Contractual Liability and the CGL Policy

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."

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¹ "Accompanying every contract is a common-law duty to perform with ordinary care the thing agreed to be done and a negligent performance constitutes a tort as well as a breach of contract." Fultz v. Union-Commerce Assoc., 683 NW2d 587 (Mich. 2004), at 591–592.

² The CGL policy can be endorsed to limit coverage to concurrent negligence (CG 24 26—Amendment of Insured Contract Definition) or endorsed to eliminate paragraph f. entirely (CG 21 39—Contractual Liability Limitation)—the latter severely limits contractual liability coverage.

³ Coverage for assuming the liability for a railroad may be obtained with CG 24 17—Contractual Liability—Railroads.

⁴ Railroad protective liability insurance does NOT provide the indemnitor any protection for demands of contractual indemnity sought by the railroad against that indemnitor. In other words, in most cases, construction or demolition operations involving railroads will likely require contractual liability coverage in the indemnitor's CGL, auto, and umbrella policies. This can be accomplished by amending the policies to include coverage for railroad construction or demolition operations as an "insured contract."