Risk Transfer in Contract Management
July 11, 2023
Risk transfer is an important aspect of contract management. When contracts come into play, risk managers must be aware of all potential risks and how to effectively transfer them for the best long-term outcomes.
In this blog post, we’ll cover:
- What is Risk Transfer in Contract Management and Why is it Important
- How risk transfer works
- Two Ways to Transfer Risk & Protect the Hiring Entity
- 6 Types of Liability to be Transferred by Indemnity & Insurance
- 5 Important Things to Know About Contracts
- Three Examples of Risk Transfer in Contract Management
Knowing these concepts can help reduce different kinds of liabilities and keep a business on track to ensure successful collaboration with partners.
What is Risk Transfer in Contract Management and Why is it Important
In contract management, risk transfer is the process of transferring the risks associated with the task or project from one party to another. This can include financial risk, legal risk, or any other type of risk that could arise during the course of the project.
In other words, risk transfer can ensure that the risks associated with a project are appropriately allocated and managed, which can provide greater confidence and peace of mind for both parties involved in the contract.
How does risk transfer work?
Risk transfer is a common risk management technique where the potential loss from an adverse outcome faced by an individual or entity is shifted to a third-party vendor or contractor. To compensate the third party for bearing the risk, the individual or entity will generally provide the third party with periodic payments.
Contractual risk transfer involves three steps:
- Identification of potential risks laid out in the Scope of Work (SOW)
- Clear requirements for financial responsibility, including insurance
- Compliance verification of indemnity and insurance coverage requirements for payment of the contractor’s liability
Overall, understanding the importance of risk transfer in contract management is essential for any business or organization that wishes to minimize its exposure to risk while maximizing its potential for success.
Two Ways to Transfer Risk & Protect the Hiring Entity
When it comes to managing risk, there are two main strategies that individuals and businesses can use:
- Insurance policies: Purchasing insurance is a common way to transfer financial risk to a third-party vendor. By paying an insurance premium, the policyholder can shift the burden of potential losses to the insurer and add the entity as an additional insured.
- Indemnification clauses in contracts: Contracts can also include an indemnification clause, which helps ensure that if losses occur, the 3rd party contractor will compensate the entity. Simply put, an indemnification clause is an agreement between parties to cover harm, liability, or loss arising from the contract work. The contractor’s insurance can also provide coverage for this indemnification.
For instance, imagine the contractor signs an indemnification clause that states they will indemnify the entity against claims for bodily injury or property damage liability. If the entity receives a claim for such, the contractor would be responsible for covering the costs related to defending against the claim and any damages paid according to the contract agreement.
Understanding these strategies can help individuals and entity organizations protect themselves from potential losses.
Six Types of Liability to be Transferred by Indemnity & Insurance
As you start to navigate the complex world of liability, it’s important to understand some of the different types of liability.
Here’s a breakdown of some common terms and their meanings:
- Negligent Tort Liability: If you accidentally harm someone or damage their property, it is considered negligence and you may be held liable. This includes both “active” liability, where your actions directly caused the harm, and “passive” liability, where you could have prevented the harm but failed to do so (such as through supervision or inspection).
- Vicarious Liability: This type of liability can arise regardless of whether or not you were personally negligent. Essentially, if you are responsible for someone else (such as an employee or subcontractor), you may also be held liable for their actions.
- Joint & Individual Liability: If multiple parties are involved in a liability case, they may be held accountable both individually and together. This can result in “deep pockets” where each party can be responsible for up to the entire amount owed.
- Contractual Liability: If you enter into a contract with someone, you may assume some of their liability or they may assume some of your liability costs. You should be aware of these risks and plan for them to be covered.
- Professional Liability: This type of liability covers financial harm caused by errors or omissions in professional services (such as consulting or engineering). It’s important to note that this is different from general liability, which covers bodily injury or property damage.
- Physical & Sexual Abuse: Cases involving intentional harm are more complicated and are not generally covered by general liability insurance, but there are specialized policies that can provide coverage. Strong risk management practices are essential in these cases.
By understanding the different types of liability, you can better protect yourself and your business. Make sure to consult with a professional to determine the best coverage for your specific needs.
5 Important Things to Know About Contracts
Contracts can come with hidden tricks and risks that can leave contractors liable and without insurance coverage.
Be especially on the lookout for these five common potential problems:
- Endorsements that limit or exclude coverage
- Non-ISO liability forms
- Large Self Insured Retentions (SIRs) on the Contractor’s policy
- Inadequate coverage for the scope of work
- Don’t hesitate to contact your insurance broker or JPA for advice on “special event” coverage
Endorsements that limit or exclude coverage. Some endorsements to contractual liability can alter the insured contract definition, leaving contractors liable for Indemnification agreements in contracts and without proper coverage.
For example, ISO CG 21 39 deletes the “f.” portion of the definition clause for insured contracts and results in no coverage for most Contracts (other than a. through e.)
Non-ISO liability forms. These manuscript or company-specific forms can change coverage, making it necessary to carefully review any documents containing legal jargon and carefully compare them to the standard ISO CGL coverages.
For example, liability for prior work, employees of subcontractors, covered location limitations, construction defect claims, coverage for subcontractor’s work liability, exclusions for various types of work or operations, or lack of occurrence coverage are but a few samples of things that may not be covered by non-standard policies or modified on ISO policies.
Large Self Insured Retentions (SIRs) on the Contractor’s policy. Be aware of high-limit SIRs, which require contractors to pay the retention first, leaving them and any additional insureds without coverage for defense or damages as if no policy existed until the SIR is fully paid.
Inadequate coverage for the scope of work. The size and scope of a project can determine the level of coverage and limits required. Discuss risks and coverage needs with risk management early in the process to avoid problems.
For instance, high-risk operations may require additional coverages and higher limits. It’s also essential to distinguish between low and high-risk scenarios, routine versus suspicious activities, and normal versus hazardous or risky situations. This could include factors like project size, high-voltage equipment, water, heights, scaffolding, or any events that include children. Additionally, special events, leases, or facility rentals may present unique risks that require additional coverage.
Don’t hesitate to contact your insurance broker or JPA for advice on “special event” coverage. Remember, it’s never worth taking on high exposure without transferring the risk. Put simply, with proper coverage, you can be confident that your project will be both successful and safe.
The amount of risk is not necessarily consistent with the size of the job. Small jobs can create large liabilities!
Three Examples of Risk Transfer in Contract Management
In the world of contract management, risk transfer plays a critical role in helping businesses manage various risks and uncertainties. Essentially, risk transfer is a strategy that involves shifting the responsibility for risk from one party to another.
There are three primary examples of risk transfer in contract management
Limitation of Liability and Indemnification Clauses
When businesses enter into contracts, it’s important to understand the Limitations of Liability and Indemnification Clauses. Essentially, these clauses protect each party and help manage the risks involved with the agreement.
The Indemnification Clause is designed to ensure that one party won’t have to bear the burden of any legal costs or damages if an issue arises that’s caused by the other party. If there’s an indemnification clause in a contract and a lawsuit arises, the indemnifying party will be responsible for the legal fees and costs, as well as any resulting damages or losses.
The Limitation of Liability Clause limits the amount of money that can be awarded in a damages case to a specific party. By understanding these clauses and incorporating them into business agreements, companies can feel more secure entering into contracts and avoid potential legal issues down the road.
In an indemnification clause, one party agrees to compensate the other party for any losses incurred due to a specific event.
Warranties, on the other hand, represent a promise made by one party regarding the quality or performance of a product or service and are generally not covered by insurance.
Insurance policies are an essential part of protecting oneself in the event of personal loss or damage. Whether it’s for your car, home, business, or any other valuable possession, having the right insurance policy can provide peace of mind in the unfortunate event of an incident.
These policies are designed to safeguard you against financial loss and ensure that you have the necessary resources to replace or repair any damaged possessions. With so many different options available, it’s important to carefully consider and choose policies that align with your specific needs.
Be sure to understand the terms and conditions of each policy before making any decisions, and don’t hesitate to ask questions to ensure that you have all the information necessary to make an informed choice.
Loss Control Services from Evident
Contract management is an important part of business operations. Risk transfer mechanisms are effective strategies for mitigating contract risks and must be addressed in contract documents.
Knowing how to reduce the amount of risk present in a contract can increase the probability of successful completion.
Evident provides Loss Control Services to assist in identifying and managing contract risks with an on-site visit and review of existing contracts, negotiation processes, and proposed policy changes. Talk with us today.