Enterprises have to constantly interact with external entities such as suppliers, business associates and customers. The terms and conditions of business collaboration are formalized through contractually binding SLAs.
Business agreements in which a third party firm bears an organization’s risks are becoming increasingly prevalent. The strategy, also known as risk transfer, is a risk management and control mechanism that gives businesses an extra layer of protection in the event of a disaster. Business leaders and proprietors are looking to take advantage of passing the monetary implications of business disruptions to an external entity. But are there any repercussions on the company’s net earnings.
Bearing the risks of others can be expensive and lead to a conflict of interests. Both parties must ensure that there is clarity on the monetary liabilities that each might incur through detailed agreements.
Risk Transfer Examples
Insurance policies and coverage programs
Unilateral and reciprocal hold-harmless agreements
Risk transfer is an effective measure to distribute risk amongst all the entities involved. The amount of risk transferred to an entity is a function of that particular entity’s ability to handle and control risk.
The following are some generic suggestions that can be adopted:
Businesses tend to become more risk prone when processes or process segments are outsourced. The amount of risk undertaken must be in line with the organization’s risk appetite.
Within the bounds of legality, organizations must look for opportunities to control risk. One way of doing this is by formulating contractually binding agreements that oblige third party vendors to take complete responsibility for their side of the operations.
Managing liabilities is crucial for optimizing operational expenditure which in turns keeps businesses competitive.
Risk Transfer Options
Insurance Policies
Insurance policies are the most common approach to risk transfer. Two entities, the insurance provider and the insurance seeker, get into a formal agreement where the insurance provider takes responsibility for the monetary risks involved in the insurance seeker’s business operations. The types of coverage include:
Injury to staff and personnel
Property damage due to natural disasters such as fires, cyclones,
earthquakes and so on
Insurance providers charge a fee for these services which are further modified by other factor such as deductibles, reserves, reinsurance and so on.
Contractual Agreements
This is a risk transfer option that in many cases includes indemnification provisions.
In an indemnity provision, one party contractually agrees to take responsibility for any listed or unlisted damage that the other party might have to bear.
Also known as hold-harmless agreements, indemnity provisions are not to be confused with insurance policies. Examples of contractual agreements with indemnification provisions include direct monetary losses, along with expenses related to legal defense and product recalls.
Risk Transfer Strategies
Company assets can be fortified through several layers of protection, such as:
Insurance Certificates
Additional Insured Status
Contracts with indemnification Provisions
Insurance Certificates
Insurance firms provide insurance seekers with certificates that include details such as:
- A Unique identifying policy number
- Coverage description
- Period of Validity
- Individuals, Groups, Assets, Resources and other entities covered under the policy
- Limiting clauses
- Additional Insured Endorsements
- Subrogation Endorsement Waivers
- Special notice of cancellation endorsement
Insurance certificates are critical documents that demonstrate proof that the insured parties are eligible for coverage.
Insurance certificates provide a detailed summary of coverage policy
The terms and conditions cannot be altered once issued. Additional recipients cannot be added at a later date.
The Need for Insurance Certificates
- The extent of third party vendors’ insurance coverage is not always aligned with the mission criticality of operations or the organization’s risk appetite.
- Enterprises would have to incur costs related to injuries or property damage if third party vendors don’t have adequate coverage. In many states, organizations are legally liable to pay for the injuries of third party vendor staff and personnel while they are at the company’s location
- Some jurisdictions allow organizations to consider uninsured third party vendors who are onsite as company staff. However, this would increase the organization’s insurance cost per unit.
- Many third party vendors have no insurance coverage whatsoever.
- The organization might not have been included as an insured entity in the third party vendor’s coverage despite being contractually obliged to do so.
Additional Insured Status
Claimants of additional insured status on an insurance policy enjoy certain unique rights and privileges.
Third party vendors can be added to an organization’s insurance policy as additional insured entities through additional insured endorsements, which are complementary inclusions to a contractual agreement.
Additional insured endorsements can protect third party vendors against damage and injury.
Coverage for additional insureds is much more limited compared to coverage for the primary policy holder. Additional insureds are eligible for coverage only if the primary policy holder is also covered. The primary policy holder is covered by default for any business operation that hasn’t been explicitly excluded from the policy coverage.
The exclusion of a business activity from policy coverage can impact both the primary policy holder as well as the additional insured. Neither of the two parties is given preference in this regard unless explicitly mentioned in a commercial general liability (CGL) policy or in an additional insured endorsement.
The Need for Additional Insured Status
- Can still provide coverage, although the hold-harmless agreement has been overruled by a court of law
- The primary policy holder is eligible for certain rights especially in lieu of defense coverage
- Additional protection
Contracts with indemnification provisions
Contractual agreements can facilitate the whole range of protection against risks. If they are worded carefully and with adequate detail, the earlier discussed risk transfer factors can be covered. These include:
- Insurance Requirements
- Additional Insured Status
- Insurance Certificates
Indemnification provisions, also known as hold-harmless agreements, are a risk transfer option that is usually included in
- Construction, Service job and Rental Contracts
- Purchase order, Lease and Consulting Agreements
It is always good practice for enterprises to make the lessees, service providers and subcontractors sign a hold-harmless agreement. This way, enterprises won’t be penalized even when they are held liable for their actions and would even be reimbursed for damage and financial loss.
Indemnity agreements achieve risk transfer depending on the way they are worded, understood and executed.
Risk transfer can be achieved:
- Entirely, partly or not at all, depending on the action taken or avoided that triggers a risk transfer from one party to the other
- Through errors committed out of negligence or intentionally by the company or the third party vendor
- By protecting the organization against impacts such as
- Financial Losses
- Damage to assets and property
- Injuries and Health & Safety Hazards
Risk transfer can only be triggered when indemnification clauses are worded in a specific manner. And these requirements differ from state to state. So it is important to understand what is required by the state jurisdiction before drafting a hold-harmless agreement that caters to the organization’s specific resiliency needs.
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