What Is Contractual Liability?

The term "contractual liability" means liability that one party assumes on behalf of another under a contract. Contractual liability insurance covers claims against a business that arise out of its assumption via a contract of someone else's liability. This article will explain why businesses need this coverage, how it's provided, and the types of contracts it covers.

What Is Contractual Liability Insurance?

Contractual liability insurance covers third-party bodily injury or property damage for which your business has assumed liability under an indemnity agreement (also called a hold harmless agreement) in a contract. This coverage is important because many businesses sign contracts in which they assume liability on behalf of someone else for third-party bodily injury or property damage claims.

Contractual liability insurance is included in the standard insurance services office (ISO) general liability policy via an exception to the contractual liability exclusion found under Coverage A, Bodily Injury, and Property Damage Liability. The exception affords coverage for liability the insured assumes under an insured contract—a defined term that's explained in the policy definitions.

The definition of insured contract includes five specific types of contracts, such as building leases, sidetrack agreements, and elevator maintenance agreements. It also includes that part of any other contract in which you assume the tort liability of someone else to pay for bodily injury or property damage to a third party.

What Is an Indemnity Agreement?

Contractual liability insurance covers liability you assume under an indemnity agreement contained in a building lease, construction contract, equipment rental agreement, or other covered contract. An indemnity agreement (also called a hold harmless agreement) transfers liability for losses from one party to another. It's a promise by one party to indemnify (reimburse) someone else for the cost of claims brought by a third party. The party providing indemnification is called the indemnitor while the party being indemnified is the indemnitee.

How Does Contractual Liability Work?

Here's an example of how contractual liability insurance works. Don owns and operates a cafe called Deli Delights in retail space he rents from Royal Realty. Don has insured his business under a standard general liability policy.

Deli Delights' building lease contains a clause that requires Don's business to indemnify the landlord for all claims, damages, costs, and defense expenses that arise from the cafe's business operations in the leased space. Deli Delights is liable under the lease for any third-party claims against the landlord for bodily injury or property damage that arises out of the cafe's operations.

One day, Bill (a cafe customer) is entering the restaurant when he trips and falls on a broken tile, sustaining a head injury. Bill sues Deli Delights and Royal Realty, claiming they are jointly liable for his injury because both knew the tile was broken and neither bothered to replace it. Bill agrees to settle the claim for $15,000, and the defendants agree to share the damages and claim expenses equally.

Royal Realty pays its half of the costs and then demands reimbursement from Deli Delights, citing the indemnity clause in the lease. Don forwards the demand to his liability insurer, which reimburses Royal Realty. The landlord's demand is covered because it arose out of Don's assumption of liability under a building lease (an insured contract) for third-party bodily injury or property damage.

Duty To Defend

Many businesses sign contracts in which they assume the obligation to defend the other party against third-party claims. The obligation to defend is significantly broader than the obligation to provide reimbursement of defense costs.

In the Deli Delights example, suppose that Don's lease requires him to indemnify Royal Realty for all damages resulting from third-party claims arising from the cafe's operations and to defend it against such claims. To fulfill his obligations under the contract, Don must hire an attorney to defend his landlord against Bill's suit and pay all legal costs until the suit is resolved. Don must also indemnify Royal Realty for any damages it pays to Bill.

Under the standard general liability policy, the costs of defending an indemnitee are covered as damages (included in the limit). However, the indemnitee's defense costs may be covered as supplementary payments (in addition to the limit) if certain conditions are satisfied. For instance, both the insured and the indemnitee must agree to be represented by the same counsel, and both must cooperate in their defense.