What is meant by contractual liability and how it actually works is not always
well understood. Craig Stanovich updates his popular treatise 16 years after
the original to help clear up the misconceptions.
Contractual liability is a very important concept in the world of risk
management and insurance. Yet, what is meant by contractual liability and how
it actually works is not always well understood. This article is intended to
clarify the concept of contractual liability with examples of risk transfer by
contract as well as providing an explanation, with illustrations, as to how the
contractual liability insurance, found in the commercial general liability
(CGL) insurance policy, applies.
In General
Outside the context of insurance, contract liability (or liability because
of a contract) has a very broad meaning—a promise that may be enforced by a
court. Consider the following simple example: I agree to paint your house for
$1,000 and collect $500 prior to the job. After I accept the $500, I obtain a
more lucrative offer and never show up to paint your house. You can go to court
and claim the $500 you paid me, as I have breached the contract. Your breach of
contract claim is a contract liability claim. Stated differently, by entering
into the contract with you, I had a duty of performance, the breach of which
will give rise to my liability to you—I must pay you back the $500 that I
accepted from you.
Agreement To Assume Liability
It is common for businesses or organizations to agree, usually in writing,
to take on the liability of someone else—liability they would not otherwise
have. This form of agreement, where one party takes on or assumes the liability
of another by contract, is commonly called a "hold harmless" or
"indemnity" agreement.
Hold Harmless or Indemnity Agreement. In an indemnity or
hold harmless agreement, one party (the indemnitor) promises to reimburse, and
in some cases defend, the other party (the indemnitee) against claims or suits
brought against the indemnitee by a third party. The purpose of the
hold harmless or indemnity agreement is to transfer the risk of financial loss
from one party (the indemnitee) to another party (the indemnitor). This
transfer or shifting of financial consequences is often called noninsurance
contractual risk transfer and is considered a risk financing technique.
Properly written hold harmless and indemnity agreements override common law
and afford an indemnitee the right to collect from the indemnitor, in some
cases even if liability arises out of the indemnitee's sole
negligence. While each state may have its own statutes and case law that
may restrict what may or may not be transferred, it is a mistake to conclude
that all hold harmless and indemnity agreements are void and against
public policy simply because the agreement assumes liability for the sole
negligence of another.
One very important aspect of the hold harmless or indemnity agreement is
that it does not relieve the indemnitee (the party with the benefit of
the promise) from liability to the third party. The indemnitee may be found to
be completely liable to the third party for its bodily injury or property
damage. The hold harmless agreement gives the indemnitee a contractual right to
collect from the indemnitor (to the extent included in the contract and allowed
by law) for the damages paid to the third party. The purpose of contractual
liability insurance is to pay, on behalf of the indemnitor, the damages because
of bodily injury or property damage to the third party.
Where To Find Hold Harmless and Indemnity Agreements.
Businesses or organizations enter into a wide variety of contracts in which
hold harmless or indemnity agreements may be found. One very common contract,
in which a hold harmless or indemnity agreement is almost always found, is a
real estate lease agreement between tenant and landlord. A sample hold harmless
and indemnity clause found in a real estate lease is:
The Lessee will save the Lessor harmless and keep it exonerated from all
loss, damage, liability or expense occasioned or claimed by reasons of acts
or neglects of the Lessee or his employees or visitors or of independent
contractors engaged or paid by Lessee whether in the leased premises or
elsewhere in the building or its approaches, unless proximately caused by the
negligent acts of the Lessor.
As many indemnity or hold harmless clauses may be quite lengthy and
difficult to read, it is often a challenge for risk managers to determine with
any precision the scope of liability that has been assumed. The following
example may prove helpful to explain how the above agreement might work.
An Illustration of the Workings of a Hold Harmless or Indemnity
Agreement. A tenant (Lessee) in a multitenant professional office
building hires an electrician (an independent contractor) to rewire a portion
of the tenant's (Lessee's) office. About a year after the rewiring is
finished, another tenant receives a severe electrical shock when plugging in an
appliance, resulting in serious injuries to the tenant.
The injured tenant brings suit against the landlord (Lessor) demanding
compensation for his or her injuries, alleging that the landlord breached its
duty to provide a safe building. The investigation strongly suggests that the
injury of the tenant was caused, at least in part, by the electrician's
faulty wiring job. Nonetheless, the landlord (Lessor) is found to have
responsibility for the injuries and is ordered to pay the injured tenant
$150,000 in compensatory damages.
As the tenant (the Lessee) has agreed to indemnify the landlord (Lessor) for
the acts of the tenant's (Lessee's) independent contractors, the tenant
(Lessee) is obligated by the lease's hold harmless clause to pay the
$150,000, either as payment to the landlord or directly to the injured tenant.
In this situation, the tenant (Lessee) would not normally have had any
liability to the injured tenant. His liability arises solely from the
agreement, as part of the lease, to take on the liability of the landlord. The
tenant's contractual liability insurance would pay on his behalf the
$150,000 damages owed.
While the electrician may ultimately have to pay $150,000 (or a lesser
amount) via a subrogation action, the landlord (Lessor) does not have
to wait for the result of further litigation or be concerned with proving fault
on the electrician's behalf in order to recover the $150,000 (the tenant
assumed liability for the acts or neglect of his independent
contractors). Even if the landlord does prove fault on the electrician's
behalf, it may only be partial fault and may result in the landlord collecting
less than the $150,000 in damages.
In short, the landlord has transferred the financial risk of having tenants
in his or her building back to each tenant via the hold harmless and indemnity
agreement inserted in the lease.
Contractual Liability Insurance and the CGL Policy
Contractual liability insurance has been automatically provided within the
CGL policy since 1986. The mechanics of how coverage is actually provided does
merit some explanation.
The first mention of "Contractual Liability" in the 2013 CGL
policy is as the title of an exclusion. Coverage is eliminated by this
exclusion "… to pay for damages by reason of assumption of liability in a
contract or agreement." The following are, however, two important
exceptions.
- Liability of the insured that would be imposed without the contract or
agreement
- Liability assumed in a contract or agreement that is an "insured
contract"
The term "insured contract" is defined later in the policy and is
critical to understanding the coverage provided. More on "insured
contract" later.
Breach of Contract Claims
On occasion, a policyholder will seek coverage under the CGL policy for a
breach of contract claim. There is a persistent tendency for insurers to
summarily conclude that the CGL policy never provides coverage for breach of
contract claims and, consequently, deny any claim in which liability is
associated with a contract. The usual basis set forth for this coverage
position is that the CGL policy provides coverage only for tort liability
claims. This position is wrong and is based on a fundamental misreading of the
CGL policy.
The CGL policy pays sums an insured "is legally obligated to pay"
with no mention of whether "legally obligated to pay" is limited to
either tort or contract. Applicability of the CGL insuring agreement is not
determined from the form of the claim but rather its substance. In other words,
the focus should not be on whether the claim is in contract or tort but rather
on whether there is bodily injury or property damage caused by an occurrence.
Consider the following California Supreme Court ruling on this matter:
The coverage agreement [which] embraces "all sums which the insured
shall become legally obligated to pay as damages .…" … is intentionally
broad enough to include the insured's obligation to pay damages for
breach of contract as well as for tort, within limitations imposed by other
terms of the coverage agreement (e.g., bodily injury and property damage as
defined, caused by an occurrence) and by the exclusions.…
Vandenberg v. Superior Court of Sacramento County, 21 Cal. 4th 815
(Cal. 1999) at 841.
Whether such claims are excluded by the contractual liability exclusion is
another matter and is discussed below.
Assumption of Liability by Contract or Agreement
What is actually meant by "liability assumed by contract" in the
context of the CGL contractual liability exclusion has been the topic of a
considerable amount of litigation, with varied outcomes. The seminal cases
appear to be an Alaska case—Olympic, Inc. v. Providence Washington
Insurance Co., 648 P2d 1008 (Alaska 1982)—and a Utah case—Gibbs M.
Smith v. United States Fidelity & Guaranty Co., 949 P2d 337 (Utah
1997). Quoting from Olympic, the Gibbs M. Smith
court explained that "liability assumed by contract" as used in the
contractual liability exclusion of the CGL policy refers to hold harmless and
indemnity agreements and not liability from breach of contract:
Liability assumed by the insured under contract refers to liability incurred
when one promises to indemnify or hold harmless another, and does not refer
to liability that results from breach of contract.
The court went on to explain the differences in the nature of the
obligations:
Liability ordinarily occurs only after breach of contract. However, in the
case of indemnification or hold harmless agreements, assumption of
another's liability constitutes performance of the contract.
Gibbs M. Smith v. United States Fidelity & Guaranty Co., 949
P2d 337 (Utah 1997) at 341.
Based on the above, the CGL policy's contractual liability exclusion
does not apply and does not eliminate coverage for breach of contract
claims.
Nonetheless, the meaning of "assumption of liability" within the
contractual liability exclusion continues to be litigated. Many, but not all,
of the cases support the view that "assumption of liability" applies
only to hold harmless and indemnity agreements and, therefore, does not apply
to breach of contract claims. The Indiana Court of Appeals, citing both
Olympic and Gibbs M. Smith, as well as cases in
other jurisdictions, concluded:
Indiana Insurance's argument is premised on the notion that you
"assume" liability every time you sign a contract because you may
be held liable for breaching it. We do not accept this argument.
Today we join those jurisdictions who have held that contractual liability
exclusions in CGL policies bar coverage not for liability incurred by a
contract breach but, rather, for liability assumed from a third party, which
seems to be the majority position by a wide margin.
Indiana Ins. Co. v. Kopetsky, 11 NE.3d 508 (Ind. Ct. App. 2014) at
523, 525.
The above interpretation of the "assumption of liability" as used
in the contractual liability exclusion is also supported by at least the
following treatise.
… the contractual liability exclusion does not "bar all
contract liability," but rather "is limited to a special
type of contract—one in which the insured has assumed the liability of
another, i.e. a hold harmless or indemnification agreement.
Jeffery E. Thomas & Francis J. Mootz, III, New Appleman on Insurance
Law (Library Ed.) (2014), § 18.03[3][a] p. 18-43.
What cannot be overlooked is the Texas Supreme Court's contrary
interpretation of "assumption of liability" in Gilbert Texas
Constr., LP, v. Underwriters at Lloyd's London, 327 SW3d 118 (Tex.
2010). In Gilbert, the court ruled that "assumption of
liability" was not limited "… to the narrow set of contracts by which
the insured assumes the liability of another person." In other words, the
Gilbert court found that the contractual liability exclusion
applied to contracts not only in which the insured assumed the
liability of others but also contracts in which the insured assumed
liability for its own actions.
The facts of the Gilbert case are unique, but Gilbert agreed to
extend liability for its own actions beyond that imposed
under general law. In other words, Gilbert agreed in a contract to have
greater liability—it was this greater liability that the
Gilbert court concluded was an "assumption of liability"
and, therefore, excluded by the contractual liability exclusion.
As expected, a few years later, an insurer attempted to apply
Gilbert to a claim for construction defects in Texas. The
insurer's contention was that the construction defect damages resulting
from the general contractor's failure to perform the contract to build an
addition to a school was "assumed liability" and excluded by the
contractual liability exclusion of the CGL policy. The Texas Supreme Court
ruled in Ewing Constr. Co. v. Amerisure Ins. Co., 420 SW3d 30, 35
(Tex. 2014), that it was not "assumed liability" and thus the damages
were not excluded by the contractual liability exclusion.
Accordingly, we conclude that a general contractor who agrees to perform its
construction work in a good and workmanlike manner, without more, does not
enlarge its duty to exercise ordinary care in fulfilling its contract, thus
it does not "assume liability" for damages arising out of its
defective work so as to trigger the Contractual Liability Exclusion.
Ewing at 38.
The Ewing court made it clear that in Texas every contract does not
involve an "assumption of liability." You have "assumed
liability" in a contract or agreement if you have agreed to greater
liability for your own actions (i.e., liability beyond
that imposed by general law) or you have assumed the liability of
others in a hold harmless agreement.
In examining both Gilbert and Ewing, the Michigan Court of
Appeals provided this succinct summary of Gilbert and its
limitations:
In short, Gilbert stands for the proposition that, in
instances where an insured would be liable at general law for damages arising
from its breach of contract, the contractually assumed liability exclusion
does not preclude coverage. However, in situations where an insured takes on
additional legal obligations and liabilities beyond those imposed at general
law, coverage is barred by the contractual liability exclusion.
In its ruling, the Michigan Court of Appeals found, similar to the above
case (with the exception of Gilbert):
In the context of a CGL policy, "assumption of liability" means
assuming the legal obligations or responsibilities of another.
Travelers Prop. Cas. v. Peaker Services, 855 NW 2d 523 (Mich. Ct.
App. 2014) at 533, 535.
For more on Ewing, see "Contractual
Liability Exclusion—The Ball Is in Your Court."
Assuming a Duty versus Assuming a Liability
Assuming the liability of another (agreeing to be responsible for
someone else's legal obligation to pay damages to third parties) is
sometimes confused with assuming a duty to others (an obligation to
act or not to act that would not exist but for an agreement). In American
Family Mut. Ins. Co. v. American Girl, Inc., 268 Wis.2d 16, 33, 2004 WI 2,
673 N.W.2d 65 (2004), the Wisconsin Supreme Court addressed the difference
between assuming a liability and assuming the duty of performance from which
liability may result:
Although, arguably, a person or entity assumes liability (that is, a duty of
performance, the breach of which will give rise to liability) whenever one
enters into a binding contract, in the CGL policy and other liability
policies an "assumed" liability is generally understood and
interpreted by the courts to mean the liability of a third party, which
liability one "assumes" in the sense that one agrees to indemnify
or hold the other person harmless.
For example, I may enter into a maintenance contract whereby I agree to
regularly service the machinery on your premises, creating a duty that I would
not otherwise have had. But I carelessly fail to service a machine that later
malfunctions, injuring your employee. It is subsequently found that my failure
to service the machine caused the malfunction and employee's injury. The
employee brings suit against me for his or her injuries.
Some insurers have mistakenly denied CGL claims such as these, contending
the claim arises from an "assumption of liability" and thus is
excluded by the contractual liability exclusion of the CGL policy. A more
careful analysis of this type of claim will reveal that it is in actuality a
tort-based claim—specifically negligence.1 I
breached a duty (to maintain the machinery), such breach being the proximate
cause of the injury to the employee. The duty was assumed or created
by the contract; no assumption of liability via a hold harmless or indemnity
agreement was involved. The damages claimed were not by the other party to the
contract and were not the cost to fulfill the contract but rather damages
resulting from injuries to an unrelated party, the injured employee.
Coverage by Exception—The "Insured Contract"
The exception to the contractual liability exclusion does provide broad
contractual liability coverage for liability assumed in a contract as long as
the following occurs.
- The bodily injury or property damage occurs after entering into the
contract.
- The liability is assumed in a contract or agreement that falls within the
definition of "insured contract."
The contractual liability coverage provided for "insured
contracts" is "blanket" in that the insured does not need to
list or designate the covered contracts (as was required under the 1973
Contractual Liability Coverage Part) nor is a separate premium charge made for
contractual liability coverage. Contractual liability coverage in the CGL
policy is also "broad form," as it applies even if an insured assumes
liability for the sole negligence of the indemnitee.2
"Insured contract" is defined, and the definition begins by
listing the following five types of contracts that are common to many
businesses and organizations.
- Lease of premises (but not for a promise to pay fire damage to a premises
you rent or occupy)
- Sidetrack agreement
- Easement or license agreement (not for construction or demolition on or
within 50 feet of a railroad)
- Indemnify a municipality (except for work for the municipality)
- Elevator maintenance agreement
Coverage for the above five contracts was automatically included in the 1973
CGL policy (and prior editions) as "incidental contracts." When the
CGL policy was overhauled and simplified in 1986, the listing of these
"incidental contracts" remained to clarify that coverage was still
intended to apply to liability assumed in these contracts.
The "blanket" contractual clause (paragraph f.) extends coverage
to any contract pertaining to the named insured's business under which they
assume the tort liability of another. Tort liability means liability
imposed other than by contract. Put another way, coverage applies only
to a particular type of assumed liability—the liability that is assumed is the
tort liability of the indemnitee, generally for the indemnitee's negligence
to others.
What Is Not an "Insured Contract"
"Insured contract" does not include an agreement to indemnify the
following.
- A railroad for construction or demolition operations within 50 feet of
railroad property and affecting any railroad bridge or trestle, tracks,
roadbeds, tunnel, underpass, or crossing3
- An architect, engineer, or surveyor for their professional services
- Others for professional services if assumed by an insured who is an
architect, engineer, or surveyor
Railroad protective liability4 and professional
liability coverage are needed if an insured has exposures falling within the
exclusions.
For more on contractual liability insurance, see "Contractual Confusion—Assuming the Liability of
Others" and "In Defense of Insured
Contracts."