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.

¹Occasionally, "hold harmless" is used to mean a release or waiver of liability. A more accurate description of a release or waiver is "exculpatory agreement" and involves only two parties. In the context of this article, a hold harmless agreement, which in some circumstances may be somewhat broader than an indemnity agreement, is considered to be synonymous with an indemnity agreement.

²The terms "people" or "person" are used for the sake of illustration only. An indemnitor, indemnitee, and the third person include not only individuals but various types of organization, such as corporations, partnerships, trusts, etc.

³For a discussion of what is considered an "insured contract," see "Contractual Liability and the CGL Policy."