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. These are discussed below.
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 caselaw, 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.