How To Effectively Use Contracts To Manage Risk

Key provisions in your contracts, including those relating to indemnification, insurance, and defense, are essential to contract risk management. While sometimes considered “boilerplate,” these provisions play a pivotal role when determining which party is responsible for certain costs and liabilities. They must always be negotiated and drafted carefully.

Indemnification Clauses

Businesses should never overlook the importance of clearly drafted indemnification provisions. The definition of “indemnity” is that you have a legal duty to make good on any loss, damage, or liability incurred by someone else. So, when you agree to accept an obligation to indemnify, for example, in a finance or sale transaction contract, the risk shifts from the other party to the contract directly onto your back.

Below is an example of a basic indemnification provision, with the caveat that many are far more complex:

“Each party agrees to indemnify, defend, and hold harmless the other party from and against any loss, cost, or damage of any kind (including reasonable outside attorneys’ fees) to the extent arising out of its breach of this Agreement, and/or its negligence or willful misconduct.”

Not only do indemnification clauses shift risk from one contracting party to the other, but they also encourage responsible conduct. Knowing they might have to indemnify the other party encourages contractors, vendors, or partners to act carefully and follow regulations. Additionally, well-drafted indemnity provisions can reduce ambiguity about who is responsible for losses, minimizing the risk of costly disputes.

Given their significance, indemnification provisions are both the most desirable of “boilerplate” provisions in commercial contracts and the toughest to negotiate. Other than price and terms, indemnification clause negotiations are the most common deal breakers in contract negotiations and the most hotly contested clauses when a dispute arises, and litigation ensues.

Insurance Clauses

In the context of contract risk management, insurance requirements are typically included to ensure the indemnitor has the financial capacity to meet their indemnification obligations. Even if a party promises to indemnify another, that promise is only as good as the party’s ability to pay.

Requiring certain insurance types, such as general liability, professional liability, or workers’ compensation, also ensures that each party is prepared for foreseeable risks. In addition, insurance can limit how much one party must pay out of pocket for indemnified claims. Finally, including insurance provisions isn’t just good practice; it’s essential. Many industries and public contracts legally require specific insurance coverage.

Defense Clauses

Defense clauses address who defends against third-party claims and who pays for legal costs. They may be a separate provision or included within an indemnification clause.

In most cases, the indemnifying party’s responsibility to defend includes the following:

• Obligation: The person providing indemnification must reimburse paid defense costs and expenditures and pay in advance for unpaid defense charges and expenditures.
• Right: The party providing indemnification has the right to assume and oversee the defense of the third-party litigation.

Negotiating Clauses for Contract Risk Management

Indemnification clauses often combine all three elements: indemnification, insurance, and defense. These provisions are commonly found in agreements where the risks associated with a party’s non-performance, breach, or misconduct are great. While you may not be able to avoid all indemnification liability, it is possible to limit the scope. For instance, clauses may be drafted to cap liability at a certain amount, to require advance notice, to restrict liability to third-party claims or other specified losses, or to restrict the right to indemnification to a limited time period.

Negotiating the indemnification “dance” involves maneuvering the other party into accepting broad potential liability while keeping yourself as clear of risk exposure as possible. While relative bargaining power is a key factor, other considerations include the availability of affordable liability insurance and the nature of the business risks.