The quiet gap between contracts and insurance: Part 2

Jun 16

11 min read

In the introductory post on this subject, I made the basic observation that traditional convention gives contracts and insurance parallel realities: The lawyers handle the contracts and brokers/risk managers assemble the insurance program. Gaps can undermine the contract or corporate insurance when the two realities lack coordination, which may remain undiscovered if a loss or liability has not materialized. Part 2 considers how this approach can yield problematic outcomes between annual corporate insurance programs and an organization’s operations and contracts generally. Part 3 will consider this issue for project-specific insurances tied to a specific contract.

As with the first part, the reference to ‘contracts’ here means non-insurance commercial agreements and operations (given that insurance is a kind of contract).

Businesses, non-profits, and governments that possess property or may be exposed to liability ordinarily place some insurance covering their activities on an ongoing basis. This may be an internal requirement or an expectation by a lender, regulator, or clients. Regardless of the undertaking, Corporate General Liability insurance is a typical aspect of most organization’s insurance programs (and therefore a focus of this article).

Unless losses arise, a corporate insurance renewal may be the only time of the year an organization’s leadership considers their risk transfer strategy. Insurance may be perceived more like an accountant’s audit (a process to be completed) than that organization’s next large contract (a legally enforceable mechanism towards the bottom line). This perception is sensible if an organization buys insurance for the sake of buying insurance (most don’t). Organizations without this instinct will benefit from reconciling their corporate insurance and their contracts to avoid turning them into two ships passing in the night.

Roadmap

This article addresses seven gaps that can arise between corporate insurance programs and an organization's contracts:

Contracting for uninsured activities or liabilities
Insurance limits eroded below contractual requirements
Failing to operationalize insurance requirements
Limitations of Liability provisions that displace insurance
Contractual indemnities that become uninsurable
Contractual standards of care exceeding common law requirements
Jurisdictional inconsistencies

Outer limits of contracts and insurance

Gaps arise in the space between the outer limits of two or more things. Appreciating the outer limits of contracts and insurance is therefore an important baseline informing the subsequent sections.

For contracts, it is enough to keep in mind that contractual privity is a critical constraint for their enforcement. No matter how ambitious a contract purports to be, it only binds the parties to that agreement, save for the rarest of exceptions.

For insurance, this does not require a detailed review of the terms of each policy placed, since most exclusions follow a few familiar parameters:

Having an insurable interest (economic stake) in avoiding a loss or peril is an important precondition for risk transfer using insurance;
Insurance is meant to return the insured to the position they would have been in but for the loss without any benefit or windfall;
Foreseeable or intended losses (from the standpoint of the insured) are generally not insurable nor are criminal or regulatory penalties;
Pure contractual obligations (not mirrored in tort) are generally not insurable;

While contracts proactively assign foreseeable and specified obligations (and consequences for non-performance) insurance reacts to general categories of unforeseen losses/perils.

Gap 1: Contracting for uninsured activities or liabilities

Arguably, the quintessential gap in this context is inadvertently uninsured contractual activities or liabilities. The broker or insurer may not have appreciated the policyholder’s commercial activities or the policyholder failed to appreciate the limits of their insurance and, given the tendency for contracts to operate in a parallel reality, contracts are signed notwithstanding this gap.

The simple example is the policyholder assuming they have more coverage than they do. A plumber subcontracting a scope of repair while out of town may assume their subcontractor’s activities are automatically covered by their insurance. A consulting firm may have obtained cyber insurance and assumed it automatically included social engineering coverage as required by their client.

Even for organizations that closely assess their corporate insurance, this issue can arise when there are operational changes, however permanent or temporary. A change order for a new scope of work may overlook a PFAS exclusion in the contractor’s CGL policy. A transport/logistics company may, for an important client, unknowingly transport some contaminated soil causing an uninsured pollution loss.

Alternatively, the commercial context for a contract may not be appreciated. A vendor supplying a product to a confidential project may not realize the magnitude of liability they and their product are exposed to. In that case, calibrating appropriate limits and coverage may be more difficult than typical.

This can be further exacerbated by new carveouts for an organization’s coverage year over year: asbestos, PFAS, and artificial intelligence have all been examples of exclusions that policyholders have been surprised to find in their policy. Contracts and operations must regularly be reconciled with the carveouts of a corporate insurance program.

Gap 2: Insurance limits eroded below contractual requirements

Contracts often specify the minimum coverage required by at least one of the parties to the contract through a minimum insurance clause like the following:

Minimum Insurance Coverage. Company will obtain and maintain during the term of this Agreement the following minimum insurance coverage: 1.1. Commercial general liability, including bodily injury, property damage, personal and advertising injury liability, and contractual liability covering operations, independent contractor and products/completed operations hazards, with limits of not less than one million dollars ($1,000,000) combined single limit per occurrence and two million dollars ($2,000,000) annual aggregate, naming [Client], its officers, directors and employees as additional insureds;

The “Company” may simply compare this provision to the Certificate of Insurance (“COI”) for their annual policy (which the Client expects to receive a copy of) and the matter ends there. What if, at the time of contract execution, the Company is anticipating a claim that will reduce the above available limits by half? The COI will not disclose any claim information. The requirement for the Company to “maintain” the coverage required is arguably unsatisfied if a claim may reduce the specified limits.

This issue is even more fragile in the context of E&O policies, which may be reduced by legal fees incurred to defend a claim (let alone payments to indemnify or settle a claim).

Claims must therefore also be reconciled with contractual requirements.

Gap 3: Failing to operationalize insurance requirements

Contractual and operational practices may unknowingly upend risk transfer opportunities if insurance requirements are siloed. This can arise in at least three circumstances.

First, all insurance policies are contingent on accurate representations at the time the policy is bound and thereafter. Most policyholders appreciate that a material misrepresentation at the time of binding can be prejudicial to the insurer’s position and may subvert coverage. The more challenging scenario is the ongoing requirement to notify the insurer of a known material change in risk. For example, undetonated explosives may be discovered on a job site requiring a suspension of work for an extended period. An insurer may raise this as a material change in risk to avoid coverage.

The second context in which insurance requirements may become at odds with contractual obligations relates to insurance claims. A contract may create additional obligations around losses that arise or direct those obligations through one of the parties, or their broker, and burden the ability of the parties generally to report a claim as soon as possible. This is especially cumbersome for policies that may be ‘claims-made-and-reported’ policies requiring strict compliance with policy periods (e.g. E&O and pollution).

The third context in which a contract can mislead risk transfer is most subtle and arises, arguably, from a lack of understanding about why certain provisions are included. A contract may contain an indemnity and hold harmless provision in one section and, in another section, require naming the upstream party as additionally insured in the downstream party’s insurance. If the upstream party is named in a lawsuit due to the downstream party’s activities, which provisions does the upstream party invoke? Assuming these sections operate redundantly are a misapprehension of their purposes and can yield unintended outcomes (discussed further below).

Even the basic operational expectation of ‘boots on the ground’ identifying and communicating potentially insurable circumstances—arguably a function of various contracts converging—may be hampered by rigid or one-dimensional duties that overlook risk transfer.

In short, insurance policies place additional obligations on policyholders that must be integrated with contractual commitments.

Gap 4: Limitations of Liability provisions that displace insurance

Limitations of liability are a common risk mitigation tool in many commercial agreements, particularly in the professional services context. Such provisions often limit liability to a proportion or multiple of the fees paid or the insurance available and are presumptively enforceable in Canada: Tercon Contractors Ltd. v. British Columbia (Transportation and Highways), 2010 SCC 4.

One example of this kind of provision is as follows:

Consultant’s Limitation of Liability. Except for Consultant’s confidentiality and indemnity obligations, respectively, and except for actions or claims arising from gross negligence or intentional or willful misconduct, Consultant’s total liability to Company shall not exceed the greater of (i) the total Consultant compensation value or (ii) the amount of recoverable insurance, regardless of whether any action or claim is based upon contract, warranty, tort (including negligence) or strict liability.

If the consultant in the foregoing is found liable for a loss to their counterparty, the consultant (in theory) ought to pay no more out-of-pocket than their contractual compensation.

The permutations of issues that can arise are too many to fully catalogue here, but a few are worth noting for the purposes of the contract-insurance gap.

A limitation of liability impairs an insurer’s ability to subrogate a claim (paid to the consultant’s client, in the example above) against the liable party (the consultant). A client’s agreement to limit the recovery of their subrogee (insurer) is ordinarily not offensive to their insurance coverage when negotiated at the outset of the agreement and such provisions are industry standard. Rather than taking this for granted, policyholders ought to confirm this remains consistent with their insurance at each renewal.

Ambiguities can also arise when liability is tied to insurance proceeds. Some questions to consider: Is the insurance contemplated only the Consultant’s insurance or any insurance available? Is the client compelled to exhaust all insurance avenues? What if the insurer wrongfully denies coverage? What if, recalling gap #2, the Consultant’s insurance limits have been eroded by the time a claim has arisen? If the Consultant’s insurance contains a large self-insured retention, does this invite litigation even in the clearest instances of liability? These issues can be complicated by insurance policies reduced by legal spend to defend a claim.

The clause may not always simplify things for the beneficiary. Even where the limitation of liability specifies an amount, the potentially liable party must either concede the claim (with the consent of their insurer) or defend against it (potentially beyond the amount at stake). An unfounded claim with reputational considerations to the Consultant may still be one their insurer prefers to concede in the interests of loss mitigation.

Gap 5: Contractual indemnities that become uninsurable

Contractual indemnification or hold harmless provisions are a critical and familiar facet of modern contracting. Consider the following wording for example:

Indemnity. The Vendor agrees to indemnify and hold harmless and defend [Client] and their officers and employees from and against all claims and suits by third parties for damages, injuries to persons (including death), property damages, losses, and expenses including court costs and reasonable attorney’s fees, arising out of, or resulting from, Vendor’s performance under this Agreement, including all such causes of action based upon common, constitutional, or statutory law, or based in whole or in part, upon allegations of negligent or intentional acts on the part of the Vendor, its officers, employees, agents, subcontractors, licensees, or invitees.

In effect, the Vendor (in the example above) says to the Client, “Given the nature of my activities under this contract, you are insulated from third party claims that may arise.” To the uninitiated, a provision like this may read like a significant exposure to the Vendor’s balance sheet. In reality, it’s made possible by the Vendor’s liability insurance accommodating such commitments. In other words, indemnity provisions depend on insurance.

Generally, a contracting party may agree to indemnify their counterparty for liability due to bodily injury or property damage—without jeopardizing their insurance—if that liability is assumed in an “insured” or “covered” contract or would be imposed in the absence of the contract (i.e. tort claims). The scope of this permissibility, including the meaning of insured/covered contract, depends on the Vendor’s liability insurance and the exclusions therein.

Aggressive indemnity provisions may seem like a win to the Client until they discover the insurer for the Vendor with a limited balance sheet is resisting coverage. One area this issue can arise is an indemnity for liability arising from the Client’s sole negligence, given this type of commitment is a pure contractual commitment. Another issue in this context relates to liabilities that arise from an apparent failure to render professional services, which are excluded by standard general liability policies (which can include professional activities like construction management). A third problem may arise with a contractual provision requiring the Vendor to fund the Client’s choice of counsel (a common source of friction between policyholders and insurers). Relatedly, while the Vendor may rightfully expect their defence costs to not reduce their available limits, the Client may not have access to the same benefit in their capacity as indemnitee. These issues require both the contract and insurance to be calibrated appropriately.

Furthermore, indemnities for certain intentional wrongs like libel, copyright infringement, and false arrest are generally insurable only to the extent that liability would arise in the absence of contract. This is due to the absolute contractual liability exclusion found in most general liability policies (Coverage “B”). Stated differently, a contract that expressly imputes this liability to one party may not have much to gain but something to lose by attempting to articulate this.

Gap 6: Contractual standards of care exceeding common law requirements

The standard to which duties performed under contract may be agreed upon expressly or by implication. For example, a landscape designer may agree to design a terrace with drainage according to a reasonable standard given the location of the project. Alternatively, a design-builder may commit to delivering a net zero facility that is fit for its intended purpose as a museum. These examples speak to two different standards of care with only one being insurable (the former).

Liability policies (e.g. CGL, E&O) do not insure commitments above the common law standard of care. This is reflected in two exclusions. The contractual liability exclusion excludes claims “directly or indirectly due to” a breach of a contractual duty that would not otherwise exist in the absence of that contract. A failure to deliver a “best in class” hospital is not an obligation that exists in the absence of any contract and would be uninsurable as a contractual liability. The second exclusion relates to claims for express warranties and guarantees. If the net zero museum from the example above is alleged to be unusable to that end, the owner may very well pursue the design-builder; however, the design-builder’s insurer may have grounds resist coverage for an uninsurable commitment. Even in circumstances when the allegedly liable party has done nothing wrong, the availability of defence costs to resist an unfounded or retaliatory claim can make the difference between closing the books on a project and not.

Gap 7: Jurisdictional inconsistencies

The global nature of insurance policies is often most apparent in their dispute resolution (or choice of law) provisions. A corporate cyber policy for a SaaS startup in Windsor, Ontario may require a coverage dispute to be decided by panel of arbitrators in the United Kingdom; a financial services firm in Winnipeg, Manitoba may carry Directors & Officers liability insurance that attorns to the jurisdiction of a court in New York; a local gas station in Golden, British Columbia may carry a CGL policy that must be disputed in Ontario.

Each of these policies will likely sit behind commercial agreements governed by a more local jurisdiction. In many cases, these provisions in the insurance policy may not be controversial (or known) if the policyholder avoids a claim or dispute with their insurer. If a dispute does arise, the uphill battle goes beyond having to retain counsel in a different (and expensive) jurisdiction.

One of the biggest issues concerns potentially inconsistent findings. A substantive dispute about liability may be heard in one jurisdiction while a coverage action, relating to the same circumstances, may need to be heard in another jurisdiction with differing timelines and rules of evidence. This problem can be exacerbated by a few factors. The local broker placing the insurance is likely to explain the purpose/operation of the insurance from a local perspective (which may not reflect the foreign jurisdiction under which it is interpreted). Further, limitation periods are not consistent across jurisdictions, and an unwitting policyholder may misapprehend their rights until a closer inspection of the policy is necessary. More than one policy (and jurisdiction) may also be implicated, and the risk of inconsistency grows to the detriment of the policyholder.

A commercial policyholder would therefore be well served to overlay their contracting practices for choice of law with their commercial insurance.

Bonus gap: Terminology

Commercial contracts that contemplate insurance can occasionally misuse terminology. A “deductible” is not the same as a “retention” or, more fully, a “self-insured retention”. Policies with deductibles implicate the insurer at the outset (who withholds an aspect of the claim payment as a deductible). Policies with self-insured retentions are more complex and, apart from notification obligations, keep the insurer at bay until such retention is exhausted by the policyholder. Insurance policies will generally only have one or the other.