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The Two "I's" of Risk Transfer: Indemnity and Insurance

David Knapp | June 12, 2020

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A recent New Jersey appellate decision highlights an important concept that parties often get wrong—while indemnification and insurance are both critical risk transfer tools, they should not be conflated.

Each tool provides a separate, independent basis for allocating risk, and parties should pay careful attention to both the indemnity and insurance language in their contracts to ensure that they are not assuming more risk than they intend.

The Gateway Park Decision

In Gateway Park, LLC v. Travelers Ins. Co., 2020 N.J. Super. Unpub. LEXIS 785 (N.J. Super. Ct. App. Div. Apr. 29, 2020), an employee of a commercial tenant ("Tenant") fell on ice in the parking lot adjacent to the Tenant's building on her way into work. She subsequently sued the building's landlord, plaintiff Gateway Park, LLC ("Landlord"). Landlord tendered the claim to Tenant's insurer for defense and indemnity as an additional insured under Tenant's commercial general liability (CGL) policy. The insurer denied coverage and Landlord filed suit seeking a declaration that it was covered under the policy. 

The lease agreement between Landlord and the policyholder required the defendant to include Landlord "as [an] additional insured, against all liability for injury to or death of a person or persons ... arising from the use and occupancy of the Premises." Id. at *3. Tenant's CGL policy included an additional insured endorsement, which provided coverage for "[a]ny ... premises owner, manager or lessor ... that you have agreed in a written contract or agreement to name as an additional insured," "but only with respect to liability for 'bodily injury' ... that ... [a]rises out of the ownership, maintenance or use of that part of any premises leased to [Tenant]."

Landlord argued that it was entitled to coverage under the plain language of the additional insured endorsement because Tenant had agreed to include Landlord as an additional insured in the lease agreement and the claim arose out of Tenant's use of the premises, as the plaintiff was on her way into work in the building when she was injured.

The trial court initially held that Landlord was entitled to additional insured coverage. The court later reversed itself, however, holding that Landlord was not an additional insured. The trial court based its reversal on the indemnification provision of the lease agreement, which provided that Tenant was to indemnify the Landlord but only for claims caused by the Tenant's negligence or willful misconduct. The trial court reasoned that "it was outside of the reasonable expectations of the lease contract between the parties that ... [Tenant] would be required to indemnify [Landlord] for [Landlord's] negligence," and thus, Landlord "should not be entitled to ... additional insured coverage" under Tenant's CGL policy.

On appeal, the New Jersey Appellate Division reversed, finding that Landlord's entitlement to additional insured coverage was based on the language of the policy, not the lease agreement. Id. at 16. ("[T]he [trial] court erred by failing to give effect to the policy's plain language, and by incorrectly relying on the lease to define the coverage under the policy.") Landlord was an additional insured because the two requirements of the additional insured endorsement in the policy—that the lease agreement require it to be an additional insured and that the liability arises out of the named insured's use of the premises—were met. Id. at 15.

Indemnity versus Additional Insured Coverage

The mistake made by the trial court—conflating the scope of additional insured coverage with the scope of the parties' indemnification obligations—is a common one, particularly in the construction industry. Indemnification and additional insured coverage are both risk transfer mechanisms; however, there are times when the parties to a contract do not intend for the scope of indemnity and the scope of additional insured coverage to be coextensive.

For example, in the construction context, it might make sense for the parties to maybe agree on a more limited scope of indemnity (i.e., the downstream contractor only agrees to indemnify the upstream contractor or owner for its vicarious liability) because the downstream contractor may not have the financial wherewithal to absorb liability for losses caused by its own negligence and the negligence of the upstream party but can afford to provide that protection in the form of insurance. As a result, the parties may intend for the scope of additional insured coverage to be broader than the scope of indemnity in order to transfer as much risk as possible to the downstream contractor's insurer. This risk transfer arrangement is reflected in the anti-indemnity statutes of many states, which prohibit contractors or subcontractors from agreeing to indemnify an upstream party for that party's own negligence but will permit an agreement to provide additional insured coverage for the upstream party's own negligence.

Other times, however, the parties may intend for the scope of additional insured coverage to be coextensive with the scope of indemnification. Indeed, there are a number of reasons why a downstream contractor that limits its indemnification obligation to claims caused by its negligence may not want to provide broader additional insured coverage to the upstream party. For example, providing broader additional insured coverage could draw down the downstream contractor's limits, which are required for other projects. Moreover, if the scope of additional insured coverage is broader than the scope of indemnity, a policyholder with a large deductible or fronting policy could end up paying for the additional insured's own negligence, effectively negating the effect of a more limited indemnity obligation.

Limiting Additional Insured Coverage to the Scope of Indemnity

So, what does a downstream party do if it does not want to provide broader additional insured coverage than the indemnity obligation it has assumed in its contracts? As Gateway Park teaches, to determine the scope of additional insured coverage, you must look to the language of the policy, specifically, the additional insured endorsement. Thus, the first step is to ensure you are using the correct additional insured endorsement.

Early versions of standard Insurance Services Office, Inc. (ISO), additional insured endorsements generally provided the additional insured coverage for liability "arising out of" the named insured's work (e.g., CG 20 10 11 85; CG 20 10 10 01; CG 20 37 10 01). Many courts construed the phrase "arising out of" broadly such that the additional insured was afforded coverage for its own negligence, even its sole negligence. See, e.g., McIntosh v. Scottsdale Ins. Co., 992 F.2d 251 (10th Cir. 1993); Admiral Ins. Co. v. Trident NGL, Inc., 988 S.W.2d 451 (Tex. Ct. App. 1999).

Later ISO additional insured endorsement versions replaced "arising out of" with "caused, in whole or in part, by" (e.g., CG 20 10 07 04; CG 20 37 07 04) with the intention of narrowing the scope of coverage afforded to additional insureds. A majority of courts have construed "caused, in whole or in part, by" to provide coverage for the additional insured's own negligence, so long as the named insured was at least partially at fault. See, e.g., Capital City Real Estate, LLC v. Certain Underwriters at Lloyd's London, 788 F.3d 375 (4th Cir. 2015); Gilbane Bldg. Co. v. Admiral Ins. Co., 664 F.3d 589 (5th Cir. 2011). None of these endorsements, however, incorporate the terms of the underlying contract; as such, the additional insured coverage they convey will not necessarily align with the agreed-upon risk transfer in the underlying contract.

In 2013, however, ISO released new additional insured endorsements that expressly incorporated certain limitations to additional insured coverage contained in the underlying contract (e.g., CG 20 10 04 13; CG 20 37 04 13). Among other things, these endorsements provide that "[i]f coverage provided to the additional insured is required by a contract or agreement, the insurance afforded to such additional insured will not be broader than that which you are required by the contract or agreement to provide to such additional insured." The 2019 ISO additional insured endorsements retain this language. Accordingly, these endorsements should incorporate any limitations to the scope of additional insured coverage contained in the underlying contract.

Notably, however, while these endorsements reference limitations on the scope of additional insured coverage in the underlying contract, they do not reference the indemnity provisions of the underlying contract. Thus, if the goal is to align the scope of additional insured coverage with the scope of indemnity, it is not enough to simply use a 2013 or 2019 ISO additional insured endorsement. The underlying contract will have to include language in the insurance requirements that limit the scope of additional insured coverage to the scope of indemnity assumed in the contract.

Unfortunately, the insurance requirements of contracts, particularly in the construction industry, are often overlooked and misunderstood. As a result, many downstream parties find themselves providing a far broader scope of additional insured coverage than they intended. If the goal, however, is to provide additional insured coverage that is no broader than the scope of indemnity in the underlying contract, then it is critical to use the correct additional insured endorsement and give careful consideration to the language in the insurance requirements of the contract.

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