Indemnity in Construction Contracts

Contracts, Insurance and Certificates…..the saga continues….

As a follow-up to my colleague’s recent post in Construction Executive, I wanted to emphasize the need for properly written contracts.  In construction projects, the contract documents form the basis of the agreement between the parties involved in the project. Written construction contracts impose many duties, obligations and liabilities on contractors. Although project owners pay great attention to the operational issues addressed in these contracts, many pay too little attention to the risk and insurance implications of various contract provisions.

When negotiated correctly, the construction contract can become a valuable risk management tool. Liabilities can be equitably distributed among the contracting parties—general contractor, subcontractors, suppliers, architects, and the owner. Written properly, the construction contract can transfer the risk to the downstream parties accordingly.

Unfortunately, many project managers rely on standard contracts, which they modify, or ask those without real-world insurance expertise to draft the contract. When this happens, a contract may transfer liability to a contractor that is costly, difficult, or impossible to insure. Often, a contractor will not recognize this potential coverage gap until hit with an uninsured loss.¹

Developing a construction contract is more complicated than simply transferring liabilities to the downstream party. All contracts should contain an indemnity agreement, also known as a “hold harmless agreement.” Hold harmless language requires the contractor to indemnify the owner with respect to the owner's liability if members of the public are injured or their property is damaged during the course of the contractor's operations.

Three common types of hold-harmless clauses are used in most construction contracts. Based on the extent of the liability they transfer, the most common hold harmless clauses are ”limited” “intermediate” and “broad”.  A word of caution…the enforceability of an indemnity provision is subject to state law and should be approached cautiously to be certain it will be upheld. 

1. Limited – Where Party A holds Party B harmless for suits arising out of Party A’s sole negligence. Party B is thus protected when it is held vicariously responsible for the actions of Party A.  Indemnitor must protect indemnitee from any loss resulting from the indemnitor’s acts or omissions, but only to the proportional extent arising out of indemnitor’s negligence.
2. Intermediate – Where Party A holds Party B harmless for suits alleging sole negligence of Party A or negligence of both parties.  Indemnitor must protect indemnitee from any loss resulting from indemnitor’s acts or omissions unless caused by the indemnitee's sole negligence or may provide complete indemnity for any loss resulting in whole or in part from the indemnitor's acts or omissions. Indemnitor must be at least partially at fault in order to trigger protection. However, regardless of the extent to which the indemnitor is at fault, the indemnitee is fully indemnified.
3. Broad Form – Where Party A holds Party B harmless for suites against Party B based on the sole negligence of A, joint negligence of A and B, or the sole negligence of B.  Broad form hold harmless agreements are unenforceable in a number of states.  Indemnitor must protect indemnitee from any loss caused by the sole negligence of the indemnitee. This language affords the most protection for the indemnitee, but places the greater burden on the indemnitor. However, this contract is legally unenforceable in a number of states.²

With the growing number of court cases regarding indemnity language in recent years and new statutes implemented by various states, we have begun to see a shift in how the legal system interprets contract language and indemnity provisions. The trend has started to shift in favor of the downstream party.

As a result, the Insurance Services Office (ISO), which provides standardized insurance forms to allow underwriting alignment among insurers, has begun making several changes to additional insured endorsements. Some of these changes include coverage that is available to the extent permitted by law, which could impact any states that prohibit indemnification to any party’s sole negligence.  Another one provides that coverage may not be broader than that granted in the contract, meaning that if a contract stipulates a lower insurance limit, the contract may prevail.  These changes limit the coverage they afford. If this trend continues, it could have a major financial impact on future construction defect and general contractor liability claims.  An excellent reference to a 50-state summary is available here.

Developers should be aware that some states are taking things one step further. Some states prohibit the use of certain indemnity provisions that require indemnification for the indemnitee’s negligence, including active and passive negligence, specifically the “limited” form outlined above. Other states are in the preliminary stages of trying to prohibit the use of additional insured endorsements to provide defense and indemnity obligations to the general contractor and developer.

What would these new changes and restrictions mean for you? Do they affect you? Do you understand how these changes will impact future developments and transactions you might be involved in? If you don’t have definitive answers to these questions, consider engaging an insurance consultant to review your coverages and exposures.

If you wish to discuss the ways to downstream your risk, please feel free to contact me.

The ALS Group is an independent insurance and risk management consulting firm focused on helping their clients reduce insurance and risk related costs.