INSURANCE AND RISK SOLUTIONS FOR COMMERCIAL PROJECTS

Michael Mills*

Much of the negotiation ofcommercial tran~actions revolves around the allocation of risks amongthe parties. However, strategic analysis ofhow to best allocate those risks has often not been done.In particular, few companies and their advisers have learnt the lessons of risk management as itapplies to effective insurance and risk solutions. This article seeks to identify the pitfalls ofconventional approaches and to outline how to achieve a more effective and cost efficient riskallocation outcome in the negotiation ofcommercial transactions.

1. INTRODUCTION

Risk management has become quite a buzz word in commercial life. For some years now, riskmanagers, financiers, company secretaries and even insurers and insurance brokers all want to talkabout how best to manage, minimise and transfer risk (though depending on their vocations, withdifferent emphasis on the preferred topic and solution). Lawyers and accountants are no different,with their emphasis on the importance of risk analysis.

Yet, the more things appear to change, the more they stay the same! For gauging by the manner inwhich many companies (and their advisers) tackle their preparation for and strategies for thenegotiation and risk allocation in substantial commercial transactions (say a major infrastructureproject) few companies and their advisers have really learnt the lessons of risk management in sofar as it applies to effective insurance and risk solutions.

This is because although much of the negotiation for commercial transactions revolves around theallocation of risks amongst the parties, a strategic and contemporary analysis of how best thoserisks can be allocated has often not been carried out. Or if carried out, it has been carried outsuperficially and or on the basis of past practice. Thus, the negotiation of the contract detailsrelating to risk allocation proceeds on the basis of long held assumptions, many of which are nolonger valid. 1 This paper seeks to identify both the pitfalls of the conventional approach (in manycases) and the procedures to achieve a more effective and cost efficient risk allocation outcome inthe negotiation of commercial contracts.

2. RISK MANAGEMENT

Generally, risk management has been treated as a corporate strategy which involves:

(1)

*

an identification of the risks facing the business, normally done through development of a"risk register/matrix" or "risk profile" though until recently, this was often only done foroperational and some financial risks;

A Partner, Freehills, Sydney and Visiting Fellow of the Law School, University of Western Australia.As has been previously noted by Robert J Smith, "Risk Identification and Allocation: Saving Moneyby Improving Contracts and Contracting Practices" (1995) International Construction Law Review40 at 54: "Existing procedures and documents are usually the result of incremental additions overthe years, with few subtractions. Many times both procedures and documents are "handed down"from one person to another, the "we've always done it this way" approach."

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(2) an analysis of the risks, especially an analysis of the likely frequency and severity of therisks identified, followed by an evaluation of those risks;

(3) treatment of the risks, which broadly revolves around 4 options:

(a) risk avoidance, such as not engaging in a particular activity;

(b) risk control, implementing practices which minimise the likely frequency and orseverity of an identified risk;

(c) risk retention, where a risk is deliberately retained and plans are put in place forthe consequences of such retained risks, such as means of financing theconsequences; and

(d) risk transfer, whereby another party shares some or all of the risk. "Mechanismsinclude the use of contracts, insurance arrangements and organisational structuressuch as partnership and joint ventures.,,2

(4) the monitoring and review of these risk management strategies on an ongoing basis.

The focus of this paper is on contractual risk management and the option of risk transfer in so far asit applies to the insurance of risks in commercial projects.

As mentioned, in the negotiation of most commercial transactions, once the "business deal isdone"; namely the crucial aspects and terms relating to the nature, price and period say of thesale/purchase of a power station, the remainder (and often the bulk) of the time spent in thenegotiation and documentation of the transaction, relates to risk allocation.

This is because in commercial transactions, the parties seek to allocate the risk by means of thecontractual assignment of rights, responsibilities and procedures. In this context, risk managementis much broader than simply transferring risk to a third party via an insurance contract. Thecontract is the means and evidence by which risks are identified, assigned and sometimestransferred. Studies have shown that contractual misallocation of risk is the leading cause ofconstruction disputes in the United States of America and improper risk allocation can causeadditional costs. Furthermore, if.the parties took a broader, more systematic and structured viewand approach to risk allocation in the planning and negotiation of construction projects, then thereis the realistic frospect of a 5% saving on current costs, primarily through proper risk identificationand allocation.

Yet, the strategy of risk transfer is not carried out as efficiently and effectively as it should be inmost commercial projects, because:

2 Standards Australia Risk Management ASINZS 4360:1999 at 4.53 Construction Insurance Institute, Assessment of Construction Industry Project Management

Practices and Performances, April 1990; cited by Robert J Smith, "Risk Identification andAllocation: Saving Money by Improving Contracts and Contracting Practices" (1995) InternationalConstruction Law Review 40 at 41 on the advantages of better contracting practices.

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(1) a comprehensive risk identification is not carried out at the outset and prior to thenegotiation of the commercial contract; and/or

(2) the negotiation of the clauses in the contract and the insurance policy are not coordinatedto jointly produce the most cost efficient and effective transfer of risk, especially given thecompany's risk priorities; and/or

(3) the insurance is poorly handled, with the result that the commercial outcome is not optimalfor the company's risk preferences and contractual allocation of risks in the project.

3. EFFECTIVE RISK ALLOCATION & TRANSFER STRATEGY

The means by which to achieve the most effective (and cost efficient) outcome for risk allocationand transfer revolves around the various advantages of the early preparation of a comprehensiverisk identification and allocation strategy. This strategy and review needs to extend to an analysisof and preferred strategy in relation to insurance and the other risk treatment options. In otherwords, this analysis needs to include both the identification and analysis of the risks, as well as thepreferred treatment options (which can be referred to as the "risk management matrix").

Such an approach enables the company at an early stage (and importantly prior to the negotiation ofthe contract and the risk allocation obligations it will encapsulate) to form a view as to thepreferable risk management and insurance approach.

There is nothing novel in this stated approach, but what is striking, is how often companies proceedon the basis of their past and or preferred risk allocation strategy, without subjecting it to a costbenefit analysis for the project, country and contracting party(s) in question. As a result, thecompany's contracting and risk management strategies often proceed on the basis of untestedassumptions about the preferable risk allocation strategy.

Another pitfall to a company simply adopting its past risk allocation strategy and contractualclauses, is the relatively recent expansion of the alternative risk transfer and financing of riskoptions now available in the financial services market. The growing convergence of the financeand insurance markets, coupled with the recognition that the traditional policies of insurance didnot address many of the strategic and business risks which concerned companies, means there willbe considerable future opportunities to access innovative insurance and or finance products whichcan be tailored to meet the specific risks of the project or transaction in question.

Added to this is the fact that although the conventional approach is for each party to allocate risksand responsibility on the basis of fault,4 there are alternative insurance and risk strategies, ranging

4 At present, the standard negotiating strategies to the allocation of risk within the contract can bedescribed as:

(a) "default based" responsibility;(1) "wilful default" or "wilful misconduct";(2) negligence;(3) breach of contract;

(b) "other cause" responsibility;(1) caused innocently;(2) caused by third parties;(3) strict liability at law;

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from one party being solely or primarily responsible for arranging the insurance on the projectthrough to a joint alliance for the management and insurance of risks.

Furthermore, to determine the most desirable insurance and indemnity clauses, it is best to knowwhich risks are preferably accepted by the company and alternatively, which risks should beexcluded or insured by a third party. For the company's risk allocation strategies and or aversions,existing insurance programme, and/or existing corporate relationships, may mean it chooses to andor can cost efficiently absorb certain risks, but not others. This needs to be identified at the outset.The negotiating strategy should then be established to reflect the chosen objective, with the efficacyof this strategy reviewed regularly and systematically.

For example, in the energy industry, especially after the Exxon Valdez and Piper Alpha disasters,the risk management and corporate objective, has been to develop a risk allocation strategy inwhich the project's risks are borne by the party in the best position to control the risk concerned.The rationale of this approach to allocation of risk, is that it will reduce costs and claims andprevent over or under insurance. This risk allocation and management technique is achieved by theuse of contractual clauses of indemnity, limitation, exclusion, insurance and force majeure. Therelevant contracts are drafted so that risk is allocated to one party or the other for matters such aspersonal injury, property loss and damage, public liability, pollution, negligent workmanship andindirect loss or damage. Yet, such a risk allocation strategy may not be appropriate in certaincircumstances and before embarking upon it, the company should know the advantages anddisadvantages of such an approach for each commercial project, measured both by cost andeffectiveness.

Another but different illustration of the importance of identifying and measuring the company'spreferred risk allocation strategy, is the company whose corporate culture is to achieve a high levelof risk tolerance and desired level of control over all or certain classes of supplier/contractor, withan ability to accommodate change and reward performance. In such circumstances, a commercialand contractual relationship along the lines of a strategic alliance or partnering or risk sharing maybe preferable. This will mean contractual indemnities and exclusions of the type described aboveare not appropriate. Conversely, the corporate risk allocation strategy rnay be to transfer risk andimpose responsibility on third parties wherever possible. In between these two extremes, there aremany viable alternatives and the chosen corporate philosophy will clearly dictate the type of riskallocation strategy which should be pursued.

Despite the broad and topical recognition of the benefits of risk management, almost invariably incommercial projects the commercial and contractual aspects are dealt with as a first priority and theinsurance is tailored to the resulting contractual and risk obligations at the latter stages of thenegotiation process. This is clearly an inefficient means of risk allocation. It is also an

(c) "residual" responsibility(1) eg "except to the extent caused or contributed by wilful default or negligence of

Principal";(2) "absolute" responsibility eg liability is accepted irrespective of cause (eg intellectual

property risk).To this list could be added another:

risk retention or as it is sometimes referred to, force majeure. In other words, thenominated risk(s) is treated as being retained by each party, whether as a matter ofcontractual specification and or due to unforeseeable events.

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increasingly expensive means of obtaining insurance, given the disparity in the rating of thedifferent risks for a project and different companies' varying claims records and risk preferences.

The thorough risk evaluation and profiling which needs to be carried out, should be tailored notonly to each company's specific circumstances and risk preferences, but also to the terms of thecontract.

When all of this is done, contractual negotiations can then be initiated in full recognition of thepreferable and most cost efficient allocation of risks and indemnities - both within and outside thecontract. It also means contractual negotiations can be undertaken with a full recognition of thedesirable strategy for risk allocation and accordingly, a fully informed negotiating stance can betaken as to which risk clauses must be preserved or where there is scope for concessions to bemade.

Finally, several recent legal decisions (which are covered below) illustrate that the preparation ofthe most effective and cost efficient risk management matrix not only requires a thorough legalappreciation of the statutory and common law exposures of the project, but also an intimateunderstanding of the extent of insurance cover available and the capacity to transfer risks by thismeans.

In summary, to achieve the most effective and cost efficient risk allocation strategy and solutions, acompany involved in any major commercial project should carry out a comprehensive riskanalysis/profile before embarking upon the negotiation of the project. Such a comprehensive riskanalysis:

• will enable the company to formulate its negotiation strategy to best achieve its commercialobjectives and the optimal treatment of risks within the project's contracts;

• aids effective negotiation and realisation of the company's preferred risk allocation strategy;and

• should mean that the allocation of risk within the contract and by insurance will be done in astrategically coordinated and cost efficient manner.

4. CONTRACTUAL ALLOCATION OF RISK

The risk management approach which is recommended is not just that the negotIatIon ofcommercial projects should proceed on the basis of a comprehensively prepared identification ofrisks, but also analysis of those risks. This analysis must extend to the best means of treating thoserisks. In commercial projects (and transactions) it is crucial that this incorporates a detailedanalysis and determination of which risks can be most effectively and cost efficiently dealt with(and then so recorded in the contractual documentation) by:

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(a) contractual exclusions5;

(b) indemnity clauses6;

(c) limitations of liability, including tiers of responsibility7;

(d) risk retentionS; and

(e) insurance. This reference to insurance includes the alternative risk transfer and financingof risk options now available in the financial services market.

5 In terms of insurance and risk solutions, there is not much to say about exclusion clauses in workscontracts and other commercial contracts, except for the reminder that exclusion clauses are voidpursuant to section 68A Trade Practices Act 1974 ("TPA") if:

(a) the provision applies to goods or services acquired for personal, domestic or householduse; and

(b) the exclusion clause is not "fair and reasonable" as defined in section 68A (2&3) TPA. Formost commercial contracts, this limitation is not relevant. However the authoritiesestablish that a party who has breached section 52 of the TPA cannot subsequently"contract" out of the liability: Petera Pty Ltd v EAJ Pty Ltd (1984) 7FCR 375, at 378;Clark Equipment Australia Ltd v Covcat Pty Ltd (1987) 71 ALR 367, at 371; CollinsMarrickwille Pty Ltd (1987) 72 ALR 601, 79 ALR 83.

6 The use of indemnity clauses as a means to transfer risk is well understood. But the effectiveness ofany indemnity clause will depend on careful drafting so that it operates in relation to risks andcircumstances contemplated by the parties. It has now been decided by the Western Australian FullCourt of the Supreme Court in Australia that, while insurance is another means to transfer risk,contractual indemnities allocate primary responsibility with insurance policies creating secondaryrather than co-ordinate obligations. See Speno Rail Maintenance Australia Pty Ltd v Hamersley IronPty Ltd [2000] WASCA 408, (2001) 111 ANZ Ins Cas 61-485.It is clear from this decision "that the use of the word 'indemnity' does not convert what is anordinary contractual provision into an insurance policy or place the contractual provision on thesame footing as an insurance policy".But, an indemnity by another contracting party and insurance provided by a third party is:(a) theoretically not as effective as an exclusion clause as a risk management mechanism, for

indemnity and insurance clauses permit liability to attach to the insured party;(b) effective to obtain reimbursement of the liability incurred, subject to:

(1) the terms of the indemnity; and(2) the ability (and occasionally, readiness) of the indemnifier/insurer to meet the

loss;(c) effective, notwithstanding statutory provisions to regulate the exclusion of liability.

7 Limitations of liability do not present any general problems in the context of insurance and risktransfer, apart from the fact that if the company does not wish to retain any portion of the risk and itssole treatment of the risk is limitation of liability, then the insurance must be arranged so that it willcover the risk in "excess" of the contractual limitation imposed. .

8 To retain risk (or treat it as a force majeure event) is, as Sir Humphrey Appleby would say from thepopular television programme of Yes Minister, "a courageous decision". What though SirHumphrey Applby would never acknowledge, is that it can also be the most prudent decision, or inthis context, the best means of treating the risk. The company though does need to fully appreciatethe likely frequency, severity and nature of the risk being retained, before such a "brave" decision istaken.

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For ease of reference in examInIng this, let us assume the commercial transaction underconsideration is a major infrastructure project, say the prospective and extensive upgrade of anoffshore oil platform (the "example"). The facts are:

Assume ("A") is the platform operator and engages Worthless ("W") to carry out theworks. A's risk allocation and therefore resulting contractual strategy is that risks shouldbe borne by the party in the best position to control the risk concerned. Accordingly A'sengagement of W is contracted, in part, on the basis that:

• W will indemnify A and hold it harmless for all claims in respect of any damagearising from the negligent act ofW, its employees and contractors;

• W will obtain insurance for its works which will insure Wand A for such potentialliability;

• A enjoys an exclusion of liability for W's negligence; and

• A undertakes the same obligations with respect to its negligence and each policy ofinsurance is to contain a waiver of subrogation.

A, being prudent, also insured the upgrade through its global insurance program.

Typically, in this example, risks have been transferred as best can be done in the negotiations.Then insurance has been negotiated to both cover those risks which could not be transferred and inaddition, wrap around insurance has been arranged as a failsafe to provide umbrella cover in caseone of the other risk treatment options fails. As a result, A has adopted a seemingly prudent riskmanagement strategy by way of a multi layered defence to the risk of the other party's negligence.Namely: (a) the party in the best position to manage the risk has the deterrence of liability for anyfailure to properly do so: (b) the other party (W) is to provide an indemnity; (c) W is to insure therisk; and (d) A has also insured the risk. For the reasons noted below, the practical reality is thatfrequently such an approach is neither an effective nor cost efficient treatment of this risk.

The first and often ignored problem with this conventional approach is the constant tension inarranging contractual clauses dealing with indemnities and insurance. On one hand, both parties tothe contract normally wish to retain as much control as possible over the project, or at least retaincontrol over their company's risks; whilst at the same time, transferring to the other party as muchof the risk as is possible. The compromise, which on occasions can be the most prudent form ofrisk allocation and prevention, is "default responsibility". Default responsibility is where eachparty accepts a responsibility to indemnify the other parties generally and insure itself (and theother parties) for specified risks where the party is in default (which normally means, at fault). Inturn, this approach often leads to 3 consequences (as in the example). Firstly, cross-indemnities,secondly, joint insurance and thirdly (and not intended) greater cost. This is because the indemnityand or insurance clauses:

(a) cut across or undermine a company's contracting strategy; and

(b) provide duplication, unnecessary added cost and or confusion in the indemnity andinsurance provisions.

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It need not be so, for with careful analysis tailored to a particular company's contracting and riskallocation strategy, the indemnity and insurance clauses can be drafted to achieve:

(a) a minimisation of risks and disputes between the contracting parties and their insurers;

(b) the advancement of the company's preferred contracting and risk allocation strategy;

(c) a more cost efficient insurance program; and

(d) the avoidance of the costs of overlapping insurance and worse, the potential argumentsthat the overlapping insurance gives rise to double insurance and therefore pro ratarecovery.

The recent decisions of Caledonia North Sea Ltd v London Bridge Engineering9 and WoodsidePetroleum Development Pty Ltd & Others v H&R - E&W Pty Ltd & Others10 illustrate howconventional commercial practice and understanding (if not assumptions) about the allocation ofrisks in construction, infrastructure, energy, power and mining projects can be misconceived. Thedecision of Elf Enterprise/Caledonia concerned the Piper Alpha disaster and held at first instancethat the recovery action by the operator's insurers (who had indemnified the operator) against thenegligent contractor by way of the indemnity from the contractor to the operator must fail, becausethe insurance principle of contribution applied to all contracts of indemnity (whether by way ofinsurance or commercial contract). This decision was reversed on appeal but uncertainty about itsapplication remained in Australia because the trial judge approved and followed a High Court ofAustralia decision, Albion Insurance Co Ltd v Government Insurance Office of NSW11

, whichsimilarly held that "persons who are under co-ordinate liabilities to make good the loss ... mustshare the burden pro rata".

However, in a recent decision, Speno Rail Maintenance Australia Pty Ltd v Hamersley Iron PtyLtd,12 the Full Court of the Supreme Court of Western Australia found that primary liability for anaccident was determined by the terms of a contract relating to maintenance work on a railway in theState's north-west. Following injury to the employee of a subcontractor, various claims toindemnity under relevant insurance policies as well as the indemnity in the works contract werelitigated. One issue was whether the insurance company, having indemnified the principal inrespect of its liability in negligence was entitled to a contribution from the employer subcontractorrelying on the indemnity in the works contract on the basis that the liability of each was not a co­ordinate liability.

Applying the Scottish Court of Appeal's decision in Elf, Wheeler J found that the contractualindemnity was intended to "allocate primary responsibility with the insurance policy creating asecondary rather than a co-ordinate obligation".

As a result, it is now clear that in Western Australia, at least contrary to the trial judge's decision inElf, "the use of the word 'indemnity' does not convert what is an ordinary contractual provision

9 [2000] 1 Lloyds Rep 249 (currently on appeal to the House of Lords).10 (1999) 20 WAR 380.11 (1969) 121 CLR 342.12 [2000] WASCA 408, (2001) 11 ANZ Ins Cas 61-485.

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into an insurance policy or place the contractual provision on the same footing as an insurancepolicy".

The recent Woodside decision held that project sub-contractors who were included in theprincipal's project insurance were entitled to rely on all of the terms of the contract of insurance,which included the insurer's waiver of rights of subrogation and recovery against the principal.This was so, even if it could be said that the sub-contractors were third parties to the contract ofinsurance. This decision, like the first instance decision of Elf, exemplified how the terms of thepolicy of insurance can affect the rights of recovery and indemnity for parties to major design andconstruction projects. The negotiation of both, therefore, needs to be carefully coordinated toachieve the best risk allocation and outcome.

To illustrate this by reference to the example, the reality is that the risk of W's negligence has beenpaid for by A threefold. W's risk of negligence is built into W's contract price. The obligation thatW provide an indemnity to A and insure this risk is also no doubt built into the price to be paid byA. Finally, A has also insured this risk in its wrap around cover and this risk is no doubt reflectedin the premium paid by A. Yet, the consequence of this cost is not three times better cover anddefence for this risk, but rather the opposite because:

(a) as between W's indemnity and W's insurance, it may be held that there are "co-ordinateindemnities" and therefore the double insurance principles may apply, even though oneindemnity arises under the contract and the other under a policy of insurance; and

(b) there is double insurance between the cover arranged by A and W.

To pick up this last point, often out of an abundance of caution (or carelessness), the parties arrangeinsurance which overlaps. (This regularly occurs between a principal and its contractors.) Theresult is not just duplication of insurance cover and payment of premium (which can be expensive)but can lead to double insurance. This means that if the same risk for the same interest in the sameproperty is insured with 2 insurers, each insurer will only be liable for its rateable proportion of theloss (though the insured party can recover in full from either).13 Potentially even worse, anydispute amongst the insurers about this could lead to delay in the payment of the claim.

The next pitfall in relation to contractual risk management and insurance, is that the risk allocationstrategy in the contract is usually reflected by subjective words. For taking the conventionalnegotiating strategy,. if a party only accepts liability where its "employees" are negligent, it will becommon for there to be a dispute as to whose employees were negligent and which employee'snegligence caused the accident/loss (referred to as "demarcation" disputes). So in the example, ifW was negligent, then W is liable, its insurance must respond and failing that, it must indemnify A.However, whether the damage (say a fire which destroyed the platform) arose through W'snegligence can be uncertain, both factually and legally. If the loss arose through the negligence ofA's employee or a combination of the acts of A's and W's employees, can be even more uncertain.The resolution of this uncertainty can considerably delay payment and completion of the contract.Depending on the circumstances, the parties may have the will to resolve this demarcation disputequickly amongst themselves, so the project can proceed. However, if this determination will affectwhich insurer has to pay (and it often will) then resolution of this issue and payment rests with the

13 Commercial Union Assurance Co v Hayden [1977] 1 Lloyd's Rep 1.

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insurers, whose principal interest is not the completion of the project, but minimising the insurer'sfinancial exposure to the loss.

The solution is again a comprehensive risk identification and analysis of the most effectiveinsurance and risk solutions. For contrary to popular belief, a cross liability clause will not avoidthis demarcation dispute. A cross liability clause is a good. idea, for it means that the parties (and ortheir insurers) cannot seek indemnity from the other party, with all the additional costs, delay andacrimony this can prompt. 14 However, the issue in such demarcation disputes is not whether thereshould be recovery against another party to the contract, but rather which party is in default and asa result, which party (and or its insurer) is obliged to meet the loss.

The best solution is to ensure that the clause/phrase/test which triggers the allocation ofresponsibility, is as clear as it can be. There are various drafting mechanisms to achieve this.Another solution is to include alternative dispute resolution ("ADR") clauses in the contract. SuchADR clauses (if drafted properly) will enable the parties to quickly and confidentially resolve suchdemarcation disputes. If possible, the ADR clauses should also apply to the insurers.

Similarly, a waiver of subrogation clause15 is a good idea, if the parties to the contract wish toavoid the insurer of any of the parties instituting cross-claims after it has indelnnified its insuredparty for a loss. This can occur because after the insurer has indemnified the party for its loss (sayparty W) it will usually seek by way of its right of subrogation to be put in the place of Wand takeadvantage of any means available to W (say a claim against A) to extinguish or diminish the lossfor which the insurer has paid out to W. A waiver of subrogation clause in the contract applicableto each party (and ideally inserted in each of the relevant contracts of insurance) will waive thisright and thereby avoid the insurers seeking to institute cross-claims pursuant to their usual right ofsubrogation.

In fact, a waiver of subrogation clause, broadly drafted may have unintended consequences asillustrated by the decision in the Full Court of the Supreme Court of Queensland in GPS Power PtyLtd v Gardiner Willis & Associates Pty Ltd. 16 There a payment was made by the insurer after abreach of professional duty by a consultant who was insured against other risks under the policy.The consultant was not in fact insured for the risk, the occurrence of which caused the loss. Thequestion for the Court was whether the waiver of subrogation clause in the policy operated toprevent the insurer suing the consultant in respect of that loss.

14 An example of a cross liability clause is: "Each party comprising the Insured shall be considered as aseparate and distinct insured party and the words the "Insured" shall be construed as applying toeach insured party as if a separate policy had been issued to each of them. The Insured and theInsurer waives all rights, remedies or relief to which the Insured may become entitled (including bysubrogation) against any of the Insured in respect of any claim".

15 An example of a subrogation clause and a waiver of the insurer's rights of subrogation is: "If theInsurers make any payment under this Policy in respect of a Claim it shall be subrogated to all rightsand remedies of the Insured and the Insurers shall be entitled to bring any action in the name of theInsured (who shall provide all reasonable assistance and co-operation to the Insurers) and theInsurers shall be entitled to money received pursuant to these rights, subject to the InsuranceContracts Act 1984 (Cwth.). However, the Insurer waives all rights of Subrogation against theNamed Insureds.".

16 [2000] QCA 435, (2002) 11 ANZ Ins Cas 61-482.

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A majority of the Court interpreted the subrogation clause broadly, in its literal terms, saying that itcould have easily been limited to exclude certain "insureds" from the benefit of its operation. Thosejudges concluded that the expression "the insured" in the waiver clause could not be interpreted toapply only to insured who were covered expressly for the risk, the occurrence of which caused theloss which gave rise to the right of subrogation. Without express words of exclusion or limitation,the waiver of subrogation clause applied to all insureds and therefore to all losses within the termsof the policy.

In summary, in order to achieve the most effective contractual allocation of risk and insurancesolutions:

• the treatment of risks by contractual allocation cannot proceed in a vacuum. It needs to becarefully coordinated with the transfer of risks by insurance, so they are consistent andcomplementary;

• there needs to be a recognition that the terms of the contracts between the parties can affect therecovery available under insurance (as exemplified by the initial outcome in Elf and dicta inAlbion's case17

) and similarly, the ambit of the insurance provided can affect the partiescontractual rights (as exemplified in the Woodside decision);

• the most effective and cost efficient allocation of risks amongst the contracting parties is notguaranteed by the contemporary risk allocation approach reflected in indemnity, exclusion andmandatory insurance clauses. Rather it will be delivered not just by reference to each party'sindividual risk preferences, but also by the parties exploring how it can be best deliveredcollectively. For often, differences in the parties' interests, risk preferences and aversions,coupled with their differing capacities to retain and insure risk, all combine to create theopportunity to develop a specifically tailored contractual allocation of risk for the parties farmore effective and cost efficient than that delivered by the standard assumptions and contractprecedents; and

17 The first instance decision of Elf was decided partly on the basis of dicta in two High Court ofAustralia decisions: Albion Insurance Company Ltd v. Government Insurance Office of New SouthWales (1969) 121 CLR 342 and The Sydney Turf Club v. Crowley (1970) 126 CLR 420. In Albion,Kitto J. refe~ed to the fact that the principle of subrogation was "a principle applicable at law noless than in equity" and that "persons who under coordinate liabilities to make good the one loss(sureties liable to make good a failure to pay the one debt) must share the burden pro rata." - 41, 42.In Crowley, Barwick CJ talked about the "well established principle that in a case where there are 2promises of indemnity in respect of the same liability the promisee can only recover once and nottwice. Being paid pursuant to one such promise, he cannot recover on the other." On appeal in Elf,Lord Sutherland p.424. makes the point, quite correctly, that these decisions are not in point. Theratio of both Australian cases concerned double insurance. As such, neither case had to consider theissue of an indemnity pursuant to a contract of insurance and the second coordinate indemnityarising through a different specie of commercial contract. The dicta though of Kitto J does give riseto the impression that the same principle applied to indemnities, whether they are found in a contractof insurance or a commercial contract. There is also the issue of whether a contract of insuranceconstitutes a different specie of contract and as such, different rules apply to contracts of insurance.It is also noticeable that the learned authors of Equity: Doctrines and Remedies (3rd ed., 1992) at[1006] adopted the reasoning of Kitto J and observed that the "list of co-ordinate indemnitiesattracting contribution is no more closed than the categories of negligence."

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• the trigger for the contract's risk allocation provisions needs to be carefully drafted so as tominimise costly demarcation disputes (both in terms of cost and delay) between the contractingparties and or their insurers.

5. INSURANCE

Although there are various options by which companies can treat risk, commercially insuranceremains one of the principal means by which companies treat risk (by transferring the risk to a thirdparty) especially in a major project. Yet it never ceases to amaze how often the consideration andnegotiation of the parties' obligations to arrange insurance and the contractual clauses relating tothat, are left to last. As a result, the parties' obligations to insure are often negotiated in a fashionwhich is neither effective nor cost efficient.

The principal mistakes in relation to insurance for commercial projects are:

(a) the consideration and negotiation of the clauses of the contract and insurance are notcoordinated to jointly produce the most cost efficient and effective transfer of risk,especially given the company's risk allocation priorities and preferences;

(b) the allocation of obligations to insure is done in such a manner that it cuts across orundermines a company's contracting strategy;

(c) similarly, the allocation of obligations to insure amongst the parties create duplication ofinsurance, unnecessary added cost and or confusion in the indemnity and insuranceprovisions;

(d) the manner in which risks are allocated to insurance and the dependence on insurance topick up the risks which neither party is prepared to retain and or unable to manage; and

(e) the assumption that insurance will cover the balance of risks not otherwise dealt with.

The first three of these common errors have already been considered above.

Dependence on & assumptions about insurance

Turning to the last two, practically insurance should be the treatment option of last resort for risks,not the option of first choice. This is because a risk management approach which seeks to avoid orcontrol a risk is clearly far more preferable to a strategy which, in effect, accepts the risk and seeksto transfer it off the balance sheet. There are various reasons for this.

A risk which is avoided or controlled means an avoided or reduced risk to life, limb and profits.Even risk retention is to be preferred, for the company has a clear incentive to do everything tominimise the risk. With insurance, this incentive is largely removed. Worse, if the risk eventuates,the consequences of the risk will befall the company. In other words, the liability will be in thecompany's name and at the company's cost, say the negligence of W's employee for W in theearlier example. W's risk treatment strategy, in effect, is dependent on 2 factors outside of itscontrol. First, the expectation that a third party (the insurer) will meet the claim and second, theexpectation that the loss will fall within the terms of the policy of insurance.

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It is beyond the scope of this paper to comment upon the commercial considerations and pressuresfor insurers in determining whether to meet an insurance claim. Suffice to say that economicconditions, the insurer's own financial performance and corporate philosophy (plus facts relating tothe insurance claim) may mean that a claim, especially a large claim, might not be met by aninsurer. IS The result is that the insured company has to prove (usually in court) that the claim fallswithin the terms of the contract of insurance. The consequences of putting the insured to proof isthat the payment of the claim may be reduced (through settlement of the litigation or decision of thecourt) and in any event, the payment of the insured risk has been significantly delayed while theindemnity issue is resolved.

As noted, all too often the parties to a commercial project will focus their negotiations on theclauses which evidence "the deal" and relate to the principal risk allocation strategy. Then,following this, insurance clauses are negotiated which are intended to pick up the balance of risks.This hopeful approach to insurance is fraught with problems.

What the parties mean in the contract by, say "property all risk insurance" and or "general liabilityinsurance" and what is available in the insurance market might differ quite markedly. Theassumption that insurance can be arranged which will match the contractual obligations is often nottested at the time of the negotiations. Even worse, all too often the discovery that certain risks havenot been insured, will only emerge much later and when it is too late.

Similarly, parties talk about types of insurance cover, such as "professional indemnity", "industrialspecial risks" to name but a few, as if such insurance policies were a standard product. They arenot. Policies of insurance are no different to any other contract, they can be as broad or narrow asthe parties agree upon. Therefore, the parties may refer to "professional indemnity insurance" witha common perception, but the policy of insurance which is subsequently arranged may: onlyprovide cover for specific nominated professions - rather than all professionals who may becomeinvolved in the project; only apply to one party's professionals - rather than any professionalinvolved in the project; be limited to a nominal amount; include exclusions which are both broadand long; and or be insured by a company which has a poor credit and or claims payment record.

What is required (again) is that the company:

• has carried out a careful risk management matrix which extends to insurance;

• conducts the negotiation of the obligations relating to insurance with a full appreciation ofwhich risks are best treated by insurance and how; and

• with the benefit of the risk management matrix, can instruct its insurance broker and lawyerbefore finalisation of the contract, to review both the scope of insurance available in the marketand precise terms of insurance cover provided by the chosen insurer, to ensure there is no gap

18 This is not intended to be a derogatory reference to insurers. As public companies with obligationsto their shareholders (as well as consumers) insurers are no different to other companies which seekwithin the constraints of the law to minimise their liabilities. As Wen Ts' ai Lim in the 1999 paper"Using Insurance to Manage Project Risks" delivered to the WA AMPLA conference observed atpage 3, the Woodside case illustrates "that insurers will contest the issue of whether a particularcontractor was an insured if there is an arguable case."

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(or at least no unknown gap) between the terms of the insurance policy(s) and the risksallocated to insurance.

The same lesson applies even more forcibly to the next two problems arising out of the "hopefulapproach" to insurance. If the obligations to insure have been allocated in the negotiations in thebelief that insurance will pick up the balance of the risks of the project (as sometimes occurs) thenthere is the real prospect that the project has risks which have not been identified and which theinsurance is intended to cover. Yet, if the risks have not been identified, there is then the strongprospect that the company's insurance broker will not know which risks have to be insured. Thelikely consequence is that the resulting insurance program will be inadequate. Even if the policy ofinsurance happens to pick up the unrecognised risk, there is then the possibility that the insurer willdeny indemnity on the basis that the policy of insurance was not negotiated to cover such a risk andor that there was inadequate disclosure of the risk, thus entitling the insurer to deny indemnity if thenon-disclosure was material.

The last problem is the misconception as to what specific terms in an insurance policy mean.Despite the advent of plain English, many of the wordings of policies of insurance are ambiguousand or confusing. This may be the product of poor draftsmanship, but often it is due to the fact thatthe wording of policies of insurance and the legal interpretation of such clauses have beendeveloping since the 17th century. Therefore various insurance phrases and words have wellestablished legal meanings and as a result have been retained, although their meaning on the test ofcontemporary speech is either unintelligible or perverse, but for well established precedent andpractice. Examples19 of some of the more important and potentially confusing insuranceexpressions and concepts are:

(a) "physical loss or damage" - If the risk insured against is "physical loss or physicaldamage", then generally the insuring clause used with this formula will exclude pureeconomic loss from cover. It can also have other consequences. For example in Transfieldv GIO,2o it was held that blockage in some pipes in a grain silo, even though rendering thesilo physically unusable, did not constitute physical damage;

(b) "defective part and defective design" - Traditionally, machinery insurance does not insurea defective part, only the damage to other parts of the machine caused by the part. Bycontrast, contract works policies will usually provide express cover for the cost ofreplacing or repairing a defective part. However, what precisely is covered remainsunclear. In Jackson v Mumjord,21 the insured did not recover, because it was held that theconnecting rod was not defective, merely under designed. In other words, it was aperfectly good rod - just not adequate for the task the designer intended it to perform.Conversely in the "Carribean Sea" [1980] 1 Lloyds LR 338, the insured recovered on thebasis that there was a defect in material, although resulting from a defect in design. Thepractical lesson is that it is necessary to examine the actual policy wording carefully to seewhether this problem arises: some modern wordings provide explicit cover for lossesresulting from defective design.22

19 Some of these examples and comments are drawn from Wen Ts'ai Lim, "Using Insurance toManage Project Risks", a paper delivered to the 1999 WA AMPLA conference.

20 (1997) 9 ANZ Ins Cas 61-377.21 [1902] 8 Comm Cas 61.22 David Sharp, Offshore Oil and Gas Insurance at 152.

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(C) "sue and labour clause" - this clause is common in contracts works policies of insuranceand owes its origins to a marine insurance concept. The clause is intended and designed toencourage an insured to take steps to avert or minimise an impending loss by providingcover in respect of the costs of doing so. In Integrated Container Service Inc v BritishTraders Insurance Company Ltd,23 Everleigh LJ put the point thus:

"I therefore think that the sue and labour clause entitles the assured to recover thecosts of such measures as were reasonably taken for the purpose of averting orminimising a loss when there is a risk that insurers might have to bear that loss. Ido not think that it is open to insurers by searching enquiries and detailedanalysis to assert that as a matter of ultimate truth they would never have beenliable".

However, precisely what averting or minimising acts are covered (ie. mitigation) canprove to be complex;24

(d) "liability cover" - different parties understand the scope of such cover quite differently.This is not surprising, especially given that even in the same policy of insurance, the levelof cover provided to the parties may differ;25

(e) "cross-liabilities clause" - this has been previously considered. It was introduced because,notwithstanding the formal allocation of liability under the construction contract, manycontractors were not prepared to undertake risk of liability, particularly with larger andmore expensive projects;

(f) "waiver of subrogation" - as noted, if an insurer indemnifies an insured, it then stands inthe position of the insured and can exercise any rights of recovery enjoyed by the insured.In order to avoid the insurer of one party to a project suing another party to the projectpursuant to the insurer's rights of subrogation, the parties normally (and prudently) inserta waiver of subrogation clause;26 and

23 (1984) 1 Lloyds LR 155.24 For example, The Nuilia [1996] Lloyd's LR 85 concerned an oil platform which was in danger of

sinking because of cracks in its steel legs. The Court held that the costs of jacking up the legs andanchoring the platform were recoverable, but the costs of towing the platform to Singapore to repairthe cracks were not.

25 As mentioned above, section 2 of the policy usually provides cover against liability, usually to thirdparties, arising out of the project. For instance, contract works policies are commonly structured sothat the liability coverage is "primary" for Principal Assureds and "excess" for Other Assureds. Inother worlds, the contractor will have to claim against and exhaust its own insurance cover firstbefore it can have recourse to the contract works policy. However, such a provision is often void inAustralia, by reason of section 45 of the Insurance Contracts Act 1984 (Cth).

26 In Co-Operative Bulk Handling Ltd v Jennings Industries Ltd (1997) 9 ANZ Ins Cas 61-355 it washeld that an insurer has no right of subrogation against another insured on the ordinary principles ofcircuity of action. In Woodside Petroleum Development Pty Ltd & Others v H&R - E&W Pty Ltd &Others (1999) 20 WAR 380 the Full Court of the Supreme Court of WA held that waiver clausesaffect rights of subrogation "as it were, at birth."

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(g) privity of contract - at common law, usually the only persons who can sue upon and enjoythe terms of a contract are the parties to a contract. Contracts of insurance are anexception to this, whereby a beneficiary under a contract of insurance can sue to enforceits terms,27 whether it is for property or liability insurance.28 It is this scope for personswho are not parties to the contract of insurance to seek to enforce it and/or exploitdifferences in the conflicting obligations imposed by the policy of insurance and otherrelevant contracts which have given rise to some of the recent and complex insurancedisputes.29

6. CONCLUSION

Insurance remains one of the principal means for parties to treat risks in commercial projects. Inthis, nothing much has changed since World War 2. Insurance's prominent role in the treatment ofsuch risks is well deserved, for frequently and despite all the contemporary focus on riskmanagement, insurance continues to be the most effective and or cost efficient rr:eans to removemany risks from a company's balance sheet.

Yet, despite insurance's prominent role in the treatment of risk and its potential importance andcost to a project's feasibility, all too often the contracting practices of companies is poor in relationto insurance. For all too often, the negotiation and arrangement of insurance is dealt with as thelast mopping up exercise of the project's negotiations. As a result, the insurance which is agreedupon and arranged, is not tailored to the project's and the parties' particular requirements, with theconsequence that it often does not produce an optimal outcome.

Equally dangerous, is the underlying and hopeful assumption about insurance's capacity to absorbthe allocated risks. The law reports are replete with examples of occasions where companies'contractual intent and/or expectations of the treatment of risk by insurance has proven, for thereasons outlined above, to be misconceived.30 The second dangerous assumption about insurance'scapacity to absorb the risk, is that although insurance is a contract with a third party, the transfer ofrisk by insurance will not be bedevilled by the vagaries which beset other commercial contracts andarrangements. For example, the risks that: the terms of the contract do not reflect the intent orunderstanding of one of the parties; and or the terms of the policy of insurance are ambiguous,silent and or misunderstood; the other party does not perform as was anticipated; and or externalcircumstances or parties adversely affect the performance of the contract. Such hopefulassumptions are not valid for insurance, any more than they are for other commercial contracts.

The consequence of such an approach is that at the time of the negotiation of the commercialproject, the insurance arrangements provide great comfort to the parties, in the belief that certainrisks have been transferred to a third party and can now be forgotten. Unless the allocation of risksto insurance is carried out in a thorough and carefully coordinated manner as part of the project'srisk management matrix, the parties:

27 Trident General Insurance Co v McNiece Bros Pty Ltd (1987) 165 CLR 107.28 Co-Operative Bulk Handling Ltd v Jennings Industries Ltd (1997) 9 ANZ Ins Cas 61-355.29 Some recent examples are Co-Operative Bulk Handling Ltd ibid, Woodside Petroleum Development

Pty Ltd & Others v H&R supra note 22 and Elf Enterprise/Caledonia supra note 9.30 Some examples of this are provided in Annexure A.

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• might never discover the extent to which insurance could have provided a more efficient andcost effective solution; but

• are always at risk of discovering one, two or even five years later in the event of a majoraccident or claim, how ill-founded their hopeful approach to insurance has been.

Such a discovery will not be new. For this has been the unfortunate fate of insured parties for thelast 300 years in which insurance has been provided as a solution to risk. Yet, if the risks andscope of insurance to treat those risks is thoroughly considered at an early stage, this need not bethe result.

Annexure A • Some judicial illustrations of insurance and risk issues

1. Antico v Heath Fielding Australia Ltd (1997) 188 eLR 652

Sir Tristan Antico took out a Directors and Officers Legal Expenses policy of insurance for legalexpenses incurred as a director. Subsequently Sir Tristan Antico sought indemnity for over $1million of legal expenses incurred in the defence of proceedings brought against him arising fromalleged misconduct as a company director. The insurer denied indemnity. On appeal to the NSWCourt of Appeal, it was held that the insurer had validly denied indemnity because Sir Antico hadfailed to comply with the conditions of the policy of insurance regarding prior consent of theinsurer to incur legal costs. On appeal to the High Court of Australia, it was held that Sir Antico'sbroker had been negligent in failing to advise Sir Antico of his obligations and this omission toobtain consent fell within the meaning of section 54 of The Insurance Contracts Act 1984.

2. GIO General Ltd v Newcastle City Council (1996) 134 ALR 605

The Newcastle City Council's public liability, product liability and professional indemnity policyof insurance was extended to "the rendering or failure to render professional advice." Followingthe 1989 Newcastle earthquake, it was alleged that many buildings were structurally unsound, buthad been negligently issued with a "Certificate of Structural Soundness" by the Council. TheCouncil sought indemnity for these claims pursuant to its policy of insurance, but indemnity wasdenied. At first instance the insurer's refusal to indemnify was upheld, on the grounds that therelevant activities of the Council consisted of carrying out statutory duties, rather than the provisionof professional advice. On appeal, it was held that the policy of insurance responded because theword "professional". involved no more than advice and services of a skilful character according toan established discipline, which the Council officers had provided.

3. Caledonia Ltd v Orbital Valve [1993] 2 Lloyd's Rep 418

This case arose out of the Piper Alpha disaster in 1998 when the oil platform and many lives werelost through a fire. The plaintiffs were the joint owners and the operators and occupiers of theplatform. The plaintiffs admitted the cause of the fire was the negligence of one of their servantsand paid out the deceaseds' estate and dependents. The plaintiffs then sought to be indemnifiedpursuant to a contract service order with the defendants. The crucial issues at trial includedwhether the plaintiffs' right to indemnity should be construed as extending to include thenegligence of the plaintiffs and their servants. Hobhouse J. held that there were establishedprinciples for the construction of contracts and amongst those was that "in the absence of clearwords the parties to a contract are not to be taken to have intended that an exemption or indemnity

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clause should apply to the consequences of a party's negligence." at p. 426. Another principle wasthat "the parties to commercial contracts must be taken to know what those principles are and tohave drafted their contract taking them into account." at p.426. In this context, it is important toalso note the Judge's observations at page 424:

"But it also has to be borne in mind that commercial contracts are drafted by parties withaccess to legal advice and in the context of established legal principles as reflected in thedecisions of the Courts. Principles of certainty, and indeed justice, require that contracts beconstrued in accordance with the established principles. The parties are always able by thechoice of appropriate language to draft their contract so as to produce a different legal effect.The choice is theirs. In the present case there would have been no problem in drafting thecontract so as to produce the result for which the plaintiffs have contended; however thecontract was not so drafted and contains only general wording and is seriously lacking inclarity."

It should be noted that these criticisms of the drafting of a contractual indemnity clause which didnot reflect the intent of the parties, was made in relation to a contract for services which cameunder scrutiny in relation to a disaster involving a loss of 130 million pounds, 146 legal actions andmany fatalities and injuries.

4. Co-Operative Bulk Handling Ltd v Jennings Industries Ltd (1995) 8 ANZ Ins Cas. 61­286

Co-Operative Bulk Handling Ltd ("CBH") had entered into a construction contract with Olympus.CBH insured itself and sub-contractors for their respective rights and interests in the contractworks. Jennings was one of the sub-contractors and believed this insurance covered it. One ofJenning's employee's through negligence caused an accident. CBH was indemnified by the insurerfor its loss. The insurer then sought to recover this loss by way of a subrogated action againstJennings. Jennings contended that the insurer couldn't recover against it, because Jennings wasalso an insured under the policy of insurance and secondly, because of a waiver of subrogationclause. Jennings succeeded both at first instance and on appeal. In this context, the real interestand importance of the decision is not so much the finding that the insurer could not bring arecovery action in the name of one insured against another insured due to the principle of circuityof action; but rather the comments, affirmed on appeal, about the commercial efficacy of a singlepolicy of insurance:

"Lloyd J in Petrofina (UK) Ltd & Ors v Magnaload Ltd & Anor [1984] 1 QB 127 at 136stated: "...there can be no doubt about the convenience from everybody's point of view,including, I would think, insurers, of allowing the head contractor to take out a singlepolicy covering the whole risk, that is to say covering all contractors and sub-contractorsin respect of loss of or damage to the entire contract works. Otherwise each sub­contractor would be compelled to take out his own separate policy. This would mean, atthe very least, extra paperwork; at worst it could lead to overlapping claims and cross­claims in the event of an accident. Furthermore, as Mr Wignall pointed out in the course of

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his evidence, the cost of insuring his liability might, in the case of a small sub-contractor,be uneconomic. The premium might be out of all proportion to the value of the sub­contract.",,31

31 This decision and dicta was affirmed on appeal - (1997) 9 ANZ Ins Cas 61-355 at 76,932 perFranklyn J Similarly, the fact that such an approach "recognises the realities of industrial life" wasnoted both at first instance and by the Full Court of the Supreme Court of WA in WoodsidePetroleum Development Pty Ltd & Drs v E&W Pty Ltd & Drs (1998) 10 ANZ Ins Cas 61-430 at74,853 [(1999) 20 WAR 380].