Risk Transfer Agreements: Basics and Uses

What is a Transfer Agreement?

What is a Risk Transfer Agreement?
As noted in the Introduction of this Guide, a risk transfer agreement is a broad category of contractual relationships that transfer liability risk from one party (the indemnified party) to another (the indemnifying party). At its core, the purpose of a risk transfer agreement is to provide the indemnified party with some level of financial protection should an unforeseen event occur.
Because many different types of risk transfer agreements exist, these agreements can be used in a wide variety of contexts. For example, a risk transfer agreement might be included in a commercial lease to protect a landlord from tenant liability. The tenant would be obligated to include and pay for general liability and service coverage policies that name the landlord as an additional insured. If an accident occurred due to a leak in the tenant’s sink, then the tenant’s insurance would cover the landlord’s damages. Therefore, the landlord is protected from at least $1.5 million in potential liability for just $100 or more per month from the tenant’s premiums.
While the risks and damages transferred through an agreement can be limited, but the potential risks and damages being transferred can be unlimited. Thus, it is important to understand your risks before entering into any kind of risk transfer agreement. For instance , although the landlord in the example above is protected from a $1.5 million liability, the landlord is exposed to $250,000 in damages relating to improper electrical wiring. Since the landlord might not be aware of the wiring issues, and the tenant could be paying for protection against such issues under a risk transfer agreement, the landlord could face substantial losses against which it does not have any protection. In the above scenario, a $750,000 cap on the landlord’s damages would be more appropriate since it provides adequate protection against the risk to which the landlord is exposed. This amount should be negotiated for in advance of entering into the lease agreement with the tenant.
Despite their differences, risk transfer agreements can be found almost anywhere. It has been estimated that at least 90% of all transactions contain risk transfer provisions of some sort. That means that almost every day you are entering into risk transfer agreements. When negotiating an agreement, understanding your risks and evaluating whether the risk transfer agreement is appropriate will be helpful. The Guide provides the reader with the knowledge necessary to understand its risk exposure and help negotiate adequate risk transfer provisions.

Types of Risk Transfer Agreements

The most common forms of risk transfer agreements are those that are entered into in the insurance industry. These may include Insurance Contracts, Indemnity Agreements and Hold Harmless Agreements.
An Insurance Contract is an agreement between an insurance company and an insured party. The Insurance Contract may operate to transfer risk from one party (the insurer) to another party (the insured). A corporation can, for example, assign to an insurance company the risks its employees, clients and investors pose to it. In return, it’ll pay the insurance broker a certain amount of money called a premium, which will allow the corporation to carry less risks and ensure it doesn’t suffer a financial loss. The insurer also receives consideration: it gets to keep the premium as payment for assuming the risk.
An Indemnification Agreement, on the other hand, is a contract whereby one party agrees to compensate the other party for losses the latter may incur should certain agreed-upon events occur, such as the breach of a contract. These types of agreements are common in the M&A context, whereby one party agrees to indemnify the other against misrepresentation in the acquisition agreement. Indemnification agreements – unlike insurance contracts – are also useful for contracts because they allow both parties to contract out of their liability.
Finally, Hold Harmless – or Save Harmless – clauses come in many forms, and are particular to the construction context. They work to exempt one party from responsibility for certain damages, loss and legal liability. Similar provisions are often included in Risk Transfer Agreements.

Essential Components of a Risk Transfer Agreement

The parties to the transfer, i.e., the transferor and the transferee. Depending on the nature and purpose of the risk transfer, these may be two or more different entities. For instance, a manufacturer may be transferring risks to its insurer. In another scenario, a contractor may be transferring a risk to an owner. The scale of the project could involve numerous parties. In many cases, particularly when the risks are being transferred to an insurer, the agreement could simply identify the parties by name rather than the party’s role in the transaction or project.
The terms and conditions of the agreement. These are often developed by negotiation or other development process between the parties. The negotiation or development process itself may be formal or informal. In the case of an insurance policy, the terms and conditions may be unilaterally developed by the insurer and accepted by the insured when its purchases insurance. The terms and conditions typically concern the scope of the liability to be covered, duration, identification of the specific risks to the covered, specifics of any exclusions, limitation on the amount of liability, and more.
Specific language allocating the identified risks. This is where you start to see a difference in risk-transfer agreements. These agreements and transfers are often billed as all-encompassing, comprehensive solutions to deal with risk. Yet, in practice, the transfers often contain numerous exclusions limiting the transfer. In addition, the transfers may be very detailed in listing the risks that are not transferred. A classic example is the professional liability policy, which transfers risks that are not inherent to the type of work being performed.

Advantages of Risk Transfer Agreements

Risk transfer agreements can be an invaluable asset to both businesses and individuals. They help with a number of things, including protecting assets, minimizing liability and adding peace of mind.
Protecting Assets
Those who suffer from or are at a high risk for chronic injuries (burns, financial abuse or falls, for example) benefit from having a risk transfer agreement in place. Such an agreement can protect assets related to a professional practice, estate or trust fund. So long as the agreement is enforced, the injured party can be completely protected from losing their assets during rehabilitation or recovering from their injuries. Those with long-term disabilities and no insurance are at high risk of needing to sue to get the restitution required to keep their businesses alive and employees paid. A risk transfer agreement can eliminate that as a possibility.
Minimizing Liability
Even just signing a few consent forms with insurance companies can minimize liability, but more proactive steps offer even better results. Signing a risk transfer agreement can help medical professionals, for instance, to ensure they do not have to pay directly for losses caused by their negligence. These negotiated agreements remove and shift the potential losses they face onto other parties.
Peace of Mind
Knowing some of the risk is shifted to another party offers peace of mind. When a risk transfer agreement is in place, an individual or business can be happy that they are doing everything possible to make sure a given risk does not cause harm.

Issues and Considerations

As with any agreement, there are potential challenges and considerations when drafting and implementing risk transfer agreements. While the intention may be to limit liability as much as possible, the agreement must be well written to prevent it from being misinterpreted. It is important to clearly define legal terms such as negligence to avoid ambiguity. Parties should agree in writing to the same definition of negligence (tortious and otherwise). Where possible and practical, the agreement should specifically describe the risk that has been allocated to each party.
In addition, parties must be careful in negotiating the agreement. Although risk transfer agreements are a good business tool , they may contain provisions that convey risk to one party to the point where that party cannot accept the full weight of that risk or where that party cannot obtain insurance to cover that risk. Risk transfer agreements should consider the negotiating power of each party. The strongest party may simply be able to negotiate to have all the risk placed on the other party through the agreement. However, it is important that all parties consider the fairness of any allocation before agreeing to the terms.
The scope of the indemnity clause in the risk transfer agreement is also important. Clauses that attempt to relieve a party of its own negligence can be found unenforceable and in the case of gross negligence or wilful misconduct, such clauses are generally unenforceable.
Ultimately, all risk transfer agreements must be considered on a case-by-case basis. It is imperative that all parties seek legal advice on risk transfer agreements and related documents prior to signing to ensure that the agreement reflects the agreed terms.

Case Studies for Risk Transfer

To illustrate the relevance of risk transfer agreements in the real world, consider the following examples:
Professional Services: A roofing contractor hires a subcontractor to roof a new house. The general contractor requests proof that the roofer has adequate general liability coverage, and the roofer provides a certificate of insurance. After the new homeowner moves in, she notices that the roof leaks. Upon hearing of the leak, the general contractor sends a letter to the roofer demanding repair. The roofer responds by sending the general contractor a copy of the same certificate of insurance. Ultimately, the bill goes to the general contractor to pay the roofer for his work, and is incurred by the homeowner who must pay to correct the leaky roof.
Health Care: A hospital enters into a service agreement with an MRI company to provide a mobile MRI service at the hospital’s facility. In the contract, the hospital agrees to indemnify the MRI company for any claims or negligence arising from the mobile service. The only problem is that MRI company’s certificate disclosed it had only $1 million in coverage, but left off the endorsement that the hospital be added as an additional insured. The MRI company had no funds available to settle a $2 million claim from a patient who fell off the mobile MRI, resulting in serious injury. Because the CPR was not in place, the hospital is on the hook for $2 million due to its indemnity obligation to the MRI company under Florida law.
Manufacturing: A tire manufacturer sends tires to a tire retailer, but the retailer’s quarterly assessment of its coverage reveals that the tire manufacturer is not named as an additional insured on the tire retailer’s certificate of insurance. The tire retailer is unable to identify the insurer. The tire retailer replaces the insurance policy, but does not list the manufacturer on the new policy. Because the old policy lapsed, the tire manufacturer is not covered for any of the claims it receives for defective tires sold in the past year. Because the tires have already been sold at the time of the alleged defect, it is too late to recall the product.
Education: A school decides after considerable time and trouble to switch banks and find a new one that offers better rates and terms. In the service contract with the new bank, the school agrees to indemnify the bank for any losses it incurs. The bank’s director is charged with embezzlement of funds, along with three credit union officers who hide the scheme under an "alternative reconciliation method." The bank attempts to sue the school for any funds it used in fraudulent transactions. Since the school’s indemnity obligations extended to "any claim or cause of action of any kind or nature…relating to the performance or non-performance of [the] Agreement," the school is responsible for reimbursing the bank for its investigation and exam expense and deposits.

Future Developments in Risk Transfer

In the years to come, risk transfer agreements are likely to undergo significant changes in line with evolving legal standards, technological advancements, and the developing business environment they seek to protect against. As courts develop new standards for indirect or consequential damages, these indirect risks will become more important from a transactional perspective. Business transactions are expected to become significantly faster in the future as innovative technologies such as Blockchain eliminate the need for intermediaries. As timeframes shorten , or as transactions become lower-value, the functions served by no-fault indemnification provisions may become unnecessary. Technology will provide new avenues for firms to manage their risks, and since the markets for these products are not well-developed, new products will enter the marketplace. As with any contractual provision, indemnification provisions are likely to adapt to meet these changing realities.