Prevent Uncovered Losses by Aligning Coverage With Third-Party Contracts

JULY 5, 2022

Today, several related issues are complicating contractual risk transfer: supply chain challenges, increased material costs, project delays, changing lease agreements, and the need to address all these problems by changing or adding new vendors. Amid this turmoil, insureds must continue to correctly identify risk transfer opportunities and manage risk assumed under contracts with improved contract language and alignment of policy terms with contractual obligations. Failing to carry out these steps effectively can result in massive uninsured losses.

Adding to the growing pains for third-party contracts is rapid digitalization, which is the No. 1 trend for 2022, according to the report “8 Contract Management Trends to Watch in 2022.”¹ Nearly 68% of organizations say that digitalizing manual processes is the top priority when contracting with vendors and other third parties.

While this trend is likely to increase efficiencies and decrease human error, its reliance on computer technology will also increase cyber exposures. A few years ago, even before the digital trend had hit its stride, 59% of companies were experiencing cyber exposures caused by one of their vendors or third parties.²

The increase in supply chain, cyber, and other types of risks is significantly impacting third-party contracts. According to data from Evident, a specialist in third-party risk:

• 75% of third parties are not meeting insurance requirements established by companies
• At least 10% of third-party vendors fall out of insurance compliance without notifying the companies that hire them
• 23% of third-party vendors do not respond at all to companies’ requests for proof of insurance

These practices may increase the liability exposure associated with:

 Step 1: Identify Risk Transfer Opportunities

Review and identify where risk can be transferred to a third party. Consider a company that hires a contractor to remove snow and ice. The contract requires the snow removal company to carry general liability (GL) insurance.

During the winter, a customer falls on some ice on the company’s property. The customer sues the company, which tenders the claim to the contractor for defense. However, the contractor’s insurance carrier denies the claim, noting that there was no defense or indemnification provision in the contract. The company has no alternative but to submit a claim under its own policy, which has a $100,000 deductible, resulting in out-of-pocket costs for the company.

To avoid this type of scenario, the company should have required the contractor to name the company as an additional insured on a primary and noncontributory basis under the policy. The contract language should have also been revised to include indemnification/hold harmless and waiver of subrogation provisions. The resulting financial impact for the company would have been equal to the $100,000 deductible, as well as transfer of future liabilities to the contractor, up to the policy limit.

 Step 2: Optimize Contract Language to Mitigate Contractual Obligations

Review contractual obligations to obtain the most favorable contract language. For example, a business is looking to rent a warehousing facility, and the lease requires the business to hold the landlord harmless from all liabilities related to hazardous substances, with limits of $25,000,000. The business does not feel that such a high limit is warranted, nor does it want to incur the additional $100,000 premium.

A comprehensive risk assessment, benchmarking and analytics review show the landlord that her liability exposure is minimal. The business successfully negotiates lower limits in the contract, resulting in a premium savings of $75,000 and compliance with the lease agreement.

 Step 3: Align Coverage With Contractual Obligations

Review contractual obligations and policies to help ensure coverage is aligned with contractual exposures, preventing an uncovered loss. For example, a manufacturer is looking to enter into a supplier agreement with a customer, which requires the manufacturer to protect and indemnify the customer from any loss arising out of bodily injury, property damage and any other damages or loss related to product failure, design and installation error.

However, the manufacturer’s GL policy only provides coverage for claims arising out of bodily injury and property damage. Therefore, the manufacturer purchases a separate errors and omissions (E&O) policy for $12,500 additional premium to address other damages or nonbodily injury and property damage claims, such as third-party financial loss. This prevents a potential breach of contract and an uncovered E&O claim up to the policy limit of $1,000,000.

To effectively manage contractual risk, organizations must continually review and improve their third-party contract language and the alignment of insurance policy terms with contractual obligations. The comprehensive review process described above is critical to success.

^Sources
1 DocuSign
² 2018 Ponemon Institute study