According to classic risk management theory, you have four main tools for controlling your risks: 1) avoidance, 2) modification, 3) retention and 4) transfer. Basically, that means you can take measures to avoid the risk altogether, make modifications that lessen the risk, be willing to accept and retain the risk yourself, or transfer the risk to another party.
Transferring risk is most commonly achieved either through an insurance policy or through a non-insurance agreement, such as a contract. The underlying concept is to pass risk to another party who may be in a better position to monitor and protect against the risk, or in a better financial position to accept and insure against the risk.
Most contracts you enter into as a business owner have contractual risk transfer components to them – indemnity (hold harmless) clauses, waivers, disclaimers and additional insured endorsements, for example. After all, the purpose of the contract is to establish who is supposed to do what and what happens if they don’t. Essentially, contracts determine how the risk will be divided up among parties.
Contractual risk transfer examples:
- Renting a venue for a special event. While venues are happy to rent you their space, they’re not likely to want to take on the risks associated with any damage you might cause to the venue or any injuries incurred by your guests. So they transfer that risk to you through a contract.
- Hiring a subcontractor. When you hire a subcontractor, you transfer much of the risk to that subcontractor, and the project owner transfers much of the risk to you.
What factors affect how risk is transferred?
Ideally, risk is transferred to the party who is best able to control it. In reality, risk is usually transferred from the party with the most leverage to the party with the least. Three of the main considerations that go into any risk transfer decision are:
- Control of the risk. Who is in the best position to control the risk? For example, a construction contractor could be in a better position to control jobsite accidents than the project owner due to contractual management requirements.
- Knowledge of the risk. Does one party’s knowledge of the risk make them a more logical choice to assume that risk? For example, a demolition contractor using explosives might be the logical choice to assume risk of injuries and damages because of their unique expertise.
- Bargaining position. The bigger the entity, the more likely they are to transfer risk to a smaller entity.
Every business contract has risk management and insurance implications, and you need solid advice from experts to understand them. Taking time at the beginning of the contract review process to negotiate equitable terms can save you a great deal of money and headaches in the future in case a problem arises.
Contractual risks exist in virtually every business document, and your liabilities aren’t always obvious. At Higginbotham, contract review is an essential component of our risk management services so we can identify those risks and give you the tools to make informed decisions about how best to handle them. In other words, we can help you avoid the pitfalls and make your Texas business thrive.
Need help with contractual review? Contact our contract review department.