Much confusion often surrounds the task of determining risk associated with a contract and then tailoring the risk and liability provisions of the contract to reflect that risk.
As a result, the risk and liability provision in contracts are often template-based with standard insurance amounts and liability caps inserted with little consideration. Consequently, the risk and liability provisions do not always allocate risk appropriately, which may result in increased and unnecessary costs to both contracting parties.
The purpose of this article is to help to demystify the risk assessment process, and provide a brief guide (with a simple example) on how to translate the outcome of a risk assessment into a tailored risk and liability regime to address the specific risks of the transaction.
Risk will be present in some form in every transaction and each transaction will present different sets of risks and issues. A failure to identify and assess risk early in contract negotiations and to determine how to manage those risks can ultimately leave the parties exposed to risk and liabilities they did not factor into their bargain.
The first step in preparing a more tailored risk and liability regime is to conduct a risk assessment.
There are many different ways of conducting a risk assessment. It should be as simple or detailed as required. However, at its core, it usually involves the following analysis:
- Identify the risks: determine what can happen and how it can happen
- Analyse the risks: determine the likelihood and the consequences of the identified risks eventuating
- Treat the risk: determine who should bear the risk and, if so, how.
For some risk assessments, it is useful to categorise risk based on categories of insurance, where insurance will be the primary mechanism for managing the risk, such as:
- Property risks: loss or damage to the assets of a party
- Liability risks: liability of a party for loss or damage suffered by another person (either personal or property)
- Insurance required by legislation: such as workers' compensation insurance and compulsory third party insurance for motor vehicles.
For other risk assessments, for example where the contract is a service delivery contract, it is useful to categorise risk based on issues such as safety, schedule, performance and price.
Identify the risks
The identification of risk generally involves thinking of each of the worst case scenarios that can occur throughout the life of the contract.
To help demonstrate the process, we will use the following example:
Transport contract facts
- A chemical manufacturer (Chemical Co) wishes to enter into a contract with a courier company (Transport Co) for the collection and transport of industrial chemicals from Chemical Co via Transport Co to customers of Chemical Co
- The contract price is $500,000 per annum
- The contract term is five years
- Total profit over the contract term is $1 million.
- Transport Co:
- Holds a $20 million third party property damage and public risk insurance policy
- Holds a $10 million workers' compensation insurance policy
- Has $10 million in assets.
The principle risk under the transport contract is a chemical spill or fire due to an act or omission of Transport Co during transport or delivery of the chemicals.
Analyse the risk
The analysis of risk generally involves consideration of the likelihood and consequence of the occurrence of each risk. An analysis of the likelihood of risk associated with the transport contract is as follows:
Risk: Chemical spill or fire due to an act or omission of Transport Co during transport or delivery of the chemicals.
- Loss or damage to the assets of Chemical Co – $25 million
- Death or injury to Transport Co staff – $4 million
- Third party personal injury or death or loss or damage to third party property – $50 million
- The total liability risk of Transport Co's negligent act or omission – $79 million.
Treat the risk
The most difficult part of any risk analysis process is determining the treatment of the identified risk – that is, how it should be allocated.
There are many ways that risks can allocate under contract. Commonly, risk is:
- allocated to or shared by the parties, for example by indemnities and limits of liability
- allocated to a third party, for example by insurance, guarantees or other financial security.
The usual principle applied to the treatment of liability risk in contract is to allocate the liability risk to the party best able to manage that risk. By following this principle, the allocation of liability risk should deliver the best value for money outcome.
Below is a suggested stepped approach to how liability risk may be treated based on the transport contract example.
Step 1 – Determine the liability risk
Based on the above example, if, due to an act or omission of Transport Co, an event occurs resulting in:
- the loss of Chemical Co assets
- death or injury to Transport Co staff
- third party personal injury or death and those third parties successfully recover their losses from Chemical Co, the liability risk is $79 million.
Step 2 – Determine who is best able to manage the risk
This second step involves building up the allocation of the liability risk based on who is best able to manage it. This is usually done in layers.
The first layer – losses covered by Transport Co's insurance
Transport Co should bear liability risk at least to the extent that such liability is covered by Transport Co's existing insurance.
We know that Transport Co holds the following insurance:
- $20 million in third party property damage and public risk insurance
- $10 million in workers' compensation insurance.
It follows that if, due to Transport Co's negligent act or omission, Chemical Co suffers $79 million of loss or damages, the maximum amount recoverable from Transport Co via insurance is:
- $20 million (of the $25 million dollar third party property damage and public risk claim)
- the full $4 million claimed for death or injury to Transport Co staff.
Obviously, at this point the parties should consider whether Transport Co should increase its level of third party property damage and public risk insurance. Generally, an increase would result in an increase in the cost of the insurance (which would be passed on to Chemical Co as an increase in the contract price). Any decision regarding an increase in insurance would be based on value for money assessment, considering the marginal cost of that additional insurance compared with whether Chemical Co is prepared to bear the risk itself or whether it can pass it on.
We will assume that the parties decide not to require Transport Co to increase its insurance or to otherwise pass it on to a third party on the basis that this would not represent value for money.
This leaves a residual liability risk of $55 million (that is, $79 million minus $24 million).
The second layer – losses to be covered by Transport Co
As noted above, Transport Co has $10 million in assets. However, it is unlikely that Transport Co will agree to put its entire company at risk, even if the loss or damage suffered by Chemical Co is due to Transport Co's own negligent act or omission. Indeed, if it were to do so, it would price this risk resulting in a (presumably substantial) increase in the contract price (which would be unlikely to be value for money).
However, Transport Co should be required to bear some of the risk due to its own negligent act or omission. In other words, this is the extent to which Transport Co has 'skin in the game'.
Determining the amount that is recoverable from a contractor (i.e. not recoverable under insurance or via a third party, etc.) is more art than science. This amount is usually the subject of significant negotiations. Some of the rough metrics often placed upon this relate to the total profit under the contract or the contract price.
Given that the total profit under the transport contract is $1 million, which represents two years of payments, this may be a reasonable approximation of the maximum amount that Transport Co would be expected to put at risk.
This leaves a residual liability risk of $54 million [that is, $79 million (minus $24 million plus $1 million)].
The third layer – losses not recoverable from Transport Co
Chemical Co has a number of options regarding the residual liability of $54 million. It may:
- seek to cover the residual liability risk via its own insurance
- seek to increase or change its policy terms to cover the risk
- decide that the risk of such a loss occurring is sufficiently low and its assets sufficiently large enough to carry the risk.
In any case, the benefit of conducting the risk assessment is that Chemical Co:
- is now aware of the residual risk
- may make an informed and value for money decision not to allocate that risk to Transport Co.
Step 3 – Allocation of liability risk
It follows that the risk and liability provisions of the transport contract should be drafted to allocate liability risk of $79 million as follows:
- $24 million is allocated to third parties via:
- Transport Co's third party property damage and public risk insurance policy of $20 million
- Transport Co's workers' compensation insurance of $10 million.
- $1 million is allocated to Transport Co
- $54 million is allocated to Chemical Co.
Step 4 – Drafting the risk and liability provisions
The final step is to ensure that the contract reflects the allocation of risk agreed between the parties.
It follows that the risk and liability provisions of the transport contract will contain the following provisions:
- Transport Co is required to maintain at least $20 million in third party and public risk insurance
- Transport Co is required to maintain at least $4 million in workers' compensation insurance
- Transport Co indemnifies Chemical Co against liability for third party property damage and public risk caused by Transport Co (this enables Chemical Co to recover for losses sustained if it is successfully pursed by third parties for any negligent act or omission of Transport Co), but up to the amount of the liability cap
- Transport Co indemnifies Chemical Co against loss or damage suffered due to death or personal injury to Transport Co's staff due to Transport Co's negligent act or omission (again, this enables Chemical Co to recover from Transport Co if successfully pursued by Transport Co staff for death or injury), up to the amount of the liability cap
- Liability cap
- Transport Co's liability is capped at $1 million (if insurable losses fall outside the cap, i.e. third party property damage and public risk and workers' compensation) or $25 million if it is a total cap on liability.
Obviously, the preceding analysis is a simple one. However, some of the key points to consider are:
- The template liability and risks provisions in a contract may be a good starting point, but that is often all they are
- Liability caps (if any) and insurance amounts should not be set arbitrarily; they are key elements of the allocation of liability risk
- All of the risk and liability provisions of a contract need to be considered together. There are significant risks in leaving the insurance arrangements to the end of negotiations and not addressing insurance provisions in tandem with other contractual provisions. As one is amended, others may need to change
- When using insurance as a means of transferring risk in a contract, consideration must be given to the identification and careful review of policies which are relevant to the risk and the premium or cost of those policies. It may be necessary to either seek extensions to cover with the insurer or negotiate variations to the contract to cover off any unintended and uninsured exposures.
The overall aim should be to allocate liability risk to the party best able to manage it. This should provide the best value for money outcome. The implications of not addressing the risk and liability provisions of a contract early in the negotiations is, perhaps, the greatest risk of all to the parties.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.