What is Contractual Liability?

The Meaning of Insured Contract is the Crux of Contractual Liability

Businessman showing client where to sign document

The term contractual liability insurance means insurance that covers liability the insured assumes under a contract. This coverage is automatically included in the standard ISO general liability policy.

Assumption of Liability

Like many small business owners, you have probably signed a contract such as a building lease or a services agreement. Alternatively, perhaps you have obtained a permit from your local municipality to erect a sign or hold a sidewalk sale outside your business location. In either case, the contract or permit you signed probably contained an indemnity agreement.

An indemnity (or hold harmless) agreement transfers liability for losses from one party to another. It is a promise by one party to indemnify (reimburse) a second party for the cost of claims brought by a third party. The party providing indemnification is called the indemnitor while the party being indemnified is the indemnitee. An indemnity agreement may be one-way or mutual. In a one-way agreement, one party releases the other from liability. In a mutual agreement, all parties release each other from liability.

An indemnity agreement transfers the financial burden of a claim or suit from the indemnitee to the indemnitor. It does not absolve the indemnitee of its liability to the third party. It simply gives the indemnitee the right to obtain reimbursement from the indemnitor for the damages paid to the third party.

Under many indemnification agreements, the indemnitor is liable for both damages and the cost of defending the indemnitee.

Example

Here's an example of how an indemnity agreement works. Carol owns the Capital Cafe, a restaurant located in Pleasantville. Carol wants to serve customers outdoors during the spring and summer months. As required by a municipal ordinance, Carol has obtained a permit from the city granting her permission to use a portion of the sidewalk adjacent to her restaurant for outdoor seating. The permit requires the Capital Cafe to indemnify Pleasantville for any claims or suits against the city that arise out of Capital's use of the public sidewalk.

Pleasantville owns the portion of the sidewalk that the Capital Cafe is using for outdoor dining. The city's staff know that Pleasantville could be sued if a restaurant patron is injured while dining outdoors. Carol has control over the serving of food outdoors so she is in a better position than the city to prevent losses related to that activity. Accordingly, the indemnity agreement transfers liability for such losses from the city to the cafe.

Contractual Liability Insurance

Most general liability policies contain a contractual liability exclusion under Coverage A, Bodily Injury and Property Damage Liability. A typical policy contains the same exclusionary wording found in the ISO Commercial General Liability Coverage (CGL) Form. The exclusion 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 doesn't 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

The first exception affords coverage for to bodily injury or property damage for which the insured would liable in the absence of the contract. For example, suppose a tree falls on your property and you rent a wood chipping machine to create wood chips for landscaping mulch. The equipment rental agreement states that you are liable for any injuries you cause to others while using the wood chipper.

An employee of yours is operating the machine when a chunk of wood flies out and injures a passerby. Even if the contract did not exist, your business would be liable for injuries it caused to others under tort law. If the injured person demands compensation, your liability policy should cover the claim.

Liability Assumed Under an Insured Contract

The second exception provides coverage for liability assumed by an insured under an insured contract if the injury or damage occurs after the contract has been executed. The meaning of insured contract is explained in the policy Definitions and includes five specific types of contracts. It also affords blanket coverage for that portion of any contract in which you assume the tort liability of someone else. That is, it covers any indemnity agreement whereby you promise to indemnify a third party for bodily injury or property damage to a third party. 

Contractual liability does not apply to assumptions of liability for claims alleging personal and advertising injury. Coverage B, Personal and Advertising Injury Liability, specifically excludes liability assumed under a contract.

In the Capital Cafe example described above, the cafe is obligated to indemnify Pleasantville for claims that arise out of the cafe's use of the sidewalk for dining. This obligation is imposed by the permit, which Carol was required to obtain under a local ordinance. The definition of insured contract includes an obligation required by a local ordinance to indemnify a municipality, except in connection with work for a municipality. Consequently, the indemnity agreement in the contract Carol signed qualifies as an insured contract under the cafe's liability policy.

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Article Sources

  1. IRMI."Contractual Liability Insurance." Accessed March 5, 2020.

  2. Upcounsel. "What Is An Indemnification Contract." Accessed March 5, 2020.

  3. IRMI. "Contractual Liability and the CGL Policy." Accessed March 5, 2020.

  4. Nolo."Indemnification Agreements in Contracts." Accessed March 5, 2020.

  5. North Star Mutual. "Commercial General Liability Coverage Form." Page 2. Accessed March 5, 2020.

  6. Legal Information Institute. "Tort." Accessed March 5, 2020.

  7. IRMI. "Contractual Confusion - Assuming the Liability of Others." Accessed March 6, 2020.

  8. North Star Mutual. "Commercial General Liability Coverage Form." Page 14. Accessed March 5, 2020.