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.

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.

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.

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