What is Contractual Liability?

A pen signing on the dotted line on blue paper
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Liability that one party assumes on behalf of another via a contract is called contractual liability. Coverage for contractual liability is automatically included in a general liability policy. This article will explain what this coverage entails and why it is important.

Like many businesses, your company may perform work for other firms. Alternatively, your firm may hire other companies to perform work on its behalf.

In either case, you have probably signed a contract containing an indemnity agreement.

An indemnity agreement is a promise by one party to assume liability on behalf of someone else. In a typical indemnity agreement, Party X agrees that if Party Y is sued by Party Z because of Party X's negligence, Party X will indemnify (reimburse) Party Y for costs that result from Party Z's lawsuit. An indemnity agreement is also called a hold harmless agreement. Here is a typical example.

Example

Busy Builders, a general contractor, has been hired by a property owner called Prime Properties to refurbish an office building Prime owns. Busy Builders hires Edwards Electrical to rip out the old wiring in the building and replace it with new wiring. Busy knows that if Edwards Electrical makes a mistake while performing the electrical work, someone might be injured or someone's property might be damaged. The injured party might seek compensation for the injury or damage by suing Busy Builders as well as Edwards Electrical.

To protect itself against such suits, Busy requires Edwards Electrical to sign a contract that contains an indemnity agreement.

The indemnity agreement states that if someone sustains bodily injury or property damage because of Edwards' negligence in performing the wiring work, and that party sues Busy Builders, Edwards will pay for the loss.

The contract requires Edwards to assume liability for any damages that are assessed against Busy Builders as a result of the lawsuit. In addition, Edwards will likely be responsible for defending (or paying the cost of defending) Busy against the lawsuit.

Transfer of Risk

As this example demonstrates, a contract can be used as a mechanism for transferring risk. Busy Builders has used an indemnity agreement to transfer the risk of potential lawsuits to Edwards Electrical. Because the electrical contractor will be doing the wiring work, it is in a better position than Busy Builders to prevent losses related to that work. For this reason, Edwards assumes the risks associated with wiring-related losses.

An indemnity agreement transfers from Party A to Party B the financial consequences of a loss. It does not eliminate Party A's liability for the injured person. In the Busy Builders example, Edwards Electrical has agreed to pay any damages and defense costs that result from lawsuits against Busy that arise out of Edwards' work. The agreement will not prevent lawsuits by third parties against Busy Builders, nor will it affect Busy's liability to an injured third party. It merely transfers, from Busy Builders to Edwards Electrical, liability for the financial consequences of the lawsuit (damages and defense costs).

Liability Coverage

Many business owners engage in contracts that contain indemnity agreements. Examples are property leases, equipment leases, easements, and construction agreements. Such contracts are very common. Thus, liability you assume under such contracts is automatically covered by the standard general liability policy. As explained below, contractual liability is covered via an exception to an exclusion found under Coverage A, Bodily Injury and Property Damage Liability.

Contractual Liability Exclusion

If you looked at Bodily Injury and Property Damage Liability Coverage in your liability policy, you might think it did not cover contractual liability. This is because Coverage A contains a contractual liability exclusion. The exclusion applies to bodily injury or property damage for which the insured is obligated to pay damages by reason of the assumption of liability in a contract or agreement.

However, this exclusion contains two exceptions.

Liability the insured would have in the absence of the contract

The policy covers bodily injury or property damage for which you would liable if the contract did not exist. For example, suppose that you rent a forklift from an equipment rental company. You are using the forklift to move some crates outside your warehouse when you accidentally hit a truck belonging to your next door neighbor. You have probably signed a rental agreement that imposes some liability on you for damage you cause to the forklift and to other property. Regardless of the terms of the rental agreement, you are legally liable to your neighbor under common law for the damage you have caused to his truck.

Liability assumed under an insured contract

The policy also covers liability assumed by an insured under an insured contract, if the injury or damage occurs after the contract has been executed. Insured contract is a defined term in the policy.

Insured contracts are covered as an exception to the exclusion. Thus, you are automatically covered for any contract you engage in during the policy period that meets the definition of insured contract.

Note that contractual liability applies only to bodily injury or property damage. If you assume liability under a contract on behalf of someone else for claims that allege personal and advertising injury, the claims will not be covered under your liability policy. Contractual liability is specifically excluded under personal and advertising injury liability coverage (Coverage B).