Contractual indemnity

Being mindful to obligate your insurers to fund your contractual indemnity undertakings

Introduction

Are you smart to contractually agree to indemnify another party on a ‘knock-forknock’ basis but refuse to name and waive them on your insurance? What about agreeing to name and waive them but only on a portion of your liability program? This paper explores the issues and consequences of common knock-for-knock indemnity schemes including unintentionally encouraging your insurer to avoid paying your contractual indemnity undertakings.

Background

Oilfield service contracts may be subject to maritime or state law interpretation and enforcement. Certain states have prohibitions against oilfield indemnities for one’s own negligence that must be considered, while maritime law respects the rights of parties to contractually allocate risks where their intentions are clearly expressed. The courts have also distinguished between expressed contractual indemnity and insurance obligations. In some instances the two are not dependent and are considered distinct.

With very rare exceptions, oilfield contracts address allocations of the financial consequences of risks arising out of the performance of the relevant work.

This is usually done on some version of a knock-for-knock basis, where each party agrees to be financially responsible for claims related to its own people and property and to indemnify, defend, and hold harmless the other party and its “group” of related/interested parties from such claims. This includes protecting a party from a claim even where the loss at issue results from the negligence, strict liability, or other legal fault of that party. Third-party claims and environmental responsibilities are often addressed separately.

This allocation of financial responsibility was driven, at least in part, by the parties’ desire to distribute liability based on who would normally carry insurance intended to cover any given loss, and it allows the parties to carry appropriate but not completely redundant insurance. One party’s insurance would be deemed primary over the other. Allowing the indemnities to apply even in the event of the fault or negligence of the indemnified party also minimizes disputes and litigation aimed at determining which party was at fault or caused the particular loss.

Certain exceptions are typically made where the party with the most to gain financially from the project at issue assumes more liability than the other party. For example, in drilling contracts, the oil and gas company stands to gain far more financially from the results of the drilling than does the contractor, who is merely earning a fixed day rate. As a result, the oil and gas company typically assumes the financial consequences of catastrophic loss—such as a blowout or pollution flowing from the well—even if caused by the fault or negligence of the drilling contractor.

The role of insurance

In addition to contractual indemnity undertakings, oilfield contracts customarily obligate the indemnitor to place insurance and name and waive the indemnified parties on its liability policies, which may also be limited to the extent of the relevant indemnity undertaking.

Insurance is contractually required so that the indemnified party does not need to rely on either the willingness or financial ability of the indemnitor to pay following a loss. Access to the indemnifying party’s insurance is particularly important if the indemnified party caused the loss, as the indemnifying party may have very little motivation to reimburse a party where the loss materially impacted business, personal relationships, and reputation. Even if the indemnitor wants to pay, it may not have the financial wherewithal to do so for a major loss.

An indemnified party that was named as an additional insured on the indemnitor’s liability insurance has status and rights under the insurance policy that it can assert directly to protect its interest should the indemnitor fail to act. Failing that, the party owed indemnity needs to exclusively rely on the indemnitor to pursue a claim under the “contractual liability” coverage of its own policy—assuming that party has it.

Naming and waiving is also very important on property policies as it legally precludes the insurer from trying to subrogate against the indemnified party following payment of a claim to the indemnitor.

This may sound inappropriate given that the insurer merely “steps into the shoes” of its insured to assert subrogation rights. Where those “shoes” come with an obligation to indemnify a third party, the property insurer should be bound by that contractual undertaking and not be able to pursue recovery against the indemnified party. But the insurer does occasionally try.

INSURERS CAN BE AGGRESSIVE WHEN LARGE LOSSES OCCUR

Large losses frequently result in the engagement of counsel who will look for ways to avoid or mitigate claims. This includes being aggressive in determining who is an insured under a policy when seeking subrogation.

In a recent case, London underwriters issued a WELCAR builders all risk (BAR) policy for an offshore project that expressly included as insureds all contractors, subcontractors, and parties that provided goods or services to the project. A boutique design firm was contracted as a subcontractor and, as such, fell within the scope of the definition of “insured” of the BAR policy.

Despite this, after paying a large claim, the London BAR insurers sued the design firm alleging (i) it caused the loss and (ii) the contract for the project did not obligate the operator to name and waive the design firm on the BAR coverage.

The court dismissed this contention after determining that the design firm was an insured in accordance with the terms of the relevant policy. So any defect in the relevant contract was moot.

The point: large losses can result in aggressive behavior by insurers.

The issue

The overwhelming majority of oilfield agreements include mutual indemnity undertakings and a reciprocal obligation for each party to name and waive the other party and its group on their relevant insurance coverages.

However, from time to time we see contracts where the larger, more economically powerful party requires the smaller party to place coverage and name and waive the larger party, but with no reciprocal undertaking by the larger party to place insurance and name and waive the smaller party or its group thereon.

The thought by the larger party is, presumably, that it does not want the other contracting party to have rights under its insurance or be able to directly pursue a claim thereunder. Instead, the smaller party will be forced to rely exclusively on the indemnity undertaking of the larger party, which can use economic clout to alter the financial outcome of the loss.

The potential problem

Liability policies are generally designed to pay to the extent the party placing the insurance is legally at fault. A knock-for-knock indemnity scheme instead requires the indemnifying contractual liability insurer to pay where an unrelated party is at fault for the loss.

Without naming and waiving the indemnified group on the indemnitor’s liability insurance, they are not insureds under the policy. They also are not clearly entitled to a waiver of subrogation. Instead, the obligation of the indemnitor’s insurer to pay is limited to the contractual liability endorsement of the relevant coverage and, again, this is only an obligation to the named insured. This raises the possibility of the insurer refusing to pay or, perhaps, paying and then seeking subrogation.

This may seem unlikely, but there are many cases where insurers have been aggressive in large losses to try to deny a claim or seek subrogation against third parties. This raises the question as to why any party that has obligated itself to indemnify another party would risk encouraging its insurers to look at coverage issues or possible subrogation opportunities that were not intended by the parties to the relevant contract.

Unintended consequences under anti-indemnity laws

Not having reciprocal insurance undertakings may also make the relevant indemnity undertakings void under applicable state laws, like those of Texas.

The Texas Oilfield Anti-Indemnity statute (Texas Practice and Remedies Code § 127.001, et. seq.) invalidates or limits indemnity provisions that purport to indemnify a person for property damage or personal injury caused by the negligence or fault of the party seeking indemnification, unless (i) the indemnities are mutual and (ii) covered by insurance. If the parties carry differing amounts of insurance, the indemnity is limited to the lower amount of insurance obtained by the parties. This means that a reciprocal knock-for-knock indemnity undertaking that is not supported by mutual insurance undertakings will be void or capped.

Like Texas, Louisiana’s Oilfield Anti-Indemnity Act (La. Rev. Stat. Ann. § 9:2780) invalidates contractual indemnity for personal injury claims caused by the person claiming indemnity (Louisiana does not nullify indemnities for property damage). Unlike Texas, the Louisiana statute does not contain an exception for insurance coverage. As a result, contracting parties cannot avoid the Louisiana statute merely by requiring mutual insurance coverages in support of the indemnity obligations.

However, Louisiana has developed a court-created work-around known as the Marcel exception. Under Marcel, a court will not void an additional insured undertaking where no material part of the cost of adding the additional insured to the policy was borne by the party owing indemnity. The thought is that where a party to be indemnified has paid the full cost to be made an additional insured it should get the benefit of the bargain with the insurer.

Where Louisiana law applies to personal injury claims, there is no enforceable naming and waiving to support the knock-for-knock indemnity; a party owed indemnity will not have access to a Marcel insurance solution by simply naming and waiving. As the contractual indemnity is legally void, the risk allocations in the contract are wholly unenforceable.

Limiting insurance

We sometimes see contracts that contain reciprocal knock-for-knock indemnity undertakings that obligate each party to place insurance and name and waive the other party’s group, but which limit the naming to some dollar amount below the actual limits of the naming party’s liability program. We assume the thought is to protect the indemnitor’s insurance from a “limits loss.”

This begs the question of why a party with no cap on its indemnity would want to nonetheless cap access to its insurance and possibly limit the liability of its insurers. Absent the application of the Texas Oilfield Anti-Indemnity Act (which should limit an indemnity obligation to the extent of available insurance), why encourage insurers to seek to avail themselves of a limit on liability and leave the indemnitor to bear the loss above that limit?

Conclusion

It is logical for a party to want to protect its insurance program from access by third parties, including third parties it owes indemnity to. But thought needs to be given to unintended consequences that may result in contractual indemnity still being owed but the indemnitor’s insurance not being available to support it.

Parties entitled to indemnity also need to realize that, without being named and waived on the other party’s insurance and absent litigation, they are at the mercy of the indemnitor to pay as agreed in the contract.

Additional Assets

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