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  • Writer's pictureThomas O'Leary

Common Contractual Risk Allocation Provisions – Covenants to Insure

By: Thomas O'Leary and Laura J. McPhee


As we’ve described in previous blog posts, a covenant is a contractual promise to do something in the future. Covenants to insure hold significant legal and practical implications in contractual arrangements. In many commercial agreements, parties agree that one or both parties are to obtain and maintain specific levels of insurance coverage against particular risks. The precise impact of such a covenant on the allocation of risks is often overlooked until some unforeseen event takes place, bringing questions of liability and coverage to the fore.


Purpose and Function of Covenants to Insure

The purpose of a covenant to insure is to safeguard the interests of the contracting parties in the subject matter of the contract and its performance. The insurance coverage obtained under such covenant helps to ensure that the responsible party has the financial capacity to satisfy contractual obligations and liabilities.


Much of the law on the impacts of covenants to insure has been developed in the context of construction contracts and commercial leases. In leases, a covenant often requires the landlord to insure against damage to the leased premises and equipment (premiums often charged back pro rata to the tenant), and a covenant requiring tenants to insure their property within and associated with the leased premises. In the construction context, a covenant often requires the general contractor to obtain general liability insurance and broad form property insurance jointly in the names of the contractor, owner, and consultant for the direction of the project, with subcontractors also included as insured parties. Covenants to insure are common in other commercial contexts as well. Regardless of context these covenants share purposes and impacts.


Legal Framework and Challenges of Covenants to Insure

The legal framework regarding covenants to insure in commercial leases was established through a trilogy of Supreme Court of Canada decisions in the 1970’s.[1] Numerous intervening cases have applied and refined these principles to a variety of circumstances.[2] The key principles regarding covenants to insure and how they can operate as a tool of contractual risk allocation include:


  1. Covenants to insure are to the benefit of the recipient, who is entitled to the benefit of insurance coverage obtained pursuant to such a covenant.

  2. A contractual undertaking by the one party to secure insurance operates in effect as an assumption by that party of the risk of loss or damage caused by the peril to be insured against – the covenant itself thus acts as a form of indemnity.

  3. The assumption of risk is limited to the insurance coverage required by the covenant – the monetary limits and scope of the insurance coverage required under the covenant are therefore critical.

  4. The assumption of risk is not negated by a failure to procure covenanted coverage[3], though this creates obvious recovery risks for the beneficiary.

  5. The assumption of risk operates regardless of whether or not premium costs are passed through to the beneficiary.

  6. A covenant to insure is not interpreted as an exculpatory provision since its exempting effect derives from the parties intending the insurance for their mutual benefit.[4]


While the courts have held that covenants to insure will relieve the beneficiary of the covenant from liability caused by negligence, whether a covenant to insure could extend to a loss intentionally caused by the beneficiary of the covenant is an unresolved question.


Covenants to insure are also used as a means of strengthening other indemnification obligations, being crafted to ensure that parties have the financial means via insurance coverage to fulfill those obligations.


Legal disputes involving covenants to insure often focus on the interpretation of the specific contractual wording used in the covenant rather than the governing legal principles. The covenant to insure will be interpreted according to the same principles as other contractual provisions – the plain, ordinary, popular, natural, or literal meaning of the words, read in light of the entire agreement and its surrounding circumstances, will govern. The surrounding circumstances, the object of the contract itself, and other contractual provisions requiring indemnity disclaiming a transfer of risk for party negligence, and extending warranties may have significant impacts on the allocation of risk provided under covenants to insure.[5] As covenants to insure are not considered to be exculpatory in nature, they are not subject to narrow reading based on the presumption against excluding contractual rights without clear language.[6]


Critical Considerations in Covenants to Insure

Important aspects of a covenant to insure, which are critical to consider and assess, include:

a. The subject matter of the insurance;

b. The perils to be insured against;

c. Required monetary coverage limits;

d. Whether counterparties should have a right to verify that covenanted coverage has been obtained;

e. Whether other parties be identified (as named or unnamed insureds) as additional insureds under the Policy;

f. The existence of potentially conflicting contractual provisions (eg. beneficiary covenants, warranties, indemnities, exclusions/limitations of liability) and how these coexist;

g. The availability of the specified coverage on the market;

h. Risks that insurers may increase premiums or deny coverage requests altogether during the course of the contract; and

i. The practical consequences of a failure to obtain coverage under the covenant, including the ability of the covenantor to satisfy losses or liabilities that it was to insure.


Conclusion

In summary, in conjunction with indemnity clauses and other risk allocation tools, covenants to insure are an important aspect of many commercial agreements for allocating risks and protecting the interests of contracting parties. Negotiating and applying covenants to insure can be complex and bring into consideration a myriad of difficult to assess factors. These include the risks to be assumed by the covenantor, and how the covenant to insure will interact coherently with other aspects of the contract. The wording of the covenant to insure, in the context of the remainder of the contract, is of the utmost importance.


Understanding the legal principles and practical implications surrounding these covenants is essential for parties entering into such agreements, ensuring that they adequately protect their interests and fulfill their contractual obligations.

 

 

 

 

 

 


[1] Agnew-Surpass v. Cummer-Yonge, [1976] 2 S.C.R. 221; Ross Southward Tire v. Pyrotech Products, [1976] 2 S.C.R. 35; and T. Eaton Co. v. Smith et al., [1978] 2 S.C.R. 749.

[2] See for example Royal Host GP Inc. v. 1842259 Ontario Ltd. (“Royal Host”), 2018 ONCA 467; Greenwood Shopping Plaza Ltd. v. Neil J. Buchanan Ltd. (1980), [1980] 2 S.C.R. 228 (S.C.C.).

[3] Active Fire Protection 2000 Ltd. v. B.W.K. Construction Co. (2005), 45 C.L.R. (3d) 278 (Ont. C.A.).

[4] Smith v. T. Eaton Co. (1977), 1977 CarswellOnt 491 (S.C.C.)].

[5] See, for example, Royal Host (Note 2) where any exclusion of liability for negligence influenced the impact of an insured covenant.

[6] Photo Production Ltd. v. Securicor Transport Ltd. (1980), [1980] A.C. 827 (U.K. H.L.); Syncrude Canada Ltd. v. Hunter Engineering Co., [1989] 1 S.C.R. 426.

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