In some service industries (e.g., oil and gas, construction, maritime), it’s common to contractually allocate property damage or bodily injury risks on a “regardless of cause” basis; that is, the allocation of loss is not based on fault, but rather on the ownership of property or the employment of personnel. Under this approach, each party (as indemnitor) agrees to indemnify the other (as indemnitee) for bodily injury and property damage suffered by the indemnitor (or its personnel), even if the loss was caused by the indemnitee’s fault. For example, Contractor agrees to defend and indemnify Owner for all bodily injury claims of Contractor’s personnel, even if the claims are caused by the sole negligence of the Owner. The expected benefits of these so-called “knock-for-knock” indemnity arrangements include efficient claims handling, preservation of commercial relationships, and the potential reduction of financial exposure to both parties. The concept can work well in the absence of contractual drafting errors, the application of anti-indemnity acts, or unusual circumstances outside of the parties’ contemplation at the time the contract was negotiated.

But how does the indemnitor fund this obligation? For example, when Contractor is called upon to indemnify Owner for the personal injury claim of Contractor’s employee caused by the Owner’s negligence, where does the Contractor obtain the money to pay defense lawyers and settle the claim (or indemnify the Owner after it is cast in judgment)? The answer in most cases is by operation of an exception to the contractual liability exclusion in the Contractor’s general liability (“GL”) policy along with the policy’s definition of “insured contract” (or its cousin, the “incidental contract”).

As an “all risk” policy, the GL’s insuring agreement/coverage grant—the basic statement of coverage—is broad. Once a claim for bodily injury or property damage is placed within the coverage grant, the insurer bears the “heavy” burden of showing that an exclusion applies to figuratively “eject” a claim from the coverage grant. See, e.g., Cochran v. B.J. Services Co. USA, 302 F.3d 499, 502-03 (5th Cir. 2002) (applying Louisiana law). One potential exclusion is the contractual liability exclusion which usually applies to an obligation to pay damages “by reason of the assumption of liability in a contract or agreement.” Another pertinent exclusion is the “Employer’s Liability” exclusion, which excludes coverage for injuries to employees of the insured. This is problematic if the insured is indemnifying another party for the employee’s injury (commonly referred to as an “action-over” claim). Luckily, most GL policies provide an exception for liability assumed in an “insured contract” to address the contractual liability and Employer’s Liability exclusions.

GL policies typically define an “insured contract” as:

That part of any other contract or agreement pertaining to your business . . . under which you assume the tort liability of another party to pay for bodily injury, property damage or environmental damage to a third person or organization. Tort liability means a liability that would be imposed by law in the absence of any contract or agreement.

The “insured contract” definition thus sets up a three-part test for contractual liability coverage to attach:

1. The policyholder contractually indemnifies,
2. Its counterparty to the contract,
3. For that counterparty’s tort liability to a third party.

This indemnity coverage is not wide open. Rather, to benefit from this coverage, the policyholder must assume liability for which it seeks coverage and the liability assumed must (under most policy forms) be tort—rather than contractual—liability. The assumption of liability requirement thus limits coverage to risks for which the policyholder would not be responsible for absent the insured contract. And tort liability typically means that “the insured has agreed to be responsible for another person’s or organization’s liability to a third party who suffers injury or damage.” Thus, for coverage to be triggered under the insured contract exception, the counterparty must have tort liability to a third party (i.e., a person or entity that is not a party to the contract). Coverage will not exist under the insured contract exception, for example, for property damage to the counterparty’s property.

Parties contemplating whether to contractually accept indemnity obligations should proceed with caution because not all assumptions of liability will fit the three-part rubric set forth above. See, e.g., Int’l Offshore Servs., LLC v. Linear Controls Operating, Inc., 122 F. Supp. 3d 528, 536 (E.D. La. 2015), aff’d on other grounds sub nom. Int’l Offshore Servs., L.L.C. v. Linear Controls Operating, Inc., 647 F. App’x 327 (5th Cir. 2016) (“The phrase ‘liability that would be imposed by law’ does not include liability assumed by contract.”); Richard v. Anadarko Petroleum Corp., No. 11-0083, 2012 WL 4753416, at *10 (W.D. La. Oct. 2, 2012) (insured “could have possible contractual liability coverage for its contractual liability obligations for another’s possible tort liability,” but another insured would have no coverage for its liability sounding solely in contract). Consequently, practitioners should counsel clients not to blindly rely on contractual liability insurance coverage when negotiating service contracts, understanding that those contractual undertakings that do not meet the policy requirements for coverage through the definition of an insured contract will be excluded. After all, the fact that coverage for contractually assumed obligations is found within an exception to exclusion ought to instinctively suggest caution in not over-promising in a service contract. Practitioners should also consider the potential applicability of anti-indemnity acts such as the Louisiana Oilfield Anti-Indemnity Act which may invalidate certain contractual defense and indemnification provisions in agreements “pertaining to a well for oil, gas, or water, or drilling for minerals which occur in a solid, liquid, gaseous, or other state.” La. R.S. 9:2780. Accepting an indemnity obligation that will not be covered through the insured contract mechanism can put the policyholder in the difficult position of having to personally fund the defense and indemnity of a valid indemnity demand, creating significant (and unpleasant) surprise and potential liability.

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Written on behalf of the Insurance Law Committee