Understanding the basics of Contract Risk

DLA Piper prepared a high-quality paper, something DLA Piper are renowned for, on Force Majeure clauses today. To view the paper, please go to: http://www.dlapiper.com/australia/force-majeure-clauses/.

Reading through the article prompted me to recall that I often came across force majeure clauses in supply agreements in my early career, but this has now more often than not been replaced with some form of penalty clause if one of the parties does not meet their end of the agreement.

I typically find that the larger organisations have risk management and/or legal departments which are focused on transferring risk away from their organisation to other organisations/companies. Of course if the other company has their own risk management and or legal team there is a chance that the transfer of risk will be identified and some negotiation will take place to make the agreement fair and/or for the company taking on the increased risk to seek some payment for the risk transfer.

So often however, smaller companies such as contractors either, small or small moving to medium-sized, do not have the resources to adequately appreciate the risk being transferred to them and in the event of, say, a fire, flood, storm damage, or some other disruption, they find that they not only sustain a business interruption loss of their own, they are contractually bound to compensate the other party to the contract for their losses.

In a similiar vein, a company may enter into a contract that includes an indemnity or a waiver of subrogation to the other party of the contract. I know in the contracts that come across my desk so often include such terms and conditions.

In today’s world, the broker is much more than an insurance salesperson. They are the outsourced risk manager for their client, particularly the SME’s that do not have any such expertise in-house. As part of their role, the broker should understand the terms of all the contracts the insured plans on entering into and advise the client on the ramifications.

This may be a suggestion to obtain Contractual Fines and Penalties cover under their business interruption insurance program. It may be that a contract with an indemnity or waiver of subrogation needs to be provided to the liability insurer to ensure that the liability program will respond to any increase in liability over and above the risks created by legislation and the common law.

I stress that this analysis needs to take place before the Insured enters into the contract and is bound by it as it may be too late to obtain liability cover in particular afterwards.

In my own experience, if the other party is challenged and is fair and reasonable some compromise position can be agreed particularly if there is no insurance cover available. On other occasions, the reply is either “sign the contact or we will find someone who will”. The Insured then has to decide whether they want to take on the risk, but they will at least know in advance the risks that they are assuming.  As always, the broker needs to document their advice and the Insured’s decision.

In summary, the article from DLA Piper prompted me to comment on two points. First the broker needs to identify if the Insured has entered into any supply or customer agreements where they are contractually bound to pay a contractual fine or penalty if they fail to supply or take goods. If so, Contractual Fines and Penalties cover, under a business interruption policy, should be considered as the liability program may well not provide cover.

Secondly, all contracts need to be understood by the broker, whether this be a lease, a contract of bailment, supply or otherwise to determine what risk is being transferred to the Insured and advise as to whether the level of risk is or can be addressed adequately by the insurance program.

One response to “Understanding the basics of Contract Risk”

  1. Martin says:

    This is a nice blog i must say, usually i don”t post comments on othersblogs but would like to say that this post really forced me to do so!

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