What is Contractual Liability?

A man signing a contract with a businessman

The term contractual liability means liability that one party assumes on behalf of another by way of a contract. Contractual liability is automatically covered by the standard ISO general liability policy.

Indemnity Agreements

Many businesses engage in contracts like building leases, equipment leases, maintenance agreements, and construction agreements. These contracts are likely to contain an indemnity agreement.

An indemnity agreement is a promise by one party to assume liability for third-party claims filed against 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. The party providing indemnification is called the indemnitor while the party being indemnified is the indemnitee.

In a building or equipment lease, the property owner is usually the indemnitee while the lessee is the indemnitor. In a construction or service contract, the person doing the work or providing the service is the indemnitor while the property owner or general contractor is the indemnitee. An indemnity agreement is also called a hold harmless agreement. The following example demonstrates how such an agreement works.

Example

Busy Builders is a general contractor that has been hired by a property owner to construct a new office building. Busy hires Lucky Landscaping to design and build the outdoor space. Lucky will be responsible for planning and installing walkways, gardens, fountains, seating areas, and other features.

Busy knows that Lucky could make a mistake while performing its landscaping work. The error could trigger an accident that injures someone or damages someone's property. The injured party might seek compensation from Busy Builders as well as Lucky Landscaping. To protect itself against potential claims, Busy requires Lucky Landscaping to sign a contract containing an indemnity agreement.

The agreement states that if someone sustains bodily injury or property damage because of Lucky's negligent landscaping work and the injured party sues Busy Builders, Lucky will pay for the loss. Lucky will pay any damages assessed against Busy and defend Busy (or pay its defense costs).

Risk Transfer

Busy Builders has used an indemnity agreement to transfer the risk of landscaping-related lawsuits to Lucky Landscaping. Lucky will be doing the landscaping work so it is in a better position than Busy Builders to prevent landscaping-related losses. For this reason, Lucky assumes the risks associated with those 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 previous example, Lucky Landscaping has agreed to pay damages and defense costs that result from lawsuits against Busy that arise out of Lucky's 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 liability for the financial consequences of the lawsuit (damages and defense costs) from Busy Builders to Lucky Landscaping.

Contractual Liability Coverage

Most general liability policies contain a contractual liability exclusion like the one found in the standard ISO policy. The exclusion is located under Coverage A, Bodily Injury and Property Damage Liability. It eliminates coverage for the following:

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.

The exclusion contains two important exceptions. It does not apply to:

  1. Liability the insured would have in the absence of the contract; or
  2. Liability assumed under a contract that qualifies as an insured contract

Liability That Exists in the Absence of the Contract

First, the exclusion doesn't apply to 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 drop a crate on a truck that belongs to a customer.

When you signed the rental agreement, you probably assumed liability for damage you might cause to other people's property while using the forklift. If the rental agreement did not exist, you will still be legally liable under common law for the damage you have caused to the customer's truck.

Liability Assumed Under an Insured Contract

The second exception applies to 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 that includes virtually any contract in which you assume the tort liability of someone else. If you engage in a contract that meets this definition, your assumption of liability should be covered.

In the Busy Builders scenario outlined previously, suppose that the building owner's cousin (Jim), is visiting the construction site when he is injured by a backhoe operated by a Lucky Landscaping employee. Jim sues Lucky Landscaping and Busy Builders for bodily injury. Lucky is liable for the claim against Busy under the construction contract. If Lucky is insured under a general liability policy, its insurance should cover Jim's claims.

No Contractual Coverage for Personal and Advertising Injury

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).