The difference between limit of indemnity and limit of liability is puzzling. Let’s unpack the complexities using this simple scenario.
ABC Pty Ltd entered into a contract with XYZ Pty Ltd. ABC is the client who have engaged XYZ for architectural services. XYZ have a $2 million limit of indemnity on their professional indemnity policy. The contract contains a limit of liability clause which states that XYZ has a limit of liability of equivalent to their fee of $1 million. Let’s assume in this case that XYZ has been negligent and that their negligence is the sole cause of the ABC’s loss. ABC then sue XYZ for damages of $2 million. In this scenario, XYZ will only be liable for $1 million, because the limit of liability clause in the contract stated that their liability will be limited to $1 million. This is also known as a “cap” on their liability i.e. XYZ’s liability is capped at $1 million. So XYZ will make a claim to their insurer, pay their excess and the insurer will pay ABC the remainder of the $1 million for which XYZ is liable.
In the same scenario, presume that ABC sued XYZ for $3 million in damages and there was no limitation of liability clause in the contract. This means that XYZ’s liability is unlimited. As the limit of indemnity on their policy is $2 million, this is the maximum amount their insurer will pay out. So, XYZ will be liable for the remaining $1 million.
Limit of Indemnity
Limit of indemnity is the maximum amount your insurer will pay out for any single claim. Let’s think about a few commonly asked questions about limit of indemnities.
Why do insurance policies contain a limit of indemnity?
If your insurer does not add a limit to how much they can indemnify you, they could be held liable for unlimited amounts. A limit of indemnity allows insurers to quantify their maximum exposure by pricing the risk they are undertaking and to gauge their potential risk exposures.
How much is a sufficient limit of indemnity?
Just like limitation of liability amounts, only you and your practice can determine your limit of indemnity. You will consider the following amongst other factors:
• size and complexity of projects you work on,
• type of projects i.e. risk exposure,
• risk level, and
• any statutory requirements.
You need to consider carefully whether the limit of indemnity you are setting will be sufficient to meet claims that may be made against you during the currency of your policy. You should also consider this same question when you are renewing your professional indemnity policy each year.
Limitation of liability
Although there is no requirement for a limitation of liability clause in a contract, it is very commonly found in most consultancy agreements. It is important to understand at the outset that your liability at law in unlimited. Only your practice can decide what sort of limitations you should use. Some factors to consider when setting the limitation of liability are:
• fee for the project;
• level of risk attached to the services and
• amount of your insurance.
The above scenario demonstrates the benefit of setting a limit of liability in your contract. Although there is no requirement to include or accept a limitation of liability clause in a contract, if you are faced with a requirement to include such a clause, most consultants prefer to set a limit that is the same as or lower than the limit of indemnity under your professional indemnity policy. Consultants should be very cautious about allowing sub-consultants to include limitation of liability clauses in their contracts. Here’s why…
Sub-consultants and Limitation of Liability
If you engage a sub-consultant and their contract states that their liability is limited to $100,000, and later down the line because of their errors you are faced with a claim of $1 million, you will be liable to pay the $1 million and you will only be able to recover $100,000 from the sub-consultant as their liability has been limited to that amount. You are likely to be uninsured for the $900,000 gap because the limit of liability clause infringes the “waiver of rights” exclusion that is commonly found in professional indemnity insurance policies. To avoid this risk, consultants should be extremely cautious about allowing sub-consultants to include limitation of liability clauses in their contracts.
If you are unable to negotiate the deletion of a limitation of liability clause in the sub-consultant’s agreement you could:
• either include the same limitation clause in your own consultancy agreement with your client, or
• make the limit of liability amount higher.
Similarly, clients also seek to limit their own liability with such clauses included in the consultancy agreements.
In conclusion, to minimise your risk exposure and keep your liability low, it is important that the agreed limit of indemnity provides adequate protection for your practice. Similarly, if you agree to include a limitation of liability clause, it is prudent to check that the amount is either the same as or lower than the limit of indemnity on your current policy.
Stay tuned for our Demystifying the Jargon – Parts 1 & 2 webinar. Part 2 will further explain the differences between limits of indemnity and limitation of liability among other crucial in topics on Risk Management.
Cordilia Thomas
Risk Manager
This article is only general advice in respect of risk management. It is not tailored to your individual needs or those of your business, nor is it intended to be relied upon as legal or insurance advice. For such assistance you should approach your legal and/or insurance advisors.