To quote former major league pitcher Roger Clemens, sometimes we
"misremember." This tendency is particularly embarrassing when you
continue to address people by someone else's name (he looked like a
"Jim" to me). Forgetting anniversaries, birthdays, graduations, or
similar events can be downright disastrous.
It is not surprising, then, if we become easily confused and
"misremember" how contractual liability insurance works. For many,
the subtleties of this rather arcane topic simply cannot be gleaned from the
superficial and infrequent contacts we have with it; for others, it may not
rank high on the excitement meter. Either way, what follows is intended to
assist in understanding contractual liability insurance by thrashing out some
concepts and offering some observations you may find helpful.
Basis of Liability
Liability can be imposed by law or by contract. You can also assume the
liability of another.
Liability Imposed by Law
The law can impose liability on us for our own actions. If we are
negligent, we are personally liable for the damages that result. We can also be
held liable for the actions of others. For example, if our employee is
negligent while acting in the scope of employment, not only is the employee
personally liable, we are also liable solely because we are the
employer. Our liability is based entirely on our relationship with our
employee. Assigning liability to an otherwise blameless party (the employer did
nothing wrong) for the acts of another (our employee was negligent) is called
"vicarious" liability and is also liability imposed by law. Although
these concepts are generally well understood, both are worth repeating—to
establish a baseline of comprehension and also to use as a point of comparison
to help gain insight into contractual liability.
Liability by Contract
Figuring out what risk is to be covered is central to grasping how any
insurance works. With contractual liability insurance, the risk is a
contract—but not just any contract. In fact, for the contracts involved, we
usually don't mean the entire contract. We mean only a particular
portion of certain contracts or agreements. That particular portion is
generally known as the hold harmless or indemnity agreement. For the sake of
discussion, we will refer to the clause simply as an indemnity
agreement.1
Assuming Liability. By entering into an indemnity
agreement, we have agreed to answer for what some else does; that is, we have
agreed to be legally liable for the actions of others. In an indemnity
agreement, our liability is based on our promise to be liable and not
because the law imposes the liability on us as illustrated above. In the jargon
of insurance, this category of liability is often referred as "assumption
of liability by contract."
Additionally, and this is important, indemnity agreements are not
about failure to fulfill or perform the terms of a contract. To the contrary,
indemnity does not relate to breach of contract but rather
performing the terms of a contract—making good on your promise to
"step up" and take financial responsibility for the liability of
another.
Three People Involved. An indemnity agreement necessarily
involves three people.2 If three people
are not involved, it is not an indemnity agreement. The first person is making
the promise to indemnify and is called the indemnitor. The second person is
accepting (or demanding) the promise to be indemnified and is called the
indemnitee. While three people must be involved, only the first (indemnitor)
and second (indemnitee) are actually parties to the indemnity agreement.
The third person is usually the one to whom the indemnitee is
legally liable, usually due to negligence of the indemnitee. Because the third
person is not a party to the indemnity agreement, the third person is not
affected by the terms of the indemnity agreement. In other words, whatever the
indemnitor and indemnitee may agree on is not binding on the third person. The
third person retains all rights and remedies available under law against the
indemnitee or indemnitor despite the indemnity agreement.
Workings of an Indemnity Agreement—An Illustration
A tenant agrees to "hold harmless and indemnify" the landlord for
"any and all injury or damage that takes place on the premises of the
tenant, unless the injury or damage is caused by the sole negligence of the
landlord." In this example, the tenant is the only tenant in the entire
building and the indemnity agreement is part of a 45-page commercial real
estate lease between the landlord and the tenant.
What is most pertinent here is that the tenant (indemnitor) has agreed to
indemnify the landlord (indemnitee) for "any and all injury or
damage" that takes place on the tenant's premises. The only exception
to the tenant's obligation to indemnify the landlord is if the injury or
damage is caused by the sole negligence of the landlord. As a result,
the tenant has agreed, in most instances, to "assume the liability"
of the landlord and therefore the tenant has agreed to "step up" and
be financially responsible for the landlord's negligence. The law would not
usually impose liability on the tenant for any of the landlord's
negligence; the source of the tenant's liability to the landlord is the
tenant's promise to pay for the landlord's legal liability for
"any and all injury or damage" taking place on the tenant's
premises.
As a result of a small fire within the building, a patron of the tenant was
seriously injured by burns and smoke inhalation. There was no damage to the
building.
The patron sued both the landlord and the tenant for his injuries. Recall
all of the rights and remedies at law are available to the third person, in
this instance the patron, despite the indemnity agreement between the tenant
and landlord. At trial, it was determined that the fire was caused by the
tenant's employee's failure to properly extinguish smoking materials
and, consequently, the tenant was found to be 20 percent negligent in causing
the patron's injuries.
The trial also determined that the landlord's smoke alarm and automatic
sprinkler systems had failed as the landlord had not maintained either in
working order. Further, the patron had difficulty leaving the building because
the landlord had not properly marked the exits and the exit doors were jammed
and could not be easily opened.
The trial court determined the landlord was 80 percent negligent. In its
judgment against the tenant and landlord, the court awarded the patron total
damages of $500,000 for his injuries. The tenant was required by the court to
pay 20 percent of the patron's damages or $100,000; the landlord was
required by the court to pay 80 percent of the patron's damages $400,000.
The combination of the payments by the tenant and landlord satisfied the
judgment and award of damages to the patron.
An Indemnity Agreement in Action. Immediately after the
trial, the landlord sought to enforce the indemnity agreement to recover from
the tenant the $400,000 of damages the landlord had paid to the injured patron.
As the tenant had "assumed the liability" of the landlord, the tenant
was contractually liable to indemnify the landlord and therefore pay the
landlord the $400,000 of damages assessed against landlord by the court for the
injuries to the patron.
Remember, the indemnity agreement required the tenant to indemnify the
landlord for "any and all injury or damage taking place on the
tenant's premises, unless caused by the sole negligence of the
landlord." The trial determined the landlord was not solely
negligent (the tenant was found 20 percent negligent); presuming the indemnity
agreement was not unenforceable because of statute or case law, the tenant is
obligated to pay the landlord $400,000. Notice the indemnity involved three
persons—the tenant (indemnitee), the landlord (indemnitor), and the third
party—the injured patron.
Purpose of Contractual Liability Insurance. Contractual
liability insurance is intended to pay on behalf of the tenant the
$400,000 of damages the tenant owed the landlord due to the landlord's
liability for damages to the injured patron. The liability of the tenant to the
landlord was not imposed by law—the court did impose liability on the
tenant, but only for $100,000 or 20 percent of the damages. As noted
previously, the tenant's liability to pay the additional $400,000 of
damages was derived completely from the tenant's promise to indemnify the
landlord. Stated differently, the tenant had agreed to be financially liable
for the actions of the landlord—including the landlord's failure to
maintain the alarm and sprinkler system, mark the exits, and keep the exits
passable.
Other than the observation as to the purpose of contractual liability
insurance, it is crucial to note that no mention was made of insurance
throughout the illustration. It is difficult to overstate that an indemnity
agreement is not insurance. The tenant is liable to the landlord for the
$400,000 of damages regardless of whether the tenant had purchased any
liability insurance. Although the tenant is the indemnitor, the tenant is not
an insurance company. The indemnity agreement itself is found within a real
estate lease. A real estate lease is not an insurance policy.
In short, the liability of the tenant to the landlord was created by a
contract that is not an insurance policy and is also outside of any insurance
the tenant may have purchased. In fact, the tenant's promise to indemnify
the landlord is often called noninsurance contractual risk
transfer.
Contractual Liability Insurance
In most cases, the tenant would have liability insurance, specifically a
commercial general liability (CGL) policy, to fund the tenant's liability
to the landlord in the example we have used. The standard Insurance Services
Office, Inc. (ISO), CGL policy is provided for bodily injury or property damage
"for liability for damages assumed in a contract or agreement that is an
'insured contract,' provided the bodily injury or property damage
occurs after the execution of the contract or agreement in which the liability
of others was assumed."3
Limitations of Contractual Liability Insurance
Too often, an indemnitee is thought to automatically have the
status of an insured or additional insured on the CGL policy of the indemnitor.
Using our illustration of tenant and landlord, the landlord does not have the
status of an insured or additional insured on the tenant's CGL policy
merely as a result the indemnity agreement.
Contractual Confusion. The confusion seems to stem from the
failure to distinguish insurance from indemnity obligations. As it is very
common for the landlord to be listed as an additional insured on the CGL policy
of the tenant in addition to the indemnity agreement, it is too often
assumed that the an indemnitee is an additional insured. Put another way,
because additional insured status and indemnity agreements are so frequently
seen together, they may seem indistinguishable from one another or at least
appear that one is the result of another, i.e., an indemnity agreement results
in additional insured status. The reasoning seems to be that if the contract
fits within the definition of "insured contract," such as a lease of
premises agreement, it follows that "insured contract" also means the
landlord is automatically an additional insured. This belief is simply
mistaken. An indemnitee is not an insured.
The tenant's CGL policy must be amended to extend coverage to provide
additional insured status to the landlord. Just because the contract happens to
be an "insured contract" does not mean the tenant's CGL provides
additional insured status to the landlord. In other words, the indemnitor's
CGL policy must be amended to include an additional insured endorsement to
provide the indemnitee the status of additional insured. To repeat—having the
status of indemnitee is not the same as being an additional insured.
A Practical Distinction. An additional insured is a party
to the insurance policy and therefore has "privity," meaning the
additional insured generally has direct rights to enforce the terms of the
policy against the insurer issuing coverage to the additional insured. An
indemnitee generally does not have privity and therefore has no right to
enforce the terms of indemnitor's CGL policy. The indemnitee's rights
are only those found in the indemnity agreement itself.
While this may seem like distinction without a difference, consider this. If
you are the indemnitee, would you rather have the ability to recover from an
insurer directly or from the indemnitor, whose financial wherewithal is likely
substantially less than the vast majority of insurers? In many cases, the
reason to be an additional insured as well as an indemnitee is that you want
two avenues of recovery. Why two avenues? Because you can't know if being
an indemnitee or an additional insured will provide you the better recovery
opportunity in any particular situation.
In fact, in serious claims, indemnitees may pursue recovery from both
directions simultaneously—as an indemnitee and as an additional insured. The
merits of this "belt-and-suspenders" approach to the
indemnitee/additional insured issue becomes more apparent when considering that
indemnity agreements, unlike insurance policies, contain no limits or
exclusions. In other words, indemnity may allow a broader or greater recovery
than insurance.
Direct Responsibility
If in our previous illustration the tenant also agreed in the lease to be
responsible for any damage to the building, regardless of cause or fault, would
this be considered "… liability for damages assumed in a contract or
agreement … for property damage…?"
Let's say that a tornado caused substantial damage to the building that
will cost the landlord, who owns the building, $750,000 to repair it. The
landlord obtained an estimate for repair, engaged a general contractor to begin
the repairs, and handed the repair bill to the tenant with a letter referring
to the portion of the lease in which the tenant has promised to be responsible
for damage to the building, even if the damage is not the fault of the tenant.
Is this also an indemnity agreement? If so, is this an "insured
contract?"
A contract for the lease of premises does fall squarely within the
definition of "insured contract," albeit with the limitation that an
agreement to indemnify any person or organization for damage by fire
to the premises rented to you is not an "insured contract." Of
course, in this instance, the damage is not by fire, so the fire limitation is
not a concern.
By agreeing to be responsible for damage to the landlord's building, has
the tenant "assumed the liability" of the landlord? More accurately,
is the landlord legally liable for damage to its own building? Drilling down a
little further, is the landlord's cost to repair its own building
"damages" that are "assumed in a contract or
agreement?"
The answer to all of the above is no. The agreement to accept responsibility
for damage to the landlord's building is not an indemnity agreement. The
landlord has no liability imposed on it by law to repair its own building.
Similarly, because the landlord has no liability, the costs to repair the
building are not "damages" from the viewpoint of the landlord. You
may have already noticed—this agreement does not involve three persons; it
involves only two persons as the landlord in our illustration is not liable to
a third person.
CGL Exclusion b. Further, while a contract for a lease of
premises is an "insured contract," that does not mean that all
obligations created in a lease of premises agreement are covered by contractual
liability insurance. To fully understand the scope of contractual liability
insurance, the definition of "insured contract" must be read in
conjunction with exclusion b. of the CGL policy.
Exclusion b. eliminates coverage in the CGL for the insured's obligation
to pay damages by reason of assumption of liability in a contract or agreement,
but does not apply to "… liability for damages … assumed in a contract or
agreement that is an "insured contract." In other words, contractual
liability insurance applies only if the insured has assumed liability
for damages in a contract or agreement and that contract or
agreement falls within the definition of "insured contract." Going
back to our illustration regarding the tenant's agreement to be responsible
for damage to the building, the tenant has neither assumed the landlord's
liability nor does the agreement involve "damages." Contractual
liability insurance does not apply in this illustration.
Contractual Liability Insurance and CGL Policy Exclusions
To some, the obvious answer to the above illustration regarding the
tenant's agreement to be responsible for damage to the landlord's
building is not whether the agreement is an "insured contract," but
rather that the CGL policy excludes property damage (with some limited
exceptions that did not apply to the illustration) for property the named
insured rents or occupies. Of course, they are correct.
Of particular importance here is understanding that the contractual
liability insurance coverage provided in the CGL via the exception to the
contractual liability exclusion b. is in turn subject to every other exclusion
found in the CGL policy. Stated differently, unless otherwise noted, all
exclusions found in the CGL apply to liability assumed by contract in an
"insured contract." The notion that liability assumed in an
"insured contract" somehow "overrides" the exclusions in
the CGL is erroneous.
The Tavern—An Illustration
Let's go back to our tenant and landlord illustration. The only
additional fact we will introduce is the tenant operates a tavern and is
engaged in the business of selling and serving alcohol. All other facts are the
same, including the indemnity in favor of the landlord.
A patron is "overserved" by the tenant and, in his intoxicated
state, injures another patron. The injured patron sues both the tenant and
landlord, alleging violation of the dram shop act. The case goes to trial and
liability is imposed on the tenant as well as the landlord—the basis of the
landlord's liability is the state's dram shop statute, which imposes
liability on the landlord for the acts of its tenant.
The injured patron is awarded $100,000 of damages; the court determines
liability to be 50 percent the tenant and 50 percent the landlord. After each
(tenant and landlord) pays its share of the damages to the injured patron, the
landlord seeks recovery for the $50,000 of damages it has paid to the injured
patron by enforcement of the indemnity agreement. Will the tenant's CGL
insurer pay on behalf of the tenant the damages owed to the landlord for the
landlord's liability to the injured patron? Keep in mind that the tenant
has assumed the liability of the landlord in a contract (lease of premises)
that is considered an "insured contract." While the tenant is liable
to the landlord via the indemnity agreement, the tenant's CGL policy
specifically excludes coverage for the tenant's liability for the selling
or serving of liquor. Therefore, the insurer will not pay the damages that the
tenant owes to the landlord as the tenant's liability originated from an
activity for which the tenant does not have coverage—the sale of alcoholic
beverages.
Employers' Liability Exclusion
In most cases, the CGL policy excludes any liability for bodily injury to
its employees arising out of and in the course of employment by the insured.
But this exclusion does not apply if the liability is assumed by the insured in
an "insured contract." Here is one of the few situations when
liability assumed in an "insured contract" is not subject to a CGL
exclusion.
The Construction Site—An Illustration
Assume a general contractor enters a construction contract with a
subcontractor. Included in the construction contract is an indemnity agreement
in which the subcontractor agrees to indemnify the general contractor for
"any injury or damage arising out of the work, except injury or damage
that is caused by the sole negligence of the General
Contractor."
The subcontractor's employee is injured on the jobsite. In addition to
collecting workers compensation benefits from the subcontractor, the employee
sues the general contractor for failing to keep a safe workplace. The general
contractor is found partially but not solely negligent in causing the
injury to the subcontractor's employee, who was awarded $200,000 damages
for his injuries, all of which were paid by the general contractor. As with the
other illustrations, the general contractor seeks to recover $200,000 from the
subcontractor by enforcing the indemnity agreement.
If the agreement to indemnify the general contractor is not considered an
"insured contract," the subcontractor's CGL policy would
not pay for the damages the subcontractor owes to the general
contractor because the liability exclusion on the subcontractor's
employers' CGL policy would apply. Fortunately, this indemnity agreement
does fall within definition f. as an "insured contract."
Therefore, even though the subcontractor is actually paying for damages
resulting from injuries to the subcontractor's own employee, the
employers' liability exclusion does not apply due to the express
exception in the exclusion for liability assumed by contract in an
"insured contract." Therefore, the subcontractor's CGL insurer
will pay $200,000 of damages on behalf of the subcontractor to the general
contractor in accordance with the indemnity agreement.
Conclusion
Some straightforward examples of the workings of contractual liability
insurance, including explanations of the nature of an indemnity agreement and
the limitations and exclusions that apply to contractual liability insurance,
are usually useful in understanding the basics. A grasp of the fundamental
concepts is the gateway to applying the principles to ever more complex
situations and also will enhance your overall command of an often misunderstood
aspect of commercial general liability insurance.