Jordan Karp | Outside General Counsel
For most companies, business insurance policies act as a crucial safety net—an assurance that if the unexpected happens, your company won’t face financial devastation.
However, when negotiating contracts, there’s a potential trap that some businesses unwittingly walk into: tying a limitation of liability in the contract directly to the limits of an existing insurance policy.
While this approach may appear straightforward on the surface, it can expose your company to significant, unintended risks.
The Problem with Using Insurance Policy Limits as a Benchmark
Insurance policies are designed to protect your business across a range of risks, from general liability, including accidents, to professional errors and omissions, fraud, and data protection. These limits are not a reserve of funds waiting to be spent on a single contractual obligation; rather, they are there to cover your entire operational risk profile.
Here’s why tying them to a specific contract can be problematic:
- Overcommitting the Policy: If you agree to limit liability in a contract to the full amount of your insurance coverage, you could put the entire policy at stake for one transaction. This creates the possibility that a single claim under that contract could exhaust the policy’s limits, leaving your business exposed to other risks with no insurance coverage.
- Operational Conflicts and Compliance Issues: Many businesses are contractually obligated to maintain certain insurance limits for other client contracts, partnerships, or vendor agreements. If a claim under one contract exhausts the entire policy limit, your company might find itself in breach of other agreement obligations now due to insufficient coverage. This could trigger legal and financial consequences that cascade across your operations.
- Unanticipated Ripple Effects: Insurance is a shared resource. A single large claim could force your business to rely on out-of-pocket funds to handle liabilities from unrelated incidents. Such an event might also lead to higher premiums, stricter policy terms, or even policy cancellations, leaving you scrambling to secure new coverage.
- Limits vs. Actual Coverage: It’s also important to note that insurance policies often include sub-limits and exclusions. Tying liability to an insurance limit may give your contracting partner a false sense of security, while leaving your company exposed if the policy doesn’t respond in full to a claim.
- Increasing Liability Over Time: Insurance limits are not static; they often increase over time due to inflation, business growth, or changes in coverage requirements. If liability in a contract is tied to your insurance limits, any increase in those limits could inadvertently increase your potential liability under the contract. This could lead to unforeseen risks that grow alongside your insurance coverage.
Best Practices for Protecting Your Business
When negotiating contracts, consider these alternatives to tying liability limitations to your insurance policy limits:
- Negotiate Reasonable Caps: Instead of using your insurance limits as a liability cap, you could negotiate a specific dollar amount that aligns with the value of the contract and the level of risk involved. This approach keeps your policy intact for its intended broader purposes.
- Educate Counterparties: Many contracting partners ask for insurance-based limitations without fully understanding the implications. You could instead explain that your insurance policy supports multiple obligations, and tying the entire policy to one agreement increases risk for both parties.
- Use Insurance as a Backstop, Not the Primary Limit: Your insurance coverage generally serves as a last line of defense. Liability caps in contracts should in most cases reflect your risk assessment, not the maximum coverage available under your policy.
- Consult Your Broker and Legal Team: Work with your insurance broker and legal counsel to structure liability provisions that balance protection for your company with reasonable assurances to your contracting partners. They can help identify potential pitfalls and recommend contract language that avoids tying liability directly to insurance limits.
When one of your cases is in need of a construction expert, estimates, insurance appraisal or umpire services in defect or insurance disputes – please call Advise & Consult, Inc. at 888.684.8305, or email experts@adviseandconsult.net.