Contractual Risk Transfer - Tips For Managing Risk With Indemnity Provisions And Insurance Coverage

Imagine you are in-house counsel at a company that is about to sign one of the largest transactions of the year, or maybe even of the past few years. But your company faces significant risks in performing its end of the bargain and some of those risks could be out of your company's control. Your CEO wants to know how to reduce the potential of those risks to undermine profitability and the ultimate success of the transaction. This article addresses some of the ways you might respond.

For example, if you are providing maintenance services to dangerous equipment that is operated by another company's employees who are not in your control, you may want to consider risk transfer. Your company may not wish to assume complete responsibility for any loss relating to the equipment simply because your company maintains or repairs it.

Risk transfer mechanisms take a number of forms. The most common forms are indemnification provisions and insurance contracts, but even those come I many iterations. Before you can employ the most appropriate risk transfer, you need to identify and analyze the risks.

Identifying the Risks That Need to Be Transferred

All agreements involve some level of risk, whether for construction service, providing product parts, obtaining equipment or having a house painted. The question commonly boils down to identifying the risks that would be so severe or frequent that your company is unwilling to bear them. Additionally, risks completely out of your control or exclusively in the control of someone else generally are good candidates for risk transfer.

For in-house counsel, indemnification provisions and insurance are not foreign concepts. It is important, however, for counsel to work with management to identify the risks presented by a particular transaction or relationship. Otherwise, counsel may draft an inappropriate indemnification or rely on insurance coverage that may not respond fully when needed.

As a first step, counsel needs to identify those risks that have high enough frequency or severity that they need to be controlled, at least partially, with indemnification provisions and insurance. A catastrophic event could put a company out of business, as could hundreds of small loses over a short period of time. Other questions to ask when identifying such risks include:

Which party controls the risk? How is the risk allocated absent an agreement? Can insurance cover the risk? Which party has greater risk tolerance? What are the relative bargaining positions of the parties? While ideally a party with control over a risk, and the best knowledge of a risk, should bear that risk, this ideal is not always met. Sometimes bargaining power rules the day. Other factors that often dictate which party bears the risk...