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Wait. What does indemnity mean?

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We sat down with Martha Binks, Corporate/Commercial Lawyer at Caravel Law, to discuss what business owners need to know about indemnity clauses in contracts. 

The terms indemnity and insurance are often used interchangeably – but while there are similarities between them, there are also crucial differences that business owners need to be aware of in order to properly protect themselves and their business.

What is indemnity?

Put simply, indemnity is a contractual agreement between two parties, where one party agrees to pay for potential losses or damages claimed by a third party.

For example, say you own a shopping centre, and you hire a snow removal service to clear your parking lot in the winter. You would likely want an indemnity clause in your contract that says the snow removal company will indemnify the shopping centre for any claim made against the shopping centre as a result of the nonperformance of their services.

What that means is that if the snow removal company doesn’t properly clear the snow, and someone slips, falls and sues the shopping centre, it is the snow removal company’s obligation to provide any financial compensation that is due.

Conversely, say you work at a digital marketing agency, and you’re producing advertisements for a client. Your client may tell you their product has X, Y, Z benefits and you include that information in the ad. But if it turns out those claims are untrue, you don’t want to be held liable for that content if legal action is taken as a result of a false claim.

So an indemnity clause can protect either party – the client or the supplier – in a contract.

How is indemnity different from insurance?

Indemnities and insurance both help protect against financial losses. However, indemnification clauses allocate risk between contracting parties. An insurance policy transfers a defined risk from one party to the insurer in exchange for payment.

Indemnity and insurance often get used interchangeably. The idea of indemnification is to make someone whole. An insurance policy may agree to indemnify its policyholder. Most insurance companies agree to indemnify you for any judgment that you’re required to pay, at least within a certain dollar amount. Indemnity is what you may purchase in insurance policies and a term that may be negotiated in contracts.

Indemnity is often established based on which party owns a particular risk. Then, like any other term in a contract, the extent to which it applies to one party or another may have more to do with which party is more powerful. A more powerful company can often require a less powerful company to accept risks they may not otherwise be willing to accept. Big companies can have broader indemnity clauses because they know they will find some supplier willing to accept the contract terms.

Generally, if you agree to indemnify another party, you would want to have insurance for that risk. Where it gets tricky is that having an indemnity clause in a contract between two parties doesn’t necessarily mean your insurance company will provide coverage.

For example, if the snow removal company referenced above agreed to the indemnity clause in the shopping centre’s contract, and then someone slipped, fell and sued, the snow removal company’s insurance company might turn around and say they aren’t paying. They could claim that it doesn’t believe its insured is at fault, and rightly point out that it did not agree to be bound by the contract terms, and in particular, the indemnity provisions.

If you were working for a company regularly as a contractor or supplier, you might ask to be added as a named insured on their policy, which would cover everyone involved if there was a lawsuit.

How do indemnity clauses protect your business?

There are a few benefits to establishing indemnification in contracts. The main advantage is cost savings on legal fees, as another party agrees to pay for certain claims against you, which they may not be willing to do come claim time if such a clause wasn’t in place.

If you have clearly defined indemnity clauses in your contract, it’s easier to avoid having to go through litigation. One of the biggest challenges with going through litigation is that even if the party is found not to be at fault, as soon as there’s an action against them, they incur defence costs. And even if they successfully defend their case, they’ll usually only have part of what they spent in legal fees recovered from the at-fault party.

Indemnity clauses are also beneficial because they help define roles and responsibilities within a contractual agreement. They set expectations between both parties, so when something does go wrong, no one is left saying, ‘Well, that wasn’t my responsibility.” If you’ve clearly defined who is responsible (and who is not responsible) for each part of the contract, you always have an agreed (and signed) document to refer to when these issues arise.

Who needs to consider indemnity clauses in their contracts?

Most commercial contracts contain at least one indemnity clause. And almost all businesses should assess risk and define responsibility when working with external suppliers and contractors.

If you’re a company that hires many freelancers, contractors and consultants, your insurance will likely be very narrow in scope in terms of what it will cover. In these instances, indemnity clauses will be essential for your business in order to minimize risk.

How do you ensure you are adequately indemnified in your contracts?

Indemnity clauses can often be an afterthought for businesses and get thrown into contracts at the last minute. When this happens, companies tend to copy standard boilerplate clauses that aren’t specific enough to the business to be of any real value.

Indemnity clauses need to be very explicit about the situations and scenarios related to your business. It’s also essential they are specific about covering any payments to a third party, including legal fees, compensation, interest, etc.

When hiring outside counsel to help with contracts, look for a lawyer with extensive experience with insurance law and reviewing contracts. A lawyer with commercial contract experience is ideal because they can help draft contracts to minimize risk for their clients from potentially unforeseen scenarios. They can also spot one-sided indemnification clauses and ensure their clients aren’t signing anything that assigns them too much risk.

Need help managing drafting and reviewing contracts? Caravel Law is an alternative legal firm with 50 qualified and experienced lawyers to help support your legal needs. Get in touch with our team today to find out more.

The information provided in this article is not intended to be legal advice. Many factors unknown to us may affect the applicability of this content to your particular circumstances.

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