afford or for whatever risk they have been contractually assigned. Some of these policies are fairly comprehensive in coverage but too many are stripped down; they lack broadness of coverage and usually are inadequate in limits.
-Hold Harmless Provisions are one of the most critical sections that influence the insurance section of a contract. To the extent that your company holds another party harmless, it relinquishes coverage from whatever insurance is in effect. Losses that your company will have to eat, or pass on to your insurance company will add to its annual insurance costs.
There is a false economy in reducing a contract cost by holding potentially responsible parties harmless. This only works when there are no losses. Generally even small losses will more than outweigh any cost savings. Besides, the contractor probably already has paid for coverage regardless of this contract.
