Key Takeaways

  • Contractual liability arises when one party agrees to assume responsibility for another party’s legal obligations under a contract.
  • Contractual liability insurance helps businesses cover the costs of lawsuits, settlements, and legal defense arising from assumed liabilities.
  • Many general liability policies include some contractual liability coverage, but specific endorsements or riders may be necessary for full protection.
  • Common exclusions can limit coverage, especially when lawsuits are directly tied to contractual obligations.
  • Careful review of indemnity clauses, insurance terms, and exclusions is critical to reducing financial risk and ensuring compliance.

Contract liability refers to liability that one party of a contract shoulders on behalf of another party. It is implemented through an indemnity agreement or hold harmless agreement in a contract. This type of liability can be used to transfer the risk of lawsuits from one party to another, making it an important concept in risk management.

What Is Contractual Liability?

When one party agrees to be held liable for the losses and damages incurred by another party, he or she is assuming contractual liability. Similar to many other companies, your business may perform work for another company or hire another company to perform work. Whichever the case may be, you may have signed a contract that includes an indemnity agreement.

Also called hold harmless agreement, an indemnity agreement occurs when one party promises to bear liability on behalf of another person or entity. In an indemnity agreement, Party A agrees to indemnify or compensate Party B for the losses and damages resulting from Party C's lawsuit in the event that Party B is sued due to Party A's negligence.

Example of Contractual Liability

A property owner called ABC Properties hires a general contractor called XYZ Builders to refurbish its office building. Then, XYZ Builders hires PQR Electrical to replace the old wiring in the building with new wiring. XYZ is aware that someone may be injured or property may be damaged if PQR makes a mistake while replacing the wiring. If that happens, the injured party may seek compensation by filing a lawsuit against XYZ and PQR.

In order to protect itself against potential lawsuits, XYZ requires PQR to enter into a contract that includes an indemnity agreement. In the indemnity agreement, it is stated that PQR will be responsible for the losses incurred if someone suffers property damage or bodily injury due to PQR's negligence while performing the wiring work. In other words, the contract requires PQR to bear liability for any damages assessed against XYZ because of the lawsuit. Also, it is likely that PQR will be responsible for the cost of defending XYZ against the lawsuit.

Contractual Liability for Transferring Risk

As shown in the example above, a contract can also serve as a tool for transferring risk. By using an indemnity agreement, XYZ Builders has transferred the risk of lawsuits to PQR Electrical. Since it will be performing the wiring work, PQR is in a better position than XYZ to prevent losses that can potentially result from that kind of work. Therefore, PQR should be the party who assumes the risk of wiring-related losses.

When liability for losses is transferred from Party A to Party B through an indemnity agreement, it does not erase Party A's liability towards the injured person. The agreement does not prevent third parties from suing Party A and has no effect on his or her liability towards an injured third party. All it does is transfer liability for the financial losses resulting from the lawsuit, including damages and defense costs, to Party B.

Coverage for Contractual Liability

Many business owners enter into contracts that include indemnity agreements. Some examples of such contracts include:

  • Property leases
  • Construction agreements
  • Equipment leases
  • Easements

The liability you bear under these contracts is automatically included in a standard general liability policy. Coverage for contractual liability is available through an exception to an exclusion under Coverage A, which covers liability for bodily injury and property damage.

Understanding Contractual Liability Insurance Coverage

While general liability policies often include some level of contractual liability coverage, businesses with frequent contractual obligations should understand how contractual liability insurance operates in practice. This type of coverage is designed to protect companies when they agree — through contracts — to take on legal responsibilities that might otherwise fall on another party.

In most cases, contractual liability insurance covers:

  • Legal defense costs: Attorney’s fees, court costs, and associated expenses when lawsuits arise from assumed obligations.
  • Judgments and settlements: Financial compensation owed if your business is found liable under the contract.
  • Third-party damages: Bodily injury or property damage claims that result from fulfilling a contractual duty.

For example, a construction company agreeing to indemnify a property owner could rely on contractual liability insurance to pay for damages if an accident occurs. Without this coverage, the company would have to pay such costs directly, potentially jeopardizing its financial stability.

Contractual Liability Exclusion

If you look at the Bodily Injury and Property Damage Coverage section in your liability policy, you may think that contractual liability is not covered. This is because Coverage A has a contractual liability exclusion. This exclusion obligates the insured to pay damages for bodily injury and property damage because of liability assumption in an agreement or contract.

Common Exclusions and Legal Implications

Despite the protection offered by contractual liability insurance, there are important exclusions to understand. Most policies do not cover liability that is solely based on a breach of contract. In other words, if a lawsuit stems exclusively from your failure to meet contractual terms — without any associated bodily injury or property damage — the insurer may deny coverage.

Additional exclusions can include:

  • Assumption of liability beyond the contract: If you accept obligations beyond what the contract requires, coverage may not apply.
  • Intentional misconduct: Acts of fraud, willful negligence, or deliberate contract breaches are typically excluded.
  • Unapproved contracts: If the agreement wasn’t disclosed to the insurer or isn’t part of your regular business operations, coverage may be limited.

Recent court rulings reinforce the importance of understanding these limitations. In one Maryland case, an insurer was found to have no duty to defend or indemnify a policyholder in a breach of contract lawsuit, even though the allegations were disputed. The court held that the contractual liability exclusion barred coverage because the claims arose solely from a contractual obligation.

Liability of the Insured Without a Contract

The liability policy provides coverage for bodily injury and property damage that you will be liable for in the absence of a contract. For instance, you have just rented a forklift to move crates outside your warehouse. Then, you accidentally collided with a truck that belongs to your neighbor. You may have signed a rental agreement that gives you some liability for damage to the forklift or other property. Regardless of the rental agreement's terms and conditions, you are liable under common law to pay for the damage you caused to your neighbor's truck.

Risk Management Tips for Businesses

Because contractual liability can expose businesses to significant financial risk, proactive risk management is essential. Consider the following best practices to reduce exposure:

  1. Review contracts thoroughly: Identify indemnity clauses and clearly define each party’s obligations before signing.
  2. Consult legal counsel: Attorneys can help negotiate terms that limit liability or shift risk appropriately.
  3. Work with an insurance advisor: Ensure your contractual liability insurance aligns with your risk profile, and consider endorsements to cover specialized exposures.
  4. Maintain accurate records: Keep detailed documentation of contracts, negotiations, and communications to support potential claims.
  5. Update policies regularly: As your business grows or expands into new markets, revisit coverage limits and exclusions.

By understanding how contractual liability insurance interacts with your contracts and legal obligations, you can safeguard your company from potentially devastating financial consequences.

Frequently Asked Questions

  1. What is contractual liability insurance?
    It’s a type of coverage that protects a business when it assumes liability for another party’s actions or obligations under a contract, helping pay for legal defense, settlements, and damages.
  2. Does a standard general liability policy include contractual liability coverage?
    Yes, most include some coverage, but it’s often limited. Businesses with frequent or high-value contracts may need additional endorsements.
  3. What types of contracts typically require this insurance?
    Construction contracts, lease agreements, service contracts, and equipment rentals often include indemnity clauses that trigger contractual liability.
  4. Are all contractual claims covered by insurance?
    No. Claims based solely on breach of contract or intentional misconduct are often excluded. Coverage usually applies when bodily injury or property damage occurs.
  5. How can businesses minimize contractual liability risk?
    Review contracts carefully, negotiate indemnity terms, consult legal counsel, and ensure adequate insurance coverage is in place.

If you need help dealing with contract liability, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.