Insuring Liability Risk, a by-product of all Business Risks 

 March 22, 2022

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Insuring Liability Risk, a by-product of all Business Risks

Let us try to explain it in simple terms: civil liability is the obligation of any person or entity to pay for damages caused to another person or entity.

Expanding on this definition, liability is the obligation to pay for damages and/or losses caused to a person or entity.

These damages may be caused by a breach of contract (known as contractual liability) or by the occurrence of a harmful event without a prior contractual relationship (usually referred to as tort liability).

The obligation to pay for damages covers both the repair “in natura” (placing the injured party in the situation immediately prior to the harmful event) and the repair by means of payment or monetary retribution, i.e. the payment of compensation for damages, a fairly well known subject.

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What is Liability Insurance and how is it related to Business Risks?

Liability Insurance protects against Liability risk. There are different types of liability risk and those are protected against through different types of liability insurance.

Liability Risk can be considered a by-product of other significant business risks simply because a risk event has to occur in order for the impacted party to bring about a financial demand or lawsuit. Basically, some business risk must occur first, which then transforms itself into a Liability Risk.

In essence, the risk is transferred to the insurance company when liability insurance is purchased.

Here are some examples:

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In a scenario of mergers and acquisitions of companies, Rep and Warranty Insurance is a type of liability insurance that covers, amongst various risks, the risk of an inaccuracy made by the Seller within the representations and warranties offered to the Buyer. So the inaccuracy or misrepresentation is a form of business risk related to the specific transaction at hand, which then gets transformed into a liability risk whereby the Buyer (in this case) would bring a suit against the Seller for such misrepresentation. Without the business risk occurring first, there wouldn’t be a liability.

Various business risks will lead to different liability risks, which can be hedged through various forms of liability insurance as some of the ones listed below:

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Mortgage impairment insurance is an insurance product that protects a lender from physical destruction to a borrower’s home before or after a default occurs. This insurance also has a liability insurance component to it protecting the lender or mortgage servicer from liability risk that happens as a result of the primary business risk of the physical destruction to the borrower’s home.

Another example is that of the risk of fraud that leads to liability risk. While a fidelity bond compensates a business for the financial loss incurred in the event of a fraud, it does not protect against the liability that could result as a result of the fraud, which is a financial risk in addition to the financial loss directly tied to the fraud event (ex. stolen funds). As a result, specific liability insurance products must be purchased in addition to a fidelity bond, namely D&O insurance and professional liability insurance.

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D&O insurance provides protection for the company and its directors against liability claims namely coming from shareholders. Whereas professional liability insurance provides protection for the company and its directors against liability claims namely coming from clients.

Finally, if you watched the movie “The Founder,” based on the story of the successful expansion of the McDonald’s franchise, you’ll want to know that the McDonald brothers might have been more at ease in the face of Ray Kroc’s aggressiveness if they had taken out franchisor insurance. This is another insurance product to consider when dealing with business risks resulting into Liability Risk and specifically relating to franchised business.

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Elements of civil liability

In short, almost any time a person or entity causes damage to another person or entity, they will be liable. It is advisable to have a civil lawyer who specializes in these types of claims, both to sue and to defend against a lawsuit. However, most important is to have wells structured liability insurance that pays all the legal fees incurred as well as indemnities due.

Civil liability requires, at least, the concurrence of three basic elements:

Personal elements. That is, the person who causes the damage and the person who suffers it. The former responds civilly and repairs, restores or compensates the latter, the one who suffers the damage.

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Injury. The injury may consist of a breach of contract or damage. In addition, it may affect the person or the assets of the injured party. In the case of contractual liability, penalties may be established when compensating the injury. And in the case of non-contractual liability, a judge will be in charge of assessing the damage.

Causal relationship. It is necessary that between the action or omission of the tortfeasor and the injury itself there is a causal relationship. In general, no one is liable for fortuitous damages (unless his duty is to avoid them) or for unforeseeable or unavoidable damages.

Consequences of civil liability

If concurrent civil liability is established, the liable party must restitute the damaged property or repair the damage caused. When restitution or reparation is impossible, compensation will be due.

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Two basic principles apply in most legal systems:

Universal patrimonial liability determines that the entire patrimony of the tortfeasor is subject to the fulfillment of an obligation. That is to say, if at this moment the liable party does not have sufficient resources to pay his fault, he will continue to be obliged to pay until he satisfies it, even if it is in the future.

The principle of full restitution determines that the tortfeasor must leave things in the state they were in before his intervention. This is why restitution and reparation are preferred to compensation.

In order to avoid the patrimonial damage that civil liability may represent, there is the insurance technique. By means of an insurance it can be established that the insurer becomes jointly and severally liable for the obligation to restitute, repair or indemnify.

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On some occasions this insurance is compulsory.

Let us think, for example, of traffic insurance. The damages resulting from a traffic accident can be so high that the responsible party does not have (and will never have) sufficient assets to pay for them. Thanks to the insurance, the injured party will be compensated at the expense of the insurer. This is without prejudice to the insurer’s right of recourse against the insured.

Many professions require liability insurance. On other occasions, insurance is taken out as a matter of prudence.

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