All commercial real estate professionals need to know the role that Contractual Risk Transfer plays in managing the total cost of risk. Real estate owners, developers, investors and property managers should have a grasp on when and how to utilize the many types of Contractual Risk Transfer mechanisms to best protect their bottom line.
Contractual Risk Transfer is a means to assign liability and financial burden of a loss to the party best able to control or prevent the loss from happening in the first place. Without a properly worded contract, the supervising party could wrongfully assume the financial responsibility for losses caused by a third party who should have been responsible. The contract is configured in a way to indemnify and hold harmless the Owner or General Contractor (GC).
Contractual Risk Transfer is extremely effective because it employs two separate Risk Management techniques: Risk Financing and Risk Control. Risk Financing, assigning a separate party to pay the cost of a claim and Risk Control, developing a means to mitigate the severity of a loss. When Contractual Risk Transfer mechanisms are in place, tenants and subcontractors have incentive to operate with safe and controlled practices because they know they will be the first party financially liable for a loss.
Liability of Contracting Parties
While undergoing a new project, Owners and GCs hold a certain amount of control and responsibility for the actions of their subcontractors, and therefore are exposed to vicarious liability. An example of this would be an HVAC Subcontractor installs an air conditioning unit on the roof of the Owner’s building. Due to poor installation, the unit falls through the roof, injuring a third-party inside the premises. The Owner can be held vicariously liable for the HVAC Subcontractor’s work but will be able to transfer that liability back to the at-fault subcontractor.
In certain situations, both the Owners/GCs and Subcontractors/Tenants are jointly liable for injury or damage. Joint liability does not consider percentages of fault, only that both parties were at-fault in some capacity. For example, a building Owner has one tenant in their entire building, and they are a restaurant. There was a small fire in the restaurant, not causing damage to the building, however the fire injured a restaurant patron with burns and smoke inhalation. The Tenant failed to extinguish the burning materials, and the Owner failed to maintain the smoke alarms and sprinkler systems in working order. Both parties can be held jointly liable for the patron’s injuries.
When the Owner/GC is found to be negligent and fully liable for injury or damage, it is referred to as sole negligence. In most sole negligence situations, there is no option for the Owner/GC to transfer the liability to the Subcontractor/Tenant. For example, an Owner is having renovations done on his building and hired a security vendor to stay onsite. During construction, part of the building collapses and a security guard gets injured. Excluding any contractual agreements with the Contractor performing the work, technically the Owner of the building would have sole negligence because they hired the Contractor to perform the work on their building. The employee of the security company may collect Workers Compensation, but they are still able to sue the building Owner, which is referred to as Third Party Over Action.
Methods of Transfer
Commercial real estate entities of all sorts are involved in various contractual relationships. Effective contractual risk transfer is crucial for these entities to lower their overall cost of risk. By doing so, risk is managed by having third parties assume their fair share of liability. It is crucial to align insurance and indemnification provisions contained in the insured’s contracts with third party vendors and subcontractors. A process should be developed by the owner and their risk management and insurance advisor to monitor and review appropriate insurance documentation for all work performed by third party vendors and subcontractors.
This article highlights the importance of insurance professionals being fully engaged with their commercial real estate clients to review all contracts and ensure alignment with existing insurance policies.
Johnson, Kendall & Johnson (JKJ) partners with a property management software firm, Re-Leased, that has a singular platform that uniformly incorporates information for commercial property owners to optimize their resources, and through our partnership, incorporates insurance solutions to streamline the full breadth of insurance information gathering, insurer loss control actions, and the claims life cycle, that can be cumbersome for property owners to manage.
For questions on your approach to Contractual Risk Transfer, feel free to contact me:
Matt Musilli, CPCU
Vice President, Construction & Real Estate Practice
C: (973) 362-6463