Avoiding insurance pitfalls in commercial transactions
This boardroom briefing takes you behind-the-scenes of the insurance industry and highs the risk management and insurance techniques that businesses use to protect and strengthen their balance sheet.
In a previous issue, we looked at how to appoint the right insurance broker for your business. In this issue, we look at some of the common insurance pitfalls that exist when businesses enter into commercial agreements and, importantly, some steps you can take to avoid them.
Often it is the sales director or commercial director who leads the charge when a business is entering into a major new commercial agreement but the ultimate responsibility for balance sheet protection does, of course, always remain with the board as a whole. So, it is important that all board members are familiar with the key contractual issues regarding insurance so they can ask the right questions when board sign-off is being sought.
Commercial agreements come in all shapes and sizes and it is not always the big strategic agreements that contain the big insurance pitfalls. For example, a simple one-page agreement with a company to erect scaffolding for a church restoration which limits the scaffolding company’s liability to £1,000 could become a major insurance pitfall if a scaffolder accidentally sets fire to the church. The church’s property insurers may seek to avoid the property insurance claim due to this limitation on their right of recovery against the scaffolding company and its insurers if the church had failed to disclose the liability cap to them.
For the purposes of this insurance briefing, let’s suppose you are about to enter into a long-term agreement with a manufacturer to outsource the manufacturing of a product that you have developed. This can be a complex transaction involving the transfer of many risks to a manufacturer and may bring with it potential insurance pitfalls in the agreement which underpins it.
So, here are our SEVEN TOP TIPS TO AVOID INSURANCE PITFALLS in an arrangement such as this.
TIP ONE – Identify and understand all the risks involved in the transaction
A thorough analysis of the arrangement between you and the manufacturer will be needed to identify and understand what risks you will be retaining (and potentially insuring yourself) and what risks you will be requiring the manufacturer to accept (and potentially insure). Insurance is generally put in place to underpin the financial ability of one party to meet a contractual liability to another party so understanding each contractual liability is the most appropriate starting point.
TIP TWO – Work out which party is to insure each insurable risk and on what terms
Not every identified risk will be insurable, but for those risks which are, a specialist insurance broker will help you determine exactly what policies need to be put in place, by which party and on what terms. The terms offered will define the risks to be insured, the premium and the limit of indemnity as well as the applicable conditions, warranties, exclusions and deductibles. It is important to recognise that an insurance policy will not cover everything. For example, it will not cover losses falling within the deductible, losses above the policy indemnity limit and (in most instances) a liability to pay liquidated damages under a contract.
TIP THREE – Take specialist advice on the transaction documentation to ensure the insuring clauses accurately capture the obligations of the parties
Even if you have an insurance broker and a commercial lawyer advising you, it is worth considering engaging the services of a specialist insurance lawyer to draft and negotiate the insuring clauses in the transaction documentation. Most insuring clauses we come across have been poorly drafted. Often they do not accurately identify and define the policies that each party to the agreement needs to put in place, the scope of cover required under the policies, the minimum rating of a participating insurer, who is liable to pay the premium and deductible, what is to happen if a risk becomes uninsurable during the period of the agreement, who is to have conduct of claims and whether cover is to be on a joint names or composite basis. They also fail to tie in the insurance arrangements with the liability caps and contractual indemnities. An insurance lawyer who understands how different types of insurance policies work and how they need to respond to the different risks will help you avoid such pitfalls and satisfy you that the insuring obligations are clear and enforceable.
TIP FOUR – Check the wording of the insurance policies to ensure they adequately cover the risks being insured
Imposing obligations on another party to an agreement to insure certain risks is one thing, making sure the policies put in place by that party to cover the risks and respond appropriately is another thing entirely. Use your insurance broker and insurance lawyer to check the policy wordings to ensure the policies are fit for purpose and do not contain any hidden exclusions, terms, warranties or conditions which could compromise the cover required.
TIP FIVE – Formally notify your insurance broker of all clauses in the contractual agreement that might adversely affect your own insurers
It is essential that you notify your insurance broker if you are taking on any liabilities (such as liquidated damages) in the transaction documentation or if you are accepting any cap on the other party’s liabilities to you. The reason why this is so important is that provisions of this nature can adversely affect your own insurers by compromising their ability to recoup any outlay they may have to make on your behalf. Your insurance broker should be able to advise you if and how this information should be passed on to your insurers. It is far better that your insurers know about and accept these provisions before you sign the agreement than see them walk away from a claim because you failed to notify them. The church scaffolding example above is not a good place to find yourself.
TIP SIX – Seek evidence that policies are actually on-risk with reputable insurers
This may sound rather obvious, but where you have imposed insuring obligations on another party, always insist on seeing proof of cover from their insurance broker and evidence that the premiums have been paid.
TIP SEVEN – Monitor regularly to check that cover is being maintained
Again, this may sound obvious, but a long-term agreement may straddle several insurance periods and it important to monitor the insurance arrangements to make sure that the other party has been maintaining insurance cover in accordance with the terms of the contract documentation.
By getting these basic steps and the contract terms right, you will have a powerful tool with which to manage your transaction risks on an ongoing basis, fulfil your management responsibilities and, importantly, safeguard your balance sheet and stakeholders.