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Contractual risk transfers: the art of reading the fine print.

Contractual Risk Transfers: The Art of Reading the Fine Print

Since most risk management and insurance professionals have mastered the language and policy framework of insurance contracts, they should be familiar with the majority of business agreements and contracts.

Effectively identifying, defining and transferring risks to reduce or control them necessitates the use of various types of contracts and commercial leases. Nearly every business transaction requiring a written agreement between parties has incidental language that shifts some exposure or financial responsibility to another party.

Naturally, jurisdictional laws and statutes attempt to establish the principles of good faith between parties while also protecting public interests or policy. However, there is considerable contractual freedom, evidenced by loosely worded leases, agreements and contracts.

Risk managers should approach these contracts with the same interest and understanding they show for other loss control and risk financing mechanisms. In fact, given that most organizations retain more risk than they transfer, contractual risk management techniques offer an important way to effectively manage financial and operational risks.

Risk managers develop and review contract specifications to underwrite data for their major renewals. This information leads to a better assessment of their transferred risk and ultimately to better terms and conditions offered by underwriters. The final product is a legal binding agreement, or policy, between the insurer and insured.

How Risk Transfer Works

The case of a multinational chemical and paint manufacturer that sold one of its sulphur-producing resource divisions vividly illustrates how contractual risk transfers work. The purchaser, E.S. Industries, requested that two conditions concerning potential environmental problems be met before signing the purchase agreement. The first called for obtaining three independent engineering environmental assessments of the sites being purchased. The company also requested that prior to the purchase agreement date an indemnification agreement be signed, which would hold E.S. Industries harmless for 10 years for problems causing environmental pollution and the resultant cleanup costs.

The seller agreed to the conditions, but E.S. Industries faced another obstacle: To carry out its new growth strategy, the company required a large amount of capital. Realizing that it was in reasonable financial health and had sufficient collateral, E.S. Industries attempted to secure a $60 million loan. Because of the size and nature of the transaction, a syndicated loan was arranged with three lenders. The agent, or lead lender, required that E.S. Industries purchase environmental impairment liability insurance with a minimum aggregate limit of $10 million.

Because of the prohibitive cost and difficulties in obtaining such coverage, the major shareholder asked that this covenant be waived. He argued that there was satisfactory protection provided by the manufacturer's 10-year indemnity agreement, the engineers' assessments and other pollution coverage afforded through E.S. Industries' comprehensive general and excess liability policies.

To reach an agreement among E.S. Industries, its major shareholder and the lenders, the risk manager would review the original asset transaction between the manufacturer and E.S. Industries. The review would consider other relevant agreements as well as the pre-acquisition indemnity provision and the results of the independent environmental reports.

This example shows how contractual risk transfers can effectively shift the burden of financial losses to other parties. More importantly, it illustrates how risk managers are ideally suited to define risks in business operations and to use the legal framework and freedom of contracts to encourage favorable results for their companies.

Aaron M. Konarsky is manager of the risk and insurance department for the National Bank of Canada in Montreal.
COPYRIGHT 1990 Risk Management Society Publishing, Inc.
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Copyright 1990 Gale, Cengage Learning. All rights reserved.

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Author:Konarsky, Aaron M.
Publication:Risk Management
Date:Oct 1, 1990
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