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An insured's perspective on contract risk management

Which common commercial contract clauses can produce uninsured claims and how can you negotiate them? Nick Wilson of Arthur J. Gallagher and Sarah McNally from Herbert Smith Freehills explain contract risk management and why it's important.

When forming a contract, the expectation may be that in the event of a claim your insurers will indemnify. However, it is you (not your insurers) who are forming a contract with your employer/counterparty. If your insurers will not provide an indemnity then you are still liable under contract, your counterparty can claim against you for any losses, and you will need to pay defence costs. The consequences of this could be severe, leading to bankruptcy of the business if the claim is substantial enough.

When reviewing contracts it is important to be aware of the liability issues that "hold harmless" indemnity clauses can create. It is also vital to be familiar with liquidated damages and contractual extensions as recent court cases have demonstrated.

Indemnity clauses

No insurance policy will cover every eventuality arising under a contact and as such there may be areas of exposure which are not covered by the insurance.

Probably the most onerous clauses appearing in contracts are indemnity clauses. The intention of an indemnity clause is to make you liable to hold harmless or indemnify your client/counterparty in respect of, for example, "all losses, claims, damages, expenses and costs" that are caused by a particular breach of contract or duty. A liability policy is unlikely to provide cover as indemnity clauses allow greater or broader redress than is normally recoverable at common law.

While removing the clause is the easiest option, if you cannot remove the clause consider other ways to manage the risk, for example qualify the indemnity with foreseeability, an obligation to mitigate, and a requirement of legal/tortious liability.

Sarah McNally, Herbert Smith Freehills

Contractual exclusions

Contractually assumed liabilities will probably not be covered by your policy unless this has been specifically negotiated. An example of such a contractually assumed liability is one based upon or attributable to any guarantee or warranty except to the extent that such liability would have attached to the insured in the absence of such contractual duty, term or agreement. The common theme in these clauses is that the exclusion generally relates to matters or legal liability which would not arise without the contractual assumption of liability.

Contractual extensions

While you can try to remove onerous terms from your contract, there will no doubt be circumstances in which you will agree to certain forms of contractual liability which will fall within a contractual exclusion clause. If you are relying on the contractual extension clause it must be very carefully and specifically negotiated so that you are comfortable that it will respond in the event of a claim for pure economic loss.

Nick Wilson, Arthur J. Gallagher

Liquidated damages

In a liquidated damages clause two parties agree up front that if there is a breach by one of them that the damages will constitute a particular sum of money. This gives rise to various issues, including whether, in light of recent court authority, the liquidated damages clause will be enforceable and, if so, whether liability under such a clause would be caught by a contractual exclusion. Many policies will have a specific exclusion for liquidated damages clauses so it is necessary to make sure that not only have you navigated any general contractual exclusion but also any specific exclusion for liquidated damages clauses.

Conclusion

While you can react to what is in the contract by trying to seek policy cover to match the contract, good risk management has to be proactive. You should ensure that, where possible, you do not incur exposures which exceed the limits under your policy by, for example, the use of a contractual cap. The level of insurance cover required of you should be appropriate to the level of services provided and you should consider specific issues such as the limits necessary for pollution and contamination. Finally, do not disclose your professional indemnity insurance policy to a client/counterparty; a broker's letter should be sufficient.

This article is based on a podcast which can be downloaded at the Arthur J. Gallagher International website.