Contractual risk transfer is an indispensable part of any construction risk management program; and the primary goal of effective contractual risk transfer is to place the financial consequences of a loss on the party best able to control and avoid the possibility of injury or damage, without violating statute or creating an “unconscionable” contract (defined as a contract that is unreasonable due to the unequal bargaining strength of the parties, or the result of undue influence or unfair tactics). Two key elements necessary to effectively accomplish this goal are: 1) a strong “Indemnification Agreement” within the construction contract; and 2) assurance that the entity to which the financial responsibility is being transferred has ample financial means to protect each party to the contract, either by sufficient financial reserves or adequate amounts of insurance.
The indemnification agreement is the heart of contractual risk transfer. Such an agreement may read, in some form, as follows: “For and in exchange for fair and equitable consideration, the “Transferee” (the sub-contractor, sub-subcontractor, etc.) agrees to indemnify and hold harmless “transferor” (the GC, owner, project manager, etc) for and from any and all loss or cost arising in whole or in part from the “transferee’s” negligence, or wrongful act.” “Indemnification” shields the transferor from the financial consequences of the loss and the “Hold Harmless” wording protects the transferor against the legal process that may result from an injury.
Indemnification agreements, in whatever form, are not affected by, nor do they directly affect the insurance coverage; they are purely contractual requirements. But beyond the indemnification agreement, and in order for contractual risk transfer to accomplish its stated goal, the entity to which the financial consequences are being transferred (the “transferee”) must extend some level of financial protection to the “transferor.” This can be accomplished by naming the transferor as Additional Insured, and by use of a Waiver of Subrogation endorsement in favor of the transferor.
Requiring the transferee name the transferor as an “Additional Insured” is recommended and a generally accepted contractual insurance requirement. Being named as an additional insured satisfies two necessities of effective contractual risk transfer for the transferor: 1) the transferor is defended against and financially protected for the negligent acts of the transferee by the transferee’s insurance carrier; and 2) the transferor is insulated, except in rare circumstances, against the subrogation rights of the insurance company.
Construction contracts can and often do require the transferee endorse a “Waiver of Subrogation” in favor of the transferor onto the insurance policy. However, insurance carriers may refuse this request for reasons outside the scope of this article. The waiver of subrogation endorsement is not absolutely necessary – if the indemnification agreement is written to include such waiver, and the additional insured requirements are met.
Subrogation rights flow from the injured party’s right to subrogate. If the subcontractor’s right to subrogate is waived by contract prior to a loss, the insurance carrier has no right to subrogate. The indemnification agreement should include provisions waiving the subcontractor’s right to subrogate; this waiver may need to be included as a separate paragraph in the contract, depending on how a particular state’s statute addresses the breadth of indemnification allowed.
Properly drawn construction contracts delineate the contractual risk transfer responsibilities of the contracting parties. However, no single article can anticipate every individual need or answer every question regarding contractual risk transfer. Outside expertise is necessary when developing a contractual risk management program or when responding to one as the transferee.