Contractual Risk Transfer: Your Policy or Mine?

Regardless of their circumstance and bargaining power, the parties should strive to negotiate reasonable contractual undertakings. If a dispute should later arise, unreasonable provisions may be set aside by a court as impossible. Restatement (Second) of Contracts '261 (2007); M.J. Paquet, Inc. v. N.J. Dep't of Transp., 171 N.J. 378, 794 A.2d 141 (2002). Overly complicated provisions may be regarded as unclear and misinterpreted. Onerous provisions may be so burdensome that they virtually guarantee one party's breach of the contract.

Understanding Contract Terminology

Risk transfer decisions should be embodied in a written agreement. The agreement will generally be part of the parties' contract relating to the overall venture, as opposed to a separate document. Risk transfer provisions should be, to the extent possible, captured in a single section of the contract so that they can be more easily understood. The reality remains, however, that the risk transfer provisions may well be spread throughout the contract. When reviewing an agreement, it is essential to read the entire agreement to understand the parties' ultimate allocation of risk, and to ensure that the risk sharing provisions are internally consistent and as intended by the parties.

Important contract clauses include exculpatory provisions, hold harmless clauses, insurance requirement provisions, choice-of-law and venue terms, and waiver of subrogation provisions.

Indemnity Provisions

Indemnity or hold-harmless clauses are among the most significant risk transfer provisions. These clauses require one party (the 'indemnitor') to indemnify the other (the 'indemnitee') for certain types of losses or liability to third parties. For example: 'XYZ Company shall protect ABC Company against all liabilities, claims or demands for injuries or damages to any person or property growing out of the performance of work under this agreement.'

Hold harmless provisions may be mutual, so that both contracting parties have a right to indemnity if held liable for the acts or omissions of the other contracting party. Indemnity obligations need not be unlimited. The parties can include caps, such as monetary limits on the amount of indemnity to be paid. They also may restrict the duration of the indemnity obligations, or limit the types of claims to which the indemnity obligation applies.

Exculpatory Provisions

An exculpatory or liability limitation clause relieves, in whole or part, one party from liability to another party. These provisions also may limit liability to a specific remedy or amount. See, e.g., Synnex Corp. v. ADT Sec. Services, Inc., 394 N.J. Super. 577, 588, 928 A.2d 37, 43-44 (App. Div. 2007). A residential developers' agreement with a homebuyer may, for example, limit the buyer's remedies to those arising from express or implied warranties. A film developer's contract may exclude consequential damages such as lost business opportunities, and cap liability for lost or destroyed film to its replacement, rather than its intrinsic, value.

When accepting an exculpatory clause, the affected party should understand that it may not be made whole if it suffers a loss. The value of the entire venture may be worth this risk. Insurance also may be available to cover the potential loss.

Choice-of-Law and Venue Provisions

A venue provision stipulates where disputes involving the parties' agreement will be resolved. A choice-of-law provision stipulates the law of the state or country that will govern their disputes. These provisions allow the parties to select locations and law more favorable to them.

Most courts honor these provisions if the selected location and law have a reasonable relationship to the parties or the place of performance, and if the clause's enforcement is not repugnant to public policy. See Restatement (Second) of Conflict of Laws '187 (2007). When entering into a contract with a choice-of-law or venue provision, the parties should confirm its effect, if any, on their contract's risk transfer provisions. A state may be a convenient location to litigate, but its law may impact enforcement of the contract's indemnification, exculpatory, or subrogation provisions.

Waiver of Subrogation Provisions

Subrogation is a common law doctrine that seeks to allocate liability to the ultimately responsible entity. Under it, a person who pays another's loss succeeds to their rights and may obtain reimbursement from the responsible entity. By way of example, if an auto insurer pays for its policyholder's car repairs following an accident caused by another, the insurer may subrogate against the other driver and seek reimbursement of the amounts it paid. This prevents any double recovery from both the insurer and the wrongdoer, without absolving the responsible third party from its liabilities. See, e.g., Commercial Union Ins. Co. v. Bituminous Cas. Corp., 851 F.2d 98 (3d Cir. 1988); School Alliance Ins. Fund v. Fama Const. Co., 353 N.J. Super. 131, 801 A.2d 459 (Law Div. 2001).

The party whose loss has been satisfied is referred to as the 'subrogor.' The 'subrogee' is the entity that has paid the subrogor's loss and succeeds to its rights against the responsible entity. The subrogee will often be an insurer, which has paid its policyholder's loss. A waiver of subrogation clause requires that a contracting party give up its rights to pursue recovery from another contracting party or that party's insurer. Meaning, the subrogor structures its contract to limit its insurer's subrogation rights against some or certain other parties. This may be appropriate where, for example, the contracting parties intend to maintain and look to insurance, rather than each other, in the event of a loss. Id.

Insurance Requirement Terms

Insurance requirement provisions obligate a contracting party to obtain, continue in force, and/or provide evidence of insurance. See, e.g., Boston Market Corp. v. Hack, 2007 WL 2349989 (N.J. App. Div. Aug. 20, 2007). A typical provision might provide: Company A shall maintain general commercial liability insurance under which Company B is named as an additional insured, with limits of liability of $5 million. Id.

Post-Contract Compliance Terms

Post-contract compliance provisions obligate parties to provide evidence of their compliance with their contractual undertakings. They most often support an insurance requirements clause, and require parties to provide evidence of insurance (such as a certificate of insurance) during the contract's term. The party benefited by the insurance requirement provision, in this way, ensures there will be adequate insurance funds to respond to risks assumed by the other party. See, e.g., Green Party of N.J. v. Hartz Mountain Indus., 164 N.J. 127, 134, 752 A.2d 315, 318 (2000).

Important Negotiating Points

Indemnification Undertakings Beyond Parties' Means

An indemnification clause only has value if the indemnitor ' the party that assumes the hold harmless obligation ' has the financial means to satisfy potential losses. The indemnitee therefore should investigate the indemnitor's financial circumstances and confirm its ability to meet the risks assumed. Financial records should be sought and reviewed during negotiations. Public filings may be available on-line, and private credit reporting services also can provide useful financial information. Bottom line: Indemnitees should be wary of obtaining significant and unlimited indemnification undertakings without some financial assurance that they can be met.

Insurance to Support Indemnification Provisions

The parties should consider whether either will obtain and maintain insurance coverage supporting any hold-harmless obligations. Doing so permits the parties to first turn to an insurer for reimbursement of covered losses, rather than each other, in the event of a loss. See, e.g., Commercial Union Ins. Co. v. Bituminous Cas. Corp., 851 F.2d 98 (3d Cir. 1988); School Alliance Ins. Fund v. Fama Const. Co., 353 N.J. Super. 131, 801 A.2d 459 (Law Div. 2001). In negotiating insurance requirements, the parties should give thoughtful consideration to the type and amount of insurance protection they require. While it may be tempting for one party to seek as much insurance as it possibly can get, insurance premiums are never inexpensive and the other party's pricing considerations will likely include expected additional premiums and the cost of future claims.

The parties also should be cautious when offering up their existing insurance policies. A party with more than adequate insurance to meet requested requirements may not be fazed by undertaking to maintain it. But the party will find sharing its limits a sacrifice if losses exhaust or seriously erode its program's limits and leave it unprotected.

The parties should confirm that insurance requirement provisions are not drafted in a way that provides insurance beyond, or differently, than what is intended. Insurance policies typically have deductibles or are excess self-insured retentions. If the parties have views as to the size of the deductibles or retentions, they should be expressly stated. If an insurance requirement clause does not prohibit, or mention deductibles, the parties may later disagree as to whether these amounts are reasonable and who will pay them. See, e.g., Boston Market Corp. v. Hack, 2007 WL 2349989 (N.J. App. Div. Aug. 20, 2007).

Insurance requirement clauses also may state the minimum limits of liability required, but not the maximum. Meaning, the contract may provide that Company A shall maintain insurance under which Company B is named as an additional insured, with limits of liability of not less than $1 million. But, Company A may have various types of insurance, and its liability policies' limits may be more than $25 million. Following a loss, Company B may seek coverage for losses up to those full limits. If the parties intend a limitation in the amount or type of coverage available, their agreement should specifically state it.

The parties should be circumspect before agreeing to incorporate specialized wording in required insurance policies. Insurers may be reluctant to use manuscripted endorsements or may charge additional premiums for them. The party obligated to maintain the insurance policy may need to restructure its existing insurance program and the insurers involved in it simply to comply with this type of contractual undertaking.

Insurance requirement provisions that are unnecessarily complex can create obstacles, or at least added expense. Detailed requirements also entail more extensive contract negotiation, document review, and monitoring. Such specifics may not be needed if the parties' interests can be adequately or better served by using standard insurance forms or their equivalents.

Parties likewise should give careful thought before requiring the use of a specific insurance form or endorsement, and referencing it in their contract by its name or form number. This level of detail may not be necessary, and meeting the requirement may be difficult or impossible. Specific insurance forms may become unavailable and be replaced by new forms during a contract's term. But where a specific type of form is needed, the parties should consider involving an insurance professional who is knowledgeable about available coverage and forms.

Sharing Insurance Policy Limits

When sharing limits on existing policies, the parties must review the policy terms. The terms of insurance policies vary, but most liability policies provide coverage for losses of others assumed by the insured in an 'insured contract.' Insured contract is defined to include a broad range of contracts, including leases, maintenance agreements, and license agreements. See, e.g., Commercial General Liability Form CG 00 01 10 01 (ISO Properties, Inc. 2000). But, contractual liability coverage is not limitless. All of the insurance policy's terms, conditions, and exclusions apply and constrain available coverage.

During negotiations, the parties should decide whether their interests are adequately protected by contractual liability coverage, or whether the party benefited by the insurance requirement clause should be made an 'additional insured' on the policy. Additional insureds often have enhanced coverage rights, such as the right to a defense of potentially covered claims. Moreover, the additional insured's coverage rights may be argued to be separate from, and independent of, the parties' contract and its hold-harmless provisions. Thus, from an indemnitee's standpoint, additional insured status is preferable. If the indemnity agreement is held unenforceable, it may negate the indemnitee's contractual liability coverage. If the indemnitee has additional insured status, its policy rights will likely survive even if its contract is set aside. Standard additional insured endorsements are available, but the parties should review them carefully because the level of protection they provide varies.

An indemnitor also needs to be mindful of the contractual insured versus additional insured distinction when negotiating an insurance requirement provision. The indemnitor may intend that the additional insured will not seek benefits under its policy unless the indemnitor is somehow responsible for indemnifying a loss. But, if the policy and the parties' contract do not explicitly state this, the additional insured may seek, and obtain, coverage in situations beyond what the parties intended.

Moreover, and more importantly, the parties must understand what it means to share policy limits. Available coverage will be reduced by amounts spent defending one or both parties against the same or different claims. Unless the policy contains a priority of payment provision, no party will have a right to have its claims paid first. Moreover, the limits may not be adequate to defend and indemnify all insureds for all potentially covered claims.

Be Cognizant of Legal Limitations

Parties to risk transfer agreements need to be cognizant of legal and other limitations.

Indemnification Limitations

Some states refuse to give effect to indemnification provisions transferring responsibility for one's own gross negligence to another. Other states hold void as against public policy agreements to transfer responsibility for punitive damages. See, e.g., Weaver v. Univ. of Cincinnati, 970 F.2d 1523, 1538 (6th Cir. 1992); Stamford Bd. of Educ. v. Stamford Educ. Ass'n, 697 F.2d 70, 73 (2d Cir. 1982). But see, First Bank (N.A.)-Billings v. Transamerica Ins. Co., 209 Mont. 93, 679 P.2d 1217 (1984).

Even if the transfer of liability is not repugnant to public policy, courts hesitate to enforce indemnity agreements that are unclear and ambiguous. See, e.g., Mautz v. J.P. Patti Co., 298 N.J. Super. 13, 688 A.2d 1088 (App. Div. 1997). Parties therefore will want their indemnification provisions to be understandable by lay people, and conspicuously located in their agreements. If the indemnification clause is limited or voided, the indemnitee will lose protections for which it bargained and paid. Id.

Subrogation Issues

Before accepting a waiver of subrogation clause, the contracting parties need to confirm that the clause is enforceable in their circumstances. A waiver of subrogation provision may be disallowed by applicable law or statute. See, e.g., Travelers Indem. Co. of Connecticut v. Losco Group, 204 F. Supp. 2d 639 (S.D.N.Y. 2002) (waiver invalidated as against public policy where claim involved gross negligence); but see St. Paul Fire & Marine Ins. Co. v. Universal Builders Supply, 317 F. Supp. 2d 336 (S.D.N.Y. 2004), aff'd as modified, 409 F.3d 73 (2d Cir. 2005). See also Colonial Properties Realty Ltd. Partnership v. Lowder Constr. Co., 256 Ga. App. 106, 567 S.E.2d 389 (2002) (waiver invalidated by acts of gross negligence, or willful or wanton conduct). Accord Oilfield Anti-Indemnity Act, LA. REV. STAT. ANN. '9:2780 (West 2007).

Contracting parties also should review relevant insurance policies to determine whether they limit the policyholder's rights to waive subrogation. Some insurance policies contain subrogation provisions, setting forth the insurer's right to subrogation and requiring the policyholder to cooperate with the insurer in asserting them. Some policies simply prohibit a policyholder from prejudicing or limiting its insurer's rights after a loss. Some policies prohibit policyholders from waiving subrogation at any time. Other policies permit policyholders to waive subrogation, in writing, even after the loss. But as many insurance policies purport to void coverage if the policyholder improperly prejudices the insurer's subrogation rights (whatever they are), the parties would be wise to consult their insurance policies so they do not run afoul of any policy conditions.

Attending to Contractual Compliance

An insurance requirement provision is only useful if there is an insurance policy supporting it. Many contracts therefore require evidence of insurance be provided to the party in whose favor the insurance requirement clause runs. This party, typically the indemnitee, must then take steps to ensure compliance with the insurance and insurance evidence requirements. An indemnitor's breach of an insurance requirement provision will not relieve it from its hold-harmless obligations, but it likely means anticipated insurance funds will not be available to pay losses.

The indemnitee should ask for a certificate of insurance ('COI'), evidencing the purchase of required insurance policies. A COI is a form issued by an insurer, identifying the insurer, its policy's type and number, its policy's effective dates and limits, and the amount of any self-insured retentions or deductible. The COI also may list those added to the policy as additional insureds. The indemnitee should promptly review the COI, and resolve all discrepancies between the insurance policies required by its contract and those actually obtained.

The indemnitee also should confirm that financially sound insurers issued the insurance policies. Moody's, A.M. Best, and Standard & Poor rate the financial health of insurers. The parties' contract also may specify a minimum acceptable insurer rating.

The indemnitee must then establish a system to monitor continued compliance with insurance requirement provisions. It may, for example, ask for updated COIs at reasonable intervals. It also may request that the insurer and indemnitor provide notice before canceling insurance policies. To the extent possible, these undertakings should also be included in the parties' contract.

The indemnitee should retain COIs for future reference in connection with later claims. They may provide useful insurance information and be regarded as evidence of insurance if the insurance policies are lost or destroyed.

COIs will not indicate whether an insurers' payment of prior claims has reduced its limits. An indemnitee will need to seek this information separately from the indemnitor or its insurer. This undertaking too should be included in the parties' contract.

Indemnitors should take timely action if they contract to provide insurance, and their policy requires them to list by name all additional insured or contractual insureds. Unless the policy's endorsement is updated before a loss, the loss may not be covered and the indemnitor may be found to be in breach of its contract. Automatic blanket endorsements are available, providing additional insured status to anyone the policyholder agrees in writing to so name. These blanket endorsements, however, may need to be amended to be precise about the types of 'written contracts' contemplated (so that, for example, a party that is to be named an additional insured on only a primary policy does not achieve insured status under excess or other insurance policies).

The parties should confirm the adequacy of their insurance coverage for their own risks and those they assume, in the aggregate, from others. Indemnitors may want to have their contracts reviewed by an insurance professional, who can help identify potential risks, gaps in coverage, and whether their program and limits are sufficient, in total, to cover their risks.

In complying with insurance requirement provisions, indemnitors should be cautious not to provide insurance beyond that to which they agreed. When an indemnitor negotiates a limitation or cap on its liability, or limits on the amount of coverage it will provide and under what circumstances, these contractual limitations should be expressly stated in relevant insurance policies. This can be accomplished by a policy endorsement.

When parties have reciprocal insurance requirements, thought must be given to their respective status under each other's insurance programs. Whose policy will respond first, and in what circumstances? Many policies provide that they share losses with all other available insurance policies. Some policies state that they provide coverage only in 'excess' of other available and/or primary insurance coverage. These issues can be addressed by making certain policies 'primary' and 'non-contributory,' and other policies 'excess.' Whatever the parties decide, it needs to be set forth in the parties' contract and their insurance policies before claims arise.

Conclusions

Contractual risk transfer is a very effective risk management strategy, but no matter how well thought out the parties' contract, there remains a potential downside that needs to be considered and addressed: The parties may be liable for losses that they had hoped to avoid. For the transferor, it needs to understand that it is 'sharing,' not absolutely avoiding, its risks. Ideally, the transferor's assets ' including its own insurance policies' limits ' will remain protected. But, the transferor may ultimately become responsible for losses if the risk transfer fails, the transferee becomes insolvent, or the insurance supporting the transfer is exhausted or otherwise unavailable. For the transferee purchasing insurance, it may be responsible for losses it hoped to share with its insurer. This may happen if it assumes more risk than it insures, its insurer becomes insolvent, its insurance policy's limits are exhausted, or its does not adequately price its risk transfer agreement (covering its additional premiums and the cost of assumed losses).

Before ' and even after ' agreeing to share your or someone else's limits, carefully consider your insurance needs. When parties share limits, one insured's expenditures (defense and/or indemnity) deplete the limits available to others. No insured can expect that full policy limits, and a complete defense, will necessarily be available when it faces losses or third-party claims. Indeed, in some states, absent bad faith, an insurer may exhaust its policy limits by funding settlements entered into by only one insured if it was unable to resolve all claims against all insureds. See, e.g., Millers Mut. Ins. Assoc. of Ill. v. Shell Oil Co., 959 S.W.2d 864 (Mo. Ct. App. 1998); American States Ins. Co. of Texas v. Arnold, 930 S.W.2d 196 (Tex. App. 1996); Country Mut. Ins. Co. v. Anderson, 257 Ill. App. 3d 73, 628 N.E.2d 499 (Ill. App. Ct. 1994). But see Shell Oil Co. v. Nat'l Union Fire Ins. Co. of Pittsburgh, PA, 44 Cal. App. 4th 1633, 52 Cal. Rptr. 2d 580 (1996) (insurer acts in bad faith where it settles for policy limits, obtaining a release for less than all of its insureds). Accord Smoral v. Hanover Ins. Co., 37 A.D.2d 23, 322 N.Y.S.2d 12 (N.Y. App. Div. 1971). Upon the policy's exhaustion, the insurer's defense and indemnity obligations end. Parties therefore need to consider contractual risk transfer one, but not the only, risk management tool at their disposal.

Sherilyn Pastor is a partner in, and Practice Group Leader of, McCarter & English's Insurance Coverage Group, which consists of more than 35 attorneys providing legal assistance to corporate policyholders throughout the country and internationally. This publication is not intended to provide legal advice. Issues relating to insurance coverage and litigation are fact specific, and their resolution will depend on the facts involved and the law governing the disputes, which varies from state to state. The views expressed in this publication are not necessarily those of McCarter & English or its clients. Copyright by author (2007).

Companies involved in collaborative undertakings frequently confront risk sharing and transfer issues. After they identify a project's hazards, they then decide who will bear what risk, in what way, and in what amounts. They also need to consider whether either party (or both) will maintain insurance for the other's benefit. When negotiating a contractual risk transfer agreement, the parties need to understand their bargaining position and relevant contract and insurance principles. They need to be cognizant of risk transfer limitations. They need to consider if the risk transfer will be supported by insurance, and if so, the scope of coverage required and their willingness to share it in the event of a loss. The companies also need to put in place measures to assure compliance with their contract. This article examines these matters and offers practice pointers for those confronting contractual risk transfer decisions.

Factors Impacting Negotiations

A number of factors are likely to influence the parties' risk sharing decisions. What are the involved risks? Are they avoidable? Are they insurable? Which contracting party is likely to create the hazard? Which party best understands the hazard? Is either party better equipped to control or minimize the risks? Which party can financially absorb losses? Who has the superior bargaining position and is therefore better positioned to offload its risks? Are there legal or other limitations impacting the risk transfer? What are the industry customs? Is, for example, the project a commercial real estate endeavor where the developer typically transfers construction-related risks to its general contractor, who then shifts those risks to its subcontractors?

Regardless of their circumstance and bargaining power, the parties should strive to negotiate reasonable contractual undertakings. If a dispute should later arise, unreasonable provisions may be set aside by a court as impossible. Restatement (Second) of Contracts '261 (2007); M.J. Paquet, Inc. v. N.J. Dep't of Transp ., 171 N.J. 378, 794 A.2d 141 (2002). Overly complicated provisions may be regarded as unclear and misinterpreted. Onerous provisions may be so burdensome that they virtually guarantee one party's breach of the contract.

Understanding Contract Terminology

Risk transfer decisions should be embodied in a written agreement. The agreement will generally be part of the parties' contract relating to the overall venture, as opposed to a separate document. Risk transfer provisions should be, to the extent possible, captured in a single section of the contract so that they can be more easily understood. The reality remains, however, that the risk transfer provisions may well be spread throughout the contract. When reviewing an agreement, it is essential to read the entire agreement to understand the parties' ultimate allocation of risk, and to ensure that the risk sharing provisions are internally consistent and as intended by the parties.

Important contract clauses include exculpatory provisions, hold harmless clauses, insurance requirement provisions, choice-of-law and venue terms, and waiver of subrogation provisions.

Indemnity Provisions

Indemnity or hold-harmless clauses are among the most significant risk transfer provisions. These clauses require one party (the 'indemnitor') to indemnify the other (the 'indemnitee') for certain types of losses or liability to third parties. For example: 'XYZ Company shall protect ABC Company against all liabilities, claims or demands for injuries or damages to any person or property growing out of the performance of work under this agreement.'

Hold harmless provisions may be mutual, so that both contracting parties have a right to indemnity if held liable for the acts or omissions of the other contracting party. Indemnity obligations need not be unlimited. The parties can include caps, such as monetary limits on the amount of indemnity to be paid. They also may restrict the duration of the indemnity obligations, or limit the types of claims to which the indemnity obligation applies.

Exculpatory Provisions

An exculpatory or liability limitation clause relieves, in whole or part, one party from liability to another party. These provisions also may limit liability to a specific remedy or amount. See, e.g., Synnex Corp. v. ADT Sec. Services, Inc. , 394 N.J. Super. 577, 588, 928 A.2d 37, 43-44 (App. Div. 2007). A residential developers' agreement with a homebuyer may, for example, limit the buyer's remedies to those arising from express or implied warranties. A film developer's contract may exclude consequential damages such as lost business opportunities, and cap liability for lost or destroyed film to its replacement, rather than its intrinsic, value.

When accepting an exculpatory clause, the affected party should understand that it may not be made whole if it suffers a loss. The value of the entire venture may be worth this risk. Insurance also may be available to cover the potential loss.

Choice-of-Law and Venue Provisions

A venue provision stipulates where disputes involving the parties' agreement will be resolved. A choice-of-law provision stipulates the law of the state or country that will govern their disputes. These provisions allow the parties to select locations and law more favorable to them.

Most courts honor these provisions if the selected location and law have a reasonable relationship to the parties or the place of performance, and if the clause's enforcement is not repugnant to public policy. See Restatement (Second) of Conflict of Laws '187 (2007). When entering into a contract with a choice-of-law or venue provision, the parties should confirm its effect, if any, on their contract's risk transfer provisions. A state may be a convenient location to litigate, but its law may impact enforcement of the contract's indemnification, exculpatory, or subrogation provisions.

Waiver of Subrogation Provisions

Subrogation is a common law doctrine that seeks to allocate liability to the ultimately responsible entity. Under it, a person who pays another's loss succeeds to their rights and may obtain reimbursement from the responsible entity. By way of example, if an auto insurer pays for its policyholder's car repairs following an accident caused by another, the insurer may subrogate against the other driver and seek reimbursement of the amounts it paid. This prevents any double recovery from both the insurer and the wrongdoer, without absolving the responsible third party from its liabilities. See, e.g., Commercial Union Ins. Co. v. Bituminous Cas. Corp. , 851 F.2d 98 (3d Cir. 1988); School Alliance Ins. Fund v. Fama Const. Co. , 353 N.J. Super. 131, 801 A.2d 459 (Law Div. 2001).

The party whose loss has been satisfied is referred to as the 'subrogor.' The 'subrogee' is the entity that has paid the subrogor's loss and succeeds to its rights against the responsible entity. The subrogee will often be an insurer, which has paid its policyholder's loss. A waiver of subrogation clause requires that a contracting party give up its rights to pursue recovery from another contracting party or that party's insurer. Meaning, the subrogor structures its contract to limit its insurer's subrogation rights against some or certain other parties. This may be appropriate where, for example, the contracting parties intend to maintain and look to insurance, rather than each other, in the event of a loss. Id.

Insurance Requirement Terms

Insurance requirement provisions obligate a contracting party to obtain, continue in force, and/or provide evidence of insurance. See, e.g., Boston Market Corp. v. Hack, 2007 WL 2349989 (N.J. App. Div. Aug. 20, 2007). A typical provision might provide: Company A shall maintain general commercial liability insurance under which Company B is named as an additional insured, with limits of liability of $5 million. Id.

Post-Contract Compliance Terms

Post-contract compliance provisions obligate parties to provide evidence of their compliance with their contractual undertakings. They most often support an insurance requirements clause, and require parties to provide evidence of insurance (such as a certificate of insurance) during the contract's term. The party benefited by the insurance requirement provision, in this way, ensures there will be adequate insurance funds to respond to risks assumed by the other party. See, e.g., Green Party of N.J. v. Hartz Mountain Indus. , 164 N.J. 127, 134, 752 A.2d 315, 318 (2000).

Important Negotiating Points

Indemnification Undertakings Beyond Parties' Means

An indemnification clause only has value if the indemnitor ' the party that assumes the hold harmless obligation ' has the financial means to satisfy potential losses. The indemnitee therefore should investigate the indemnitor's financial circumstances and confirm its ability to meet the risks assumed. Financial records should be sought and reviewed during negotiations. Public filings may be available on-line, and private credit reporting services also can provide useful financial information. Bottom line: Indemnitees should be wary of obtaining significant and unlimited indemnification undertakings without some financial assurance that they can be met.

Insurance to Support Indemnification Provisions

The parties should consider whether either will obtain and maintain insurance coverage supporting any hold-harmless obligations. Doing so permits the parties to first turn to an insurer for reimbursement of covered losses, rather than each other, in the event of a loss. See, e.g., Commercial Union Ins. Co. v. Bituminous Cas. Corp. , 851 F.2d 98 (3d Cir. 1988); School Alliance Ins. Fund v. Fama Const. Co. , 353 N.J. Super. 131, 801 A.2d 459 (Law Div. 2001). In negotiating insurance requirements, the parties should give thoughtful consideration to the type and amount of insurance protection they require. While it may be tempting for one party to seek as much insurance as it possibly can get, insurance premiums are never inexpensive and the other party's pricing considerations will likely include expected additional premiums and the cost of future claims.

The parties also should be cautious when offering up their existing insurance policies. A party with more than adequate insurance to meet requested requirements may not be fazed by undertaking to maintain it. But the party will find sharing its limits a sacrifice if losses exhaust or seriously erode its program's limits and leave it unprotected.

The parties should confirm that insurance requirement provisions are not drafted in a way that provides insurance beyond, or differently, than what is intended. Insurance policies typically have deductibles or are excess self-insured retentions. If the parties have views as to the size of the deductibles or retentions, they should be expressly stated. If an insurance requirement clause does not prohibit, or mention deductibles, the parties may later disagree as to whether these amounts are reasonable and who will pay them. See, e.g., Boston Market Corp. v. Hack, 2007 WL 2349989 (N.J. App. Div. Aug. 20, 2007).

Insurance requirement clauses also may state the minimum limits of liability required, but not the maximum. Meaning, the contract may provide that Company A shall maintain insurance under which Company B is named as an additional insured, with limits of liability of not less than $1 million. But, Company A may have various types of insurance, and its liability policies' limits may be more than $25 million. Following a loss, Company B may seek coverage for losses up to those full limits. If the parties intend a limitation in the amount or type of coverage available, their agreement should specifically state it.

The parties should be circumspect before agreeing to incorporate specialized wording in required insurance policies. Insurers may be reluctant to use manuscripted endorsements or may charge additional premiums for them. The party obligated to maintain the insurance policy may need to restructure its existing insurance program and the insurers involved in it simply to comply with this type of contractual undertaking.

Insurance requirement provisions that are unnecessarily complex can create obstacles, or at least added expense. Detailed requirements also entail more extensive contract negotiation, document review, and monitoring. Such specifics may not be needed if the parties' interests can be adequately or better served by using standard insurance forms or their equivalents.

Parties likewise should give careful thought before requiring the use of a specific insurance form or endorsement, and referencing it in their contract by its name or form number. This level of detail may not be necessary, and meeting the requirement may be difficult or impossible. Specific insurance forms may become unavailable and be replaced by new forms during a contract's term. But where a specific type of form is needed, the parties should consider involving an insurance professional who is knowledgeable about available coverage and forms.

Sharing Insurance Policy Limits

When sharing limits on existing policies, the parties must review the policy terms. The terms of insurance policies vary, but most liability policies provide coverage for losses of others assumed by the insured in an 'insured contract.' Insured contract is defined to include a broad range of contracts, including leases, maintenance agreements, and license agreements. See, e.g., Commercial General Liability Form CG 00 01 10 01 (ISO Properties, Inc. 2000). But, contractual liability coverage is not limitless. All of the insurance policy's terms, conditions, and exclusions apply and constrain available coverage.

During negotiations, the parties should decide whether their interests are adequately protected by contractual liability coverage, or whether the party benefited by the insurance requirement clause should be made an 'additional insured' on the policy. Additional insureds often have enhanced coverage rights, such as the right to a defense of potentially covered claims. Moreover, the additional insured's coverage rights may be argued to be separate from, and independent of, the parties' contract and its hold-harmless provisions. Thus, from an indemnitee's standpoint, additional insured status is preferable. If the indemnity agreement is held unenforceable, it may negate the indemnitee's contractual liability coverage. If the indemnitee has additional insured status, its policy rights will likely survive even if its contract is set aside. Standard additional insured endorsements are available, but the parties should review them carefully because the level of protection they provide varies.

An indemnitor also needs to be mindful of the contractual insured versus additional insured distinction when negotiating an insurance requirement provision. The indemnitor may intend that the additional insured will not seek benefits under its policy unless the indemnitor is somehow responsible for indemnifying a loss. But, if the policy and the parties' contract do not explicitly state this, the additional insured may seek, and obtain, coverage in situations beyond what the parties intended.

Moreover, and more importantly, the parties must understand what it means to share policy limits. Available coverage will be reduced by amounts spent defending one or both parties against the same or different claims. Unless the policy contains a priority of payment provision, no party will have a right to have its claims paid first. Moreover, the limits may not be adequate to defend and indemnify all insureds for all potentially covered claims.

Be Cognizant of Legal Limitations

Parties to risk transfer agreements need to be cognizant of legal and other limitations.

Indemnification Limitations

Some states refuse to give effect to indemnification provisions transferring responsibility for one's own gross negligence to another. Other states hold void as against public policy agreements to transfer responsibility for punitive damages. See, e.g., Weaver v. Univ. of Cincinnati , 970 F.2d 1523, 1538 (6th Cir. 1992); Stamford Bd. of Educ. v. Stamford Educ. Ass'n , 697 F.2d 70, 73 (2d Cir. 1982). But see, First Bank (N.A.)-Billings v. Transamerica Ins. Co., 209 Mont. 93, 679 P.2d 1217 (1984).

Even if the transfer of liability is not repugnant to public policy, courts hesitate to enforce indemnity agreements that are unclear and ambiguous. See, e.g., Mautz v. J.P. Patti Co. , 298 N.J. Super. 13, 688 A.2d 1088 (App. Div. 1997). Parties therefore will want their indemnification provisions to be understandable by lay people, and conspicuously located in their agreements. If the indemnification clause is limited or voided, the indemnitee will lose protections for which it bargained and paid. Id.

Subrogation Issues

Before accepting a waiver of subrogation clause, the contracting parties need to confirm that the clause is enforceable in their circumstances. A waiver of subrogation provision may be disallowed by applicable law or statute. See, e.g., Travelers Indem. Co. of Connecticut v. Losco Group , 204 F. Supp. 2d 639 (S.D.N.Y. 2002) (waiver invalidated as against public policy where claim involved gross negligence); but see St. Paul Fire & Marine Ins. Co. v. Universal Builders Supply , 317 F. Supp. 2d 336 (S.D.N.Y. 2004), aff'd as modified, 409 F.3d 73 (2d Cir. 2005). See also Colonial Properties Realty Ltd. Partnership v. Lowder Constr. Co. , 256 Ga. App. 106, 567 S.E.2d 389 (2002) (waiver invalidated by acts of gross negligence, or willful or wanton conduct). Accord Oilfield Anti-Indemnity Act, LA. REV. STAT. ANN. '9:2780 (West 2007).

Contracting parties also should review relevant insurance policies to determine whether they limit the policyholder's rights to waive subrogation. Some insurance policies contain subrogation provisions, setting forth the insurer's right to subrogation and requiring the policyholder to cooperate with the insurer in asserting them. Some policies simply prohibit a policyholder from prejudicing or limiting its insurer's rights after a loss. Some policies prohibit policyholders from waiving subrogation at any time. Other policies permit policyholders to waive subrogation, in writing, even after the loss. But as many insurance policies purport to void coverage if the policyholder improperly prejudices the insurer's subrogation rights (whatever they are), the parties would be wise to consult their insurance policies so they do not run afoul of any policy conditions.

Attending to Contractual Compliance

An insurance requirement provision is only useful if there is an insurance policy supporting it. Many contracts therefore require evidence of insurance be provided to the party in whose favor the insurance requirement clause runs. This party, typically the indemnitee, must then take steps to ensure compliance with the insurance and insurance evidence requirements. An indemnitor's breach of an insurance requirement provision will not relieve it from its hold-harmless obligations, but it likely means anticipated insurance funds will not be available to pay losses.

The indemnitee should ask for a certificate of insurance ('COI'), evidencing the purchase of required insurance policies. A COI is a form issued by an insurer, identifying the insurer, its policy's type and number, its policy's effective dates and limits, and the amount of any self-insured retentions or deductible. The COI also may list those added to the policy as additional insureds. The indemnitee should promptly review the COI, and resolve all discrepancies between the insurance policies required by its contract and those actually obtained.

The indemnitee also should confirm that financially sound insurers issued the insurance policies. Moody's, A.M. Best, and Standard & Poor rate the financial health of insurers. The parties' contract also may specify a minimum acceptable insurer rating.

The indemnitee must then establish a system to monitor continued compliance with insurance requirement provisions. It may, for example, ask for updated COIs at reasonable intervals. It also may request that the insurer and indemnitor provide notice before canceling insurance policies. To the extent possible, these undertakings should also be included in the parties' contract.

The indemnitee should retain COIs for future reference in connection with later claims. They may provide useful insurance information and be regarded as evidence of insurance if the insurance policies are lost or destroyed.

COIs will not indicate whether an insurers' payment of prior claims has reduced its limits. An indemnitee will need to seek this information separately from the indemnitor or its insurer. This undertaking too should be included in the parties' contract.

Indemnitors should take timely action if they contract to provide insurance, and their policy requires them to list by name all additional insured or contractual insureds. Unless the policy's endorsement is updated before a loss, the loss may not be covered and the indemnitor may be found to be in breach of its contract. Automatic blanket endorsements are available, providing additional insured status to anyone the policyholder agrees in writing to so name. These blanket endorsements, however, may need to be amended to be precise about the types of 'written contracts' contemplated (so that, for example, a party that is to be named an additional insured on only a primary policy does not achieve insured status under excess or other insurance policies).

The parties should confirm the adequacy of their insurance coverage for their own risks and those they assume, in the aggregate, from others. Indemnitors may want to have their contracts reviewed by an insurance professional, who can help identify potential risks, gaps in coverage, and whether their program and limits are sufficient, in total, to cover their risks.

In complying with insurance requirement provisions, indemnitors should be cautious not to provide insurance beyond that to which they agreed. When an indemnitor negotiates a limitation or cap on its liability, or limits on the amount of coverage it will provide and under what circumstances, these contractual limitations should be expressly stated in relevant insurance policies. This can be accomplished by a policy endorsement.

When parties have reciprocal insurance requirements, thought must be given to their respective status under each other's insurance programs. Whose policy will respond first, and in what circumstances? Many policies provide that they share losses with all other available insurance policies. Some policies state that they provide coverage only in 'excess' of other available and/or primary insurance coverage. These issues can be addressed by making certain policies 'primary' and 'non-contributory,' and other policies 'excess.' Whatever the parties decide, it needs to be set forth in the parties' contract and their insurance policies before claims arise.

Conclusions

Contractual risk transfer is a very effective risk management strategy, but no matter how well thought out the parties' contract, there remains a potential downside that needs to be considered and addressed: The parties may be liable for losses that they had hoped to avoid. For the transferor, it needs to understand that it is 'sharing,' not absolutely avoiding, its risks. Ideally, the transferor's assets ' including its own insurance policies' limits ' will remain protected. But, the transferor may ultimately become responsible for losses if the risk transfer fails, the transferee becomes insolvent, or the insurance supporting the transfer is exhausted or otherwise unavailable. For the transferee purchasing insurance, it may be responsible for losses it hoped to share with its insurer. This may happen if it assumes more risk than it insures, its insurer becomes insolvent, its insurance policy's limits are exhausted, or its does not adequately price its risk transfer agreement (covering its additional premiums and the cost of assumed losses).

Before ' and even after ' agreeing to share your or someone else's limits, carefully consider your insurance needs. When parties share limits, one insured's expenditures (defense and/or indemnity) deplete the limits available to others. No insured can expect that full policy limits, and a complete defense, will necessarily be available when it faces losses or third-party claims. Indeed, in some states, absent bad faith, an insurer may exhaust its policy limits by funding settlements entered into by only one insured if it was unable to resolve all claims against all insureds. See, e.g., Millers Mut. Ins. Assoc. of Ill. v. Shell Oil Co. , 959 S.W.2d 864 (Mo. Ct. App. 1998); American States Ins. Co. of Texas v. Arnold , 930 S.W.2d 196 (Tex. App. 1996); Country Mut. Ins. Co. v. Anderson , 257 Ill. App. 3d 73, 628 N.E.2d 499 (Ill. App. Ct. 1994). But see Shell Oil Co. v. Nat'l Union Fire Ins. Co. of Pittsburgh, PA, 44 Cal. App. 4th 1633, 52 Cal. Rptr. 2d 580 (1996) (insurer acts in bad faith where it settles for policy limits, obtaining a release for less than all of its insureds). Accord Smoral v. Hanover Ins. Co. , 37 A.D.2d 23, 322 N.Y.S.2d 12 (N.Y. App. Div. 1971). Upon the policy's exhaustion, the insurer's defense and indemnity obligations end. Parties therefore need to consider contractual risk transfer one, but not the only, risk management tool at their disposal.

Sherilyn Pastor is a partner in, and Practice Group Leader of, McCarter & English's Insurance Coverage Group, which consists of more than 35 attorneys providing legal assistance to corporate policyholders throughout the country and internationally. This publication is not intended to provide legal advice. Issues relating to insurance coverage and litigation are fact specific, and their resolution will depend on the facts involved and the law governing the disputes, which varies from state to state. The views expressed in this publication are not necessarily those of McCarter & English or its clients. Copyright by author (2007).