A wide variety of commercial contracts arising across industries include insurance coverage requirements. Although dealmakers often agree to counterparty forms or boilerplate language on this topic, doing so may result in the assumption of unnecessary risk. This article describes typical insurance clauses and advises on key drafting considerations. Though intended to provide context regarding a common issue businesses face, this article is merely a brief overview of the language and legal considerations contracting parties will encounter in the course of negotiating transactions. Since it provides general guidance based on principles that often apply, it is not legal advice and must not be relied upon in any specific situation, the results of which will depend on the particular policy terms and applicable law.
Fundamentally, contracts are designed to allocate risk among parties. Insurance accomplishes a similar goal by allowing a person to transfer risk to an insurer in exchange for a known premium. Contracts and insurance, therefore, are natural partners.
The two principal categories of insurance are (1) coverage against loss or damage to the insured’s property — usually not based on the insured’s fault — and (2) coverage against liability to third parties based on the fault of an insured. There are many insurance policies from each category that could be implicated in a contract. This article focuses on a common third-party liability policy as an example: Commercial General Liability (CGL). The CGL policy is a standard policy of insurance issued to businesses to protect against certain liability to third parties for, among other things, bodily injury and property damage arising out of the insured’s business operations.
Below, this article first explains the insurance “lingo” commonly invoked in commercial contracts requiring CGL policies and then provides tips to avoid traps for the unwary.
Contracts generally state the minimum amount of damages a CGL policy is required to cover – that is, the minimum policy limits. Such limits apply both on a “per occurrence” basis (the maximum the insurance company will pay for any one incident) and an “aggregate” basis (the maximum the insurance company will pay for all claims during a period specified in the policy). Commercial contracts and CGL policies may go into greater detail on these topics. For example, per occurrence limits may be stated separately for bodily injury, property damage, and other types of claims. More commonly, though, policies specify a “combined single limit” or the maximum dollar amount an insurer will pay to cover any combination of injuries or property damage in one incident. Contractual minimum limits generally are negotiable. Contracting parties should ensure that their policy coverage meets contractual requirements but also should consider whether they need higher limits as a matter of sound risk management.
Counterparties may request to be added as an “additional insured” on a named insured’s policy via the filing of a specific endorsement on the named insured’s policy. Such a designation generally works to permit the additional insured to seek reimbursement from the named insured’s policy if the additional insured is included in a lawsuit arising out of the named insured’s business operations. This status is particularly valuable if the named insured may not have the financial resources to stand behind a contractual commitment to pay for such lawsuits (that is, an indemnity).
The term additional insured is misleading, however, because this status does not convey all of the rights of a named insured party. Rather, an additional insured’s rights depend entirely on the terms of the specific endorsement. Therefore, parties seeking additional insured status should request to review the terms of the corresponding policy endorsement prior to executing a contract and consider pushing back on language inappropriately limiting rights. An endorsement might, for example, forbid claims arising after work has been completed on a project undertaken by both parties or apply only to incidents arising from the named insured’s negligence. Depending on a project’s risk management needs and applicable costs, such limitations may not be apt.
Waiver of Subrogation
Contracting parties may request a “waiver of subrogation.” The term “subrogation” refers to an insurer’s right to be put in the position of the insured; that is, to pursue recovery from third parties legally responsible to the insured for a loss that the insurer has both insured and paid. A subrogated insurer is said to “stand in the shoes” of its insured because it has no greater rights than the insured and is subject to the same defenses assertable against the insured. By waiving subrogation, then, a contracting party eliminates its insurer’s right to seek damages from a counterparty that had a role in causing an insured loss. Whenever a contract requires a waiver of subrogation, insureds should take care to ensure their policies permit doing so. The standard CGL form permits waivers of subrogation in writing and before the occurrence of a loss. However, certain policies may require a specific endorsement and associated fee or other compliance undertakings, in which case waiving subrogation without taking these steps could result in a denial of coverage.
Allocation of Coverage
As almost all businesses maintain insurance coverage, contracts often include language dictating which party’s insurance coverage will apply to a casualty involving both parties. Often, one party’s policy is deemed “primary and noncontributory.” “Primary” designates that one party’s policy is responsible for covering a claim first before the other’s policy applies. “Noncontributory” prohibits the primary insurer from seeking contributions from the secondary policy to pay a claim. Note, however, that this language does not prevent recourse to a secondary insurance policy if the “primary and noncontributory” policy’s limits are exhausted. Contracts may make this principle explicit by providing that a policy’s coverage is “excess” or “secondary.” To avoid this result, a party seeking to avoid recourse to its insurance policy by a counterparty could request a waiver of subrogation as described above. Pursuant to this approach, the counterparty would sustain an uninsured loss once its policy limits were exhausted. However, this approach may increase the risk that the counterparty resorts to litigation in the event of a casualty, which may be expensive, disruptive, and potentially very risky. For this reason, it is generally advisable to implement risk allocation mechanisms that make full use of available insurance.
Notice of Cancellation
Contracts may require that written notice be provided if a required policy is canceled, typically at least 30 days before the effective date thereof. To avoid a technical breach, parties should double check applicable contractual language when their policies are terminated and act accordingly.
Traps for the Unwary
Limitations of Liability
As noted above, contracting parties must ensure that they comply with the terms of applicable insurance policies when waiving subrogation. However, commercial contracts often provide for broad limitations on liability for one or both parties, such as by capping any damages at a specific amount. These limitations may cause a party unwittingly to waive its insurer’s rights. If such a waiver is made in violation of policy terms, a denial of coverage may result. Parties, therefore, should carefully review such provisions alongside applicable insurance contracts before signing.
Insurance provisions are frequently invoked in combination with indemnity clauses, pursuant to which a person (the “indemnitor”) agrees to take on specified liabilities arising from the conduct of a counterparty (the “indemnitee”) or a third party. However, CGL policies — and liability insurance policies generally — expressly exclude liability assumed by contract, subject to certain exceptions. Suffice it to say that ensuring insurance coverage applies to indemnities given to third parties is complex, and if such coverage is desired, indemnitors should work with their insurance brokers and attorneys to construct appropriate arrangements. Do not assume that liability for indemnities will be covered.
Sometimes, contracts will include broad language that does not give parties actionable guidance regarding expected insurance coverage, for example, stating that a party obtains insurance coverage “consistent with industry standards” or “in types and amounts as are reasonably prudent.” As a matter of best practice, we recommend avoiding such language in favor of specific requirements. Broad language invites disputes as to the scope of coverage intended by the parties. In the event of a casualty, it could cause an insurance coverage dispute to transform into a breach of contract battle; if a court determined that the insurance procured did not meet the required level, the breaching party could be held liable for damages notwithstanding other limitations on liability in the contract.
Certificates of Insurance
Contracts also may require parties to deliver certificates of insurance evidencing required coverage. Such requirements most commonly apply upon entry into a contract but may also apply periodically thereafter. As a matter of best practice, we recommend resisting unconditional future obligations to deliver certificates of insurance. Such requirements may easily be overlooked long after the agreement has been signed, and failure to comply potentially could constitute a breach, giving rise to counterparty default rights. Certificates of insurance generally confer no rights on the holder pursuant to their express terms. Accordingly, to confirm coverage details, a certificate recipient should ask to review the relevant portions of the underlying policy and endorsements.
Mergers and Acquisitions (M&A) and Restructuring
It is particularly important to think about insurance coverage issues in an M&A context. Insurance policies may contain limitations on assignment, and failure to transfer coverages could give rise to a breach of entire categories of the target’s contracts containing coverage requirements. Even internal corporate reorganizations (for example, establishing a new holding company or merging sister companies) could give rise to uninsured aspects of a group’s business operations absent careful coordination with insurance advisors.
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Taft frequently advises clients on contract drafting issues and insurance coverage disputes arising in high-stakes transactions. Please contact any Taft attorney who focuses on business matters with questions.