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Protecting contractors through risk transfer

February 8, 2022

Meeting on a construction site between the architect and the craftsmen who wear protective masks against Covid-19

Contractors rely on the help of subcontractors and other third parties to complete construction projects, both large and small. For instance, a contractor might seek the help of a subcontractor to complete the electrical work on a project. Or they might need the help of a specialty tradesperson to complete unique jobs that would otherwise be inefficient for them to handle on their own. Balancing these relationships is critical, especially when you consider that business arrangements with subcontractors and other third parties can introduce risk.

During a project, third parties — such as subcontractors’ employees or subs of subs — can damage property, cause injuries or fail to perform contractual obligations, among other undesirable outcomes. Together, these exposures underscore the importance of risk transfer, which is a risk management strategy involving the contractual shifting of risk from one party to another. This article provides an overview of risk transfer and considerations that contractors should keep in mind when creating an effective risk transfer program.

What is risk transfer?

In general, risk transfer refers to the process of contractually shifting a specific risk from one party to another. Risk transfer is when one party assumes the liabilities of another and gives businesses better control of the exposures they are willing to undertake. When used effectively, risk transfer places the burden of a specific risk on the party that has the most control over preventing a loss.

Risk transfer is accomplished in two primary ways:

  1. Insurance — Securing an insurance policy is one of the most common risk transfer strategies. By securing coverage for a specific risk, an insurer agrees to assume strictly defined financial risks on behalf of the policyholder.
  2. Contracts — Businesses can transfer risk through contracts, specifically ones that include an indemnity clause and additional insured requirements. By signing a contract that includes these clauses, a party is essentially agreeing to defend and pay costs and expenses on behalf of the other party under certain circumstances. It’s worth noting that indemnification agreements are independent of insurance and work by transferring legal liability from one party to another.

Risk transfer is particularly useful for any contractor engaging in subcontracted work. This is because risk transfer ensures that subcontractors take on their fair share of liability and that businesses aren’t culpable for losses that are out of their control. Trade contractors may also subcontract work to others.

For example, imagine that a contractor hires a subcontractor to demolish a portion of a building. During the process, one of the subcontractor’s employees falls from the roof and suffers severe injuries. Without the proper insurance or contract in place, the contractor is sued and forced to pay thousands of dollars in a settlement. It should be noted that risk transfer is critical to reducing a contractor’s exposure, regardless of the size or scope of a project.

“Even small, seemingly straightforward subcontracted work can open contractors up to liability if the proper precautions aren’t taken.”

To avoid claims and protect assets, it’s in a contractor’s best interest to transfer their risks down to their subcontractors. However, just because a business requires their third-party partners to carry insurance or sign a contract doesn’t mean they are adequately covered should a loss occur. For instance, a subcontractor’s insurance might not appropriately respond to certain risks. Or a subcontractor’s insurance limits might be inadequate to provide protection following a loss.

Subcontractors could even lie and say they have insurance in place when they don’t, or their coverage might cancel for nonpayment during the project. In some cases, particularly when working with subcontractors they know or trust, contractors may rely on handshake agreements that offer no protection in the face of a claim.

In these instances, contractors would be left to pay all damages following a loss, which, depending on the severity of the claim, could irreparably harm their bottom line. Thankfully, there are some ways that contractors can secure additional layers of protection when transferring risk.

It should be noted that project owners and general contractors typically transfer risk down to subcontractors. Don’t accept responsibility for the accidents of others (e.g., your subcontractors).

Creating an effective risk transfer program

Even when contracts are signed or insurance is in place, contracting firms might be held responsible for a subcontractor’s negligence. Contracts might not be infallible, and without insurance, there might be little financial recourse available for contractors.

That’s why it’s so important for contractors to bolster their risk transfer practices by securing certificates of insurance, asking for indemnification and additional insured status, and following contract best practices. These strategies offer layers of protection and serve as contingencies if one of the layers fail.

Securing certificates of insurance

One of the best ways for construction firms to manage and review their subcontractors’ coverages is through the use of certificates of insurance, which serve as proof that a specific party has a policy in place. Certificates of insurance are summary documents that outline the names of the insurer and insured, essential terms and conditions, policy limits, and the duration of the policy.

Put simply, certificates of insurance serve as proof of coverage that can be provided to customers, contractors or other third parties. For contractors, certificates of insurance prove that the subcontractor has the financial resources available to protect those who could be harmed by their actions.

“Certificates of insurance keep companies from taking on unnecessary risks if a subcontractor is responsible for a loss and is not properly insured. Furthermore, certificates of insurance ensure that organizations are compensated if contracted work is done improperly or is otherwise incomplete.”

Firms should secure certificates of insurance for every subcontractor or vendor they hire. Doing so can help ensure that the contracting business doesn’t take on risks associated with the work of their subcontractors. And while requesting a certificate of insurance does not in and of itself transfer any risk, it does provide evidence that the subcontractor has the proper coverage and limits in place.

Once a business has secured a certificate of insurance from its subcontractors, it should review the certificate alongside qualified insurance and legal professionals. These professionals can verify whether the subcontractor has the correct insurance in place and that there are no glaring gaps in coverage.

It should be noted that managing certificates of insurance can be an administrative challenge, particularly if a firm hires multiple subcontractors. To address this challenge, businesses should have procedures in place to collect and maintain certificates of insurance along with a copy of the written contract between the contractor and subcontractor. One of the best ways to manage certificates of insurance is through automated systems that notify a business when a certificate of insurance has expired. Certificates of insurance should be updated annually for repeat subcontractors or for projects lasting longer than a year.

Keep in mind that certificates of insurance can be faked. As such, firms should accept certificates of insurance only from insurance companies or agents, rather than the subcontractor. Asking for other corresponding documents (e.g., copies of additional insured status or waivers of subrogation) can provide further evidence that insurance is in force.

Asking for additional insured status

When it comes to transferring risk successfully, businesses should ask to be an additional insured on their subcontractor’s general liability policy (for both ongoing and completed operations), auto liability policy and umbrella coverage. An additional insured status offers a layer of protection, extending liability coverage to other individuals or groups that were not initially named in the policy. Put another way, these endorsements protect the additional insured (i.e., the contracting firm) against accidents stemming from the named insured’s (i.e., the subcontractor’s) activities.

In particular, additional insured endorsements can:

  • Protect contracting firms if indemnity provisions of a contract are unenforceable in court
  • Give contracting firms rights (e.g., defense coverage) they wouldn’t otherwise have if they weren’t listed as additional insureds
  • Discourage the subcontractor’s insurers from collecting damages from the contracting firm; this requires a waiver of subrogation endorsements on the subcontractor’s commercial general liability, auto liability, workers’ compensation/employer’s liability and umbrella policies
  • Offer protection beyond securing certificates of insurance

It’s worth noting that additional insureds are covered only for claims that relate to the subcontractor’s work or operations in some way. Also, any exclusions listed on the subcontractor’s policy will apply to additional insureds.

Prior to asking to be added as an additional insured, businesses are encouraged to consult legal and insurance professionals.

Following contract best practices

When structured and worded correctly, contracts offer contractors some of the most comprehensive protection against subcontractor negligence. This is because contracts can include specific provisions regarding coverage requirements, additional insured status and certificates of insurance.

Effective contracts should contain the following elements:

  • General acceptance provisions — To successfully transfer risk, contracts should contain general acceptance provisions, including hold harmless/indemnification agreements and additional insured status provisions:
    • Hold harmless/indemnification agreements — These agreements specify that contractors will not be held liable for losses that stem from a subcontractor’s work. It should be noted that hold harmless and indemnification agreements are often voided if subcontractors bear the sole responsibility of a contractor’s negligence. These provisions should follow any relevant state anti-indemnity statutes. Hold harmless and indemnification agreements should be reviewed with an attorney.
    • Additional insured coverage, and minimum insurance requirements and limits for subcontractors — As part of their contracts, contractors should request to be named as additional insureds. In particular, contractors should secure additional insured status on their subcontractor’s general liability, auto and umbrella policies, accounting for both ongoing and completed operations. Additionally, it’s crucial that contractors clearly outline minimum insurance requirements and limits for their subcontractors. This is especially true when you consider that subcontractors might secure coverage from nonstandard insurance carriers that could exclude primary liability exposures. In some cases, pollution liability or professional liability might be required of the subcontractor as well. These requirements should be reviewed with an attorney.

Above all, general acceptance provisions must clearly indicate that, by beginning work, the subcontractor accepts the terms of the contract. These provisions should also detail how long they remain in effect (e.g., until the work is completed).

  • Requirements specifying that the subcontractor’s insurance will respond first following a loss — If a loss occurs as a result of the subcontractor’s work, it’s important that they be held responsible. Thus, contracts should explicitly state that the subcontractor’s insurance —whether it be general liability, auto or umbrella coverage — must pay for claims first on a primary and noncontributory basis.
  • Requirements indicating that the contract applies to other parties (e.g., additional subcontractors) that subcontractors bring onto a job — It’s not uncommon for subcontractors to hire other subcontractors to complete special jobs. When this happens, businesses will want protection should the sub of their subcontractor damage property or cause injury. To account for this risk, contracts should indicate that any and all listed requirements that apply to the subcontractor also apply to other parties the subcontractor hires to complete a job.
  • A certificate of insurance requirement — Contracts should require subcontractors to provide certificates of insurance. These certificates should confirm that the subcontractor has the appropriate coverage and limits in place and that the contractor is named as an additional insured. In short, no subcontractor should be allowed on a job site until they have first provided an up-to-date certificate of insurance. It’s also important to remember that certificates of insurance don’t indicate policy exclusions or guarantee that the policy will be in effect if a loss occurs in the future.
  • A waiver of subrogation — Subrogation is a basic insurance concept used in insurance contracts. If a loss occurs, it typically happens through someone’s negligence. In general, the negligent or at-fault party is liable for the cost of the loss. An insurance carrier can then choose to sue the at-fault party to recover the amount of a claim they paid for in a process known as subrogation. By entering a contract in which a waiver of subrogation is required, the subcontractor waives all rights of subrogation against the contractor.
  • A safety program requirement — Contracts should require subcontractors to follow the same safety programs, policies and standards that the contractor adheres to. Above all, these programs should promote a culture of safety and aim for an accident-free job site.

Contractors should seek the advice of legal and insurance professionals before entering into a contract with their subcontractors. Doing so ensures that contracts are structured appropriately and that the contracting firm is protected if a loss occurs.

It’s also crucial for contractors to maintain project files that contain certificates of insurance, signed contracts and any change orders related to a project. Designating a project manager to maintain these company files is highly recommended. This information will be critical to a business’s defense when a claim is presented. Businesses should maintain projects based on their state’s statute of repose, which can be 12 years or more. Businesses should review their state’s statute of repose with their attorney.