Broad Indemnities and Narrow Insurances – A Match Made in Hell

When drafting indemnities into contracts, it is important to consider the relevant insurances that sit behind the parties and the interplay between them.

Too often, contracting parties insert indemnity clauses into contracts without giving adequate consideration to the effect and operation of those indemnities.  It is usually the contracting party with the most bargaining power that will insist on broad indemnities.  This article touches on some of the issues, particularly those relating to insurance, that need to be considered (by both contracting parties) before entering into a contract that contains indemnities.

An indemnity, put simply, provides that one party is to be held harmless for the actions or omissions of another. This effectively transfers risk from one party to a contract to the other party in relation to a specific event.

As we know, each project is different, and each contracting relationship has its own distinct nuances.  It follows that ‘boiler-plate’ indemnity clauses obtained from a previous contract or a lawyer’s precedent files are unlikely to allocate risk between the parties in a manner that reflects the inherent or underlying risk of the project or the contracting parties’ relationship.

These broad indemnities may also be inconsistent with the parties’ respective common law rights and obligations.  This is where the parties’ insurances become relevant.  A party who offers a broad indemnity may not be able to obtain insurance for the full extent of the liability imposed by the indemnity.

The issues that arise for insurers (who may ultimately be responsible for defending liability claims) are many.  Below are three of the more significant considerations.

  1. From a legal perspective, indemnities often alter the tests for causation and remoteness. It is the wording of the indemnity provision itself that determines causation (as opposed to actual cause), meaning that it is not necessary for the indemnified party to prove that the wrongdoer actually caused the loss claimed.  Similarly, indemnity provisions may be drafted in a manner that removes the common law test of remoteness (reasonable foreseeability).  This extends the indemnifier’s liability to types of loss and damage that is not reasonably foreseeable (and would not otherwise be recoverable).
  2. Another issue to consider is that indemnities may remove the common law duty of the innocent party to mitigate its loss. Again, this extends the indemnifier’s liability to losses that may not have been incurred if the indemnified party had taken steps to reduce its loss (as it would be required to do in relation to a common law damages claim).
  3. Thirdly, an indemnity can have the effect of extending the relevant statutory limitation period. For example, in NSW, the time period within which a claim may be brought for breach of contract is 6 years (commencing from the date of the breach).  With respect to indemnities however, the relevant breach (and therefore the limitation period) commences from the date on which the indemnifier refuses to honour the indemnity. This may be some time after the act or omission that triggered the indemnity.

Not only are the above considerations important for parties to understand the extent of their liability, but they also may have an effect on a party’s ability to obtain adequate insurance, or be determinative on whether an existing policy will respond.

The obvious example, in a construction context, is where a principal requires its contractor to indemnify it against loss and damage caused not only by that contractor but also the contractor’s sub-contractors and consultants.  In practice, the average contractor will have an existing public liability insurance policy in place.  Such policy will usually exclude liability assumed by way of contract, unless that liability would have existed in the absence of the contract.  The effect of this exclusion is that the insurance policy will cover liability only where the contractor or sub-contractor has been negligent.

Public liability insurance policies are also typically narrower than indemnities in that those policies:

  1. will not cover the proportionate liability of a concurrent wrongdoer who is not covered by the insurance;
  2. may only cover liability in respect of personal injury (or death) and property damage (and not liability where it does not arise or flow from property damage); and
  3. will exclude professional services such as design, specification and advice.

Consequently, it is likely that any broad contractual indemnity will be broader than the average public liability policy that is maintained by contractors.  This has obvious effects for the contractor who has assumed uninsured risk and must bear the loss itself.  This dominos to affect the project, as the principal may be faced with a contractor who is not financially capable of satisfying the principal’s claim.

To cover its ‘contractually assumed’ liability, the contractor may effect and maintain additional liability insurance (covering itself and its sub-contractors and consultants), and it may name the principal as an insured. It is therefore important that a contract specifies the scope of insurance cover required by each party.  Indeed, a prudent principal may insist that a contractor effect and maintain insurance that will respond to a claim under each indemnity (and to provide a copy of all such policies in order to confirm that is the case).

In the absence of such additional insurance, a party giving an indemnity under a contract is best advised to ensure that indemnity provisions are covered by the insurances in place, and do not invalidate those policies. This can be achieved by:

  1. limiting the indemnity to losses foreseeable at the time of contract;
  2. amending the indemnity to require the indemnifier to mitigate its loss;
  3. amending the indemnity to apply only to loss or damage caused by the indemnifier;
  4. amending the indemnity to reduce proportionately to the extent the loss, claim or damage is caused or contributed to by the indemnified party or its agents;
  5. amending the indemnity to exclude ‘consequential loss’ (and defining that term sufficiently);
  6. seeking an overall liability limit on the indemnity (to the proceeds of available insurance policies); and
  7. amending the indemnity to limit the time period within which claims can be brought under the indemnity (e.g. 6 years from the date of completion of the relevant work).

If you or your business needs advice in relation to this subject matter, please do not hesitate to contact us.