Contractual Confusion—Assuming the Liability of Others

Liability Imposed by Law

The law can impose liability on us for our own actions. If we are negligent, we are personally liable for the damages that result. We can also be held liable for the actions of others. For example, if our employee is negligent while acting in the scope of employment, not only is the employee personally liable, we are also liable solely because we are the employer. Our liability is based entirely on our relationship with our employee. Assigning liability to an otherwise blameless party (the employer did nothing wrong) for the acts of another (our employee was negligent) is called "vicarious" liability and is also liability imposed by law. Although these concepts are generally well understood, both are worth repeating—to establish a baseline of comprehension and also to use as a point of comparison to help gain insight into contractual liability.

Liability by Contract

Figuring out what risk is to be covered is central to grasping how any insurance works. With contractual liability insurance, the risk is a contract—but not just any contract. In fact, for the contracts involved, we usually don't mean the entire contract. We mean only a particular portion of certain contracts or agreements. That particular portion is generally known as the hold harmless or indemnity agreement. For the sake of discussion, we will refer to the clause simply as an indemnity agreement. ¹

Assuming Liability. By entering into an indemnity agreement, we have agreed to answer for what some else does; that is, we have agreed to be legally liable for the actions of others. In an indemnity agreement, our liability is based on our promise to be liable and not because the law imposes the liability on us as illustrated above. In the jargon of insurance, this category of liability is often referred as "assumption of liability by contract."

Additionally, and this is important, indemnity agreements are not about failure to fulfill or perform the terms of a contract. To the contrary, indemnity does not relate to breach of contract but rather performing the terms of a contract—making good on your promise to "step up" and take financial responsibility for the liability of another.

Three People Involved. An indemnity agreement necessarily involves three people. ² If three people are not involved, it is not an indemnity agreement. The first person is making the promise to indemnify and is called the indemnitor. The second person is accepting (or demanding) the promise to be indemnified and is called the indemnitee. While three people must be involved, only the first (indemnitor) and second (indemnitee) are actually parties to the indemnity agreement.

The third person is usually the one to whom the indemnitee is legally liable, usually due to negligence of the indemnitee. Because the third person is not a party to the indemnity agreement, the third person is not affected by the terms of the indemnity agreement. In other words, whatever the indemnitor and indemnitee may agree on is not binding on the third person. The third person retains all rights and remedies available under law against the indemnitee or indemnitor despite the indemnity agreement.

Limitations of Contractual Liability Insurance

Too often, an indemnitee is thought to automatically have the status of an insured or additional insured on the CGL policy of the indemnitor. Using our illustration of tenant and landlord, the landlord does not have the status of an insured or additional insured on the tenant's CGL policy merely as a result the indemnity agreement.

Contractual Confusion. The confusion seems to stem from the failure to distinguish insurance from indemnity obligations. As it is very common for the landlord to be listed as an additional insured on the CGL policy of the tenant in addition to the indemnity agreement, it is too often assumed that the an indemnitee is an additional insured. Put another way, because additional insured status and indemnity agreements are so frequently seen together, they may seem indistinguishable from one another or at least appear that one is the result of another, i.e., an indemnity agreement results in additional insured status. The reasoning seems to be that if the contract fits within the definition of "insured contract," such as a lease of premises agreement, it follows that "insured contract" also means the landlord is automatically an additional insured. This belief is simply mistaken. An indemnitee is not an insured.

The tenant's CGL policy must be amended to extend coverage to provide additional insured status to the landlord. Just because the contract happens to be an "insured contract" does not mean the tenant's CGL provides additional insured status to the landlord. In other words, the indemnitor's CGL policy must be amended to include an additional insured endorsement to provide the indemnitee the status of additional insured. To repeat—having the status of indemnitee is not the same as being an additional insured.

A Practical Distinction. An additional insured is a party to the insurance policy and therefore has "privity," meaning the additional insured generally has direct rights to enforce the terms of the policy against the insurer issuing coverage to the additional insured. An indemnitee generally does not have privity and therefore has no right to enforce the terms of indemnitor's CGL policy. The indemnitee's rights are only those found in the indemnity agreement itself.

While this may seem like distinction without a difference, consider this. If you are the indemnitee, would you rather have the ability to recover from an insurer directly or from the indemnitor, whose financial wherewithal is likely substantially less than the vast majority of insurers? In many cases, the reason to be an additional insured as well as an indemnitee is that you want two avenues of recovery. Why two avenues? Because you can't know if being an indemnitee or an additional insured will provide you the better recovery opportunity in any particular situation.

In fact, in serious claims, indemnitees may pursue recovery from both directions simultaneously—as an indemnitee and as an additional insured. The merits of this "belt-and-suspenders" approach to the indemnitee/additional insured issue becomes more apparent when considering that indemnity agreements, unlike insurance policies, contain no limits or exclusions. In other words, indemnity may allow a broader or greater recovery than insurance.

Direct Responsibility

If in our previous illustration the tenant also agreed in the lease to be responsible for any damage to the building, regardless of cause or fault, would this be considered "… liability for damages assumed in a contract or agreement … for property damage…?"

Let's say that a tornado caused substantial damage to the building that will cost the landlord, who owns the building, $750,000 to repair it. The landlord obtained an estimate for repair, engaged a general contractor to begin the repairs, and handed the repair bill to the tenant with a letter referring to the portion of the lease in which the tenant has promised to be responsible for damage to the building, even if the damage is not the fault of the tenant. Is this also an indemnity agreement? If so, is this an "insured contract?"

A contract for the lease of premises does fall squarely within the definition of "insured contract," albeit with the limitation that an agreement to indemnify any person or organization for damage by fire to the premises rented to you is not an "insured contract." Of course, in this instance, the damage is not by fire, so the fire limitation is not a concern.

By agreeing to be responsible for damage to the landlord's building, has the tenant "assumed the liability" of the landlord? More accurately, is the landlord legally liable for damage to its own building? Drilling down a little further, is the landlord's cost to repair its own building "damages" that are "assumed in a contract or agreement?"

The answer to all of the above is no. The agreement to accept responsibility for damage to the landlord's building is not an indemnity agreement. The landlord has no liability imposed on it by law to repair its own building. Similarly, because the landlord has no liability, the costs to repair the building are not "damages" from the viewpoint of the landlord. You may have already noticed—this agreement does not involve three persons; it involves only two persons as the landlord in our illustration is not liable to a third person.

CGL Exclusion b. Further, while a contract for a lease of premises is an "insured contract," that does not mean that all obligations created in a lease of premises agreement are covered by contractual liability insurance. To fully understand the scope of contractual liability insurance, the definition of "insured contract" must be read in conjunction with exclusion b. of the CGL policy.

Exclusion b. eliminates coverage in the CGL for the insured's obligation to pay damages by reason of assumption of liability in a contract or agreement, but does not apply to "… liability for damages … assumed in a contract or agreement that is an "insured contract." In other words, contractual liability insurance applies only if the insured has assumed liability for damages in a contract or agreement and that contract or agreement falls within the definition of "insured contract." Going back to our illustration regarding the tenant's agreement to be responsible for damage to the building, the tenant has neither assumed the landlord's liability nor does the agreement involve "damages." Contractual liability insurance does not apply in this illustration.

The Tavern—An Illustration

Let's go back to our tenant and landlord illustration. The only additional fact we will introduce is the tenant operates a tavern and is engaged in the business of selling and serving alcohol. All other facts are the same, including the indemnity in favor of the landlord.

A patron is "overserved" by the tenant and, in his intoxicated state, injures another patron. The injured patron sues both the tenant and landlord, alleging violation of the dram shop act. The case goes to trial and liability is imposed on the tenant as well as the landlord—the basis of the landlord's liability is the state's dram shop statute, which imposes liability on the landlord for the acts of its tenant.

The injured patron is awarded $100,000 of damages; the court determines liability to be 50 percent the tenant and 50 percent the landlord. After each (tenant and landlord) pays its share of the damages to the injured patron, the landlord seeks recovery for the $50,000 of damages it has paid to the injured patron by enforcement of the indemnity agreement. Will the tenant's CGL insurer pay on behalf of the tenant the damages owed to the landlord for the landlord's liability to the injured patron? Keep in mind that the tenant has assumed the liability of the landlord in a contract (lease of premises) that is considered an "insured contract." While the tenant is liable to the landlord via the indemnity agreement, the tenant's CGL policy specifically excludes coverage for the tenant's liability for the selling or serving of liquor. Therefore, the insurer will not pay the damages that the tenant owes to the landlord as the tenant's liability originated from an activity for which the tenant does not have coverage—the sale of alcoholic beverages.

The Construction Site—An Illustration

Assume a general contractor enters a construction contract with a subcontractor. Included in the construction contract is an indemnity agreement in which the subcontractor agrees to indemnify the general contractor for "any injury or damage arising out of the work, except injury or damage that is caused by the sole negligence of the General Contractor."

The subcontractor's employee is injured on the jobsite. In addition to collecting workers compensation benefits from the subcontractor, the employee sues the general contractor for failing to keep a safe workplace. The general contractor is found partially but not solely negligent in causing the injury to the subcontractor's employee, who was awarded $200,000 damages for his injuries, all of which were paid by the general contractor. As with the other illustrations, the general contractor seeks to recover $200,000 from the subcontractor by enforcing the indemnity agreement.

If the agreement to indemnify the general contractor is not considered an "insured contract," the subcontractor's CGL policy would not pay for the damages the subcontractor owes to the general contractor because the liability exclusion on the subcontractor's employers' CGL policy would apply. Fortunately, this indemnity agreement does fall within definition f. as an "insured contract."

Therefore, even though the subcontractor is actually paying for damages resulting from injuries to the subcontractor's own employee, the employers' liability exclusion does not apply due to the express exception in the exclusion for liability assumed by contract in an "insured contract." Therefore, the subcontractor's CGL insurer will pay $200,000 of damages on behalf of the subcontractor to the general contractor in accordance with the indemnity agreement.