Australia: Insurance Clauses: Part 1 – Another way to manage risk?

WHO SHOULD READ THIS

  • Anyone involved in contract negotiations and procurement

THINGS YOU NEED TO KNOW

  • Insurance clauses can offer an alternative way to allocate and fund contractual risk.
  • Allocation of risk in this way can lead to more efficient and cost effective project insurance programs.
  • Successful risk allocation using this strategy requires careful analysis on a case-by-case basis.

WHAT YOU NEED TO DO

  • Check whether your contract contains an insurance clause and consider how it interacts with any indemnity clause.
  • Make sure that appropriate insurance cover is in place to satisfy the requirements of the insurance clause.

In our last focus article, we looked at common types of indemnity clauses, how they operate and some of the practical limitations associated with their use in contracts to manage and allocate risk where these clauses do not align with the available insurance cover.

In this article, we explore whether insurance clauses can provide a more effective and efficient way to allocate risk between contracting parties.

Problems with risk allocation using indemnities

When an event happens during the performance of a contract that leads to loss or liability, attention immediately turns to who is responsible and who is to pay for any loss.  If one party to the contract agrees to indemnify the other or if the loss is substantial, questions about the capacity of the indemnifying party to fund the loss will often arise.  In addition, public liability and professional indemnity insurance policies commonly do not cover liability assumed solely under a contractual indemnity.

Another approach

Aside from indemnity clauses, contracts may also contain an insurance clause.  An insurance clause provides that one party must effect and maintain insurance that provides cover for the nominated parties in the event of a loss arising in defined circumstances.  Often, these circumstances are a predictable outcome of the performance of a contract: injury to third parties, damage to property and damage to the works.

As with indemnity clauses, insurance clauses come with benefits and burdens depending upon from whose perspective they are viewed.  Principals may find it attractive to require their contractors to arrange insurance for their benefit because it transfers risk away from their own insurance policies or balance sheet.  However, such benefits will only exist where the contractors have the capacity and willingness to insure the risks.  A commercially realistic approach needs to be adopted when determining what is insurable and by whom.

What does an insurance clause deal with?

  • If the objective is to ensure that there is insurance available to pay for loss or liability when a predicted event occurs, such clauses will usually stipulate:
  • who is to arrange and pay for the cover required;
  • the class of insurance cover required;
  • which parties are to be covered;
  • the limits of liability applying under the policy;
  • the duration of cover required;
  • the type of liability or event which is to be covered;
  • that the party taking out the insurance policy must disclose a copy of the policy terms and schedule upon request; and
  • who is to pay the policy deductible or excess which may apply in the event of a claim.

It is also important to consider whether and to what extent the insurance clause is to operate in conjunction with an indemnity clause. Sometimes, an insurance clause will only be activated when the indemnity is triggered. At other times, an insurance clause may require losses to be insured where the indemnity does not apply.

Who should arrange insurance?

Whether insurance should be arranged by one of the contracting parties for the benefit of both of them or whether each party should have their own insurance requires careful consideration on a case by case basis having regard to an analysis of the risks of the particular contract. This requires consideration of which risks are capable of being insured on acceptable terms and by which party and the existing insurance arrangements that are in place.

There should also be a contractual mechanism enabling disclosure of the insurance policies that are in place. Disclosure of certificates of currency alone may not be sufficient to allow a proper assessment of the adequacy of cover. If the contract or agreement is to operate over an extended period, ongoing requirements to substantiate the existence of cover may be necessary.

In some instances, it may be more efficient and effective to have principal arranged or project specific insurance that allows for a single point of control over placement of the policy and management of claims. Principal arranged or project specific insurance may cover all contracting parties and others involved in the project, which can reduce the likelihood of failure to insure by a contracting party, double insurance of risks and of existing premium costs becoming a project or contract expense.

In our next article in this series, we look at the the key mechanisms which trigger insurance clauses, how they align with insurance policies and the consequences of failing to have cover.

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.

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