Liability Risk Management

Abstract

Society must balance the interests of business and the injuries that flow from it. The law attempts to strike that balance by allowing the injured to recover and also by giving businesses an incentive to prevent injury. To minimize the risks of legal liability, a business or individual must first understand the nature and source of legal liability within their particular field of endeavor. With that knowledge, steps can be taken to eliminate known risks, reduce the effects of possible risks and prepare for the chance of unforeseeable or uncontrollable risks. This essay provides an overview of risk factors generally faced by business and methods to control them.

Keywords Commercial insurance; Contract liability; Insurance; Liability insurance; Liability Risk; Limited Liability Entity; Negligence; Tort Liability

Insurance & Risk Management > Liability Risk Management

Overview

Liability risk management is a concept with specific application to a variety of settings. For a general introduction, it is helpful to begin with clear definitions of the terms to frame the discussion. Liability is a legal obligation that is enforceable by a civil remedy or criminal punishment. A risk is the chance of injury, damage or loss (Garner, 1999). Management is the act of handling or controlling. Generally, liability risk management is an activity that controls the chances of incurring legal obligations for injury, damage or loss. The range of risk any particular organization may face varies according to their industry and to their position within that industry. A business may incur liability to individuals within the organization. For example, federal employment discrimination laws give employees the right to sue and recover from employers that violate those laws. Employers must also comply with certain standards that mandate safety and fairness in the workplace. Managers may attempt to minimize risk through accounting strategies and diversification to help absorb shocks caused by lawsuits (Gormley & Matsa, 2011). The most effective way to avoid such liabilities, however, is to prevent the happening of events that may cause claims or lawsuits. With positive control of their environment, businesses can eliminate or minimize their exposure to internally generated liabilities. Commanding positive control of the work environment entails training, education and other programs and systems designed to enable employees and management to act appropriately with respect to each other.

For this discussion, liability risks are unintended or unexpected legal obligations that an organization may incur to an individual or entity outside the organization that arise from conduct in which a business must engage. A business must carry on their business and those activities carry a degree of risk. Some activities may be safer than others, but the chance of injury does not disappear; things can go wrong in ways never imagined. To minimize such risks, an organization should understand how they may arise and then take active steps to eliminate the factors that may contribute to unexpected or unwanted legal obligations. Specific events that can cause liability are too numerous to list. However, as general matter, troublesome legal obligations, in the form of lawsuits, arise from the law of torts. A tort is a civil wrong for which a remedy may be obtained. Defamation and interference with business relations are examples of torts, but the centerpiece of the tort system is negligence. Negligence is cause of action whereby an injured person may recover from a responsible party if they can show that another party breached their duty of care and that the breach caused their injury. A standard of care is the minimum level of care (e.g. precaution, expertise) that a business must exercise in the course of their dealings to protect others from injury. If a business fails to meet that standard, the business is said to have breached their duty of care and the legal mechanism, or cause of action, which allows the injured person to recover, is called negligence.

Every business, and indeed every person, has a permanent responsibly to meet their duty of care at all times and every activity has a corresponding standard of care. For example, a construction company builds a bridge with grade "A" steel, which is the same steel they had always used without incident. The bridge buckles and collapses during an especially cold winter. Some people are killed and others are injured. It is later determined that grade A-1 steel would have held up. Is the construction company liable to the people for injuries? Did they fail to meet their standard of care by not using A-1 steel? Maybe and maybe not, but the company would be likely to find out because the injured will seek a remedy and the construction company would almost certainly be sued and maybe even bankrupted as a result. For another example, imagine that morning commuters are crowding into a train from the platform as the train's doors begin to close in anticipation of departure. A man who arrived a few seconds too late is determined to be on that train. He tries to squeeze between the doors with some help from the train workers and by doing so drops a package onto the tracks. The package contains fireworks that begin to go off causing a clock, hanging from a column on the other end of the platform, to shake lose. The clock falls on a woman waiting for the next train and causes her injury. Is the railroad liable to the woman for her injuries? These circumstances are based on a famous case decided by the highest court in New York State. In that case, the railroad was not liable and the court announced a famous and much debated rule that limited liability to foreseeable plaintiffs. The results of litigation over injuries are all around us. Have you seen a coffee cup warn that its contents are hot? (Wild west judgments, 1996)

The appropriate level of reasonable precaution required by the law varies with the circumstances and according to the parties involved. For example the standard of care is determined differently for professionals (lawyers, doctors, architects, etc.), grocery store clerks, and hotel owners. A standard can also evolve over time to adapt to society; the same conduct that may have been acceptable in the past may incur legal liability at some point in the future. Situations tend to be unique and whether any particular precaution should have been taken requires close examination of the facts in light of similar cases previously decided. A general formula, called the "Hand Formula," named after Judge Learned Hand, can help to determine which precautions should be taken under a business's duty of care. The formula is represented by B < P x L. "B" is the cost or burden on the company of taking a precaution that would avoid a foreseeable injury. "P" is the increase in the probability of loss if "B" is not done and "L" is the probable magnitude of loss. If the cost of taking a precaution, "B" is less than the benefit of the precaution to the consumer, calculated by "P x L," the company should take the precaution and if not then negligence is suggested. The "Hand Formula" is helpful as a tool to understand the obligations that a business could face. Clearly, enormously costly initiatives to eliminate a minor injury are generally not required but inexpensive actions that would prevent great injury are generally always required (Owens, 2005).

Strict products liability is of particular concern for businesses that sell or produce products (cars, drain cleaners, frozen dinners, perfumes, airplanes, etc.). Depending on the case, an injured party can recover based on negligence or strict liability. Strict liability is often preferable because an injured party does not have to prove that an offending company, usually a manufacturer or retailer, was at fault or negligent. The injured party need only prove that the product was defective. Products can have manufacturing defects, design defects or inadequate warnings. Manufacturing defects are unintended flaws in production. Design defects are unnecessarily risky designs that reasonably could have been avoided. Warning defects are those injuries that could have been avoided with reasonable access to information.

Contracts are an integral part of any business and a potential area that businesses can incur unwanted liability. Contracts are a voluntary exchange of promises by parties that are enforceable as legal obligations. Parties are free to negotiate the terms, or promises, that make up the contract. Contracts can be written, oral or implied by conduct of the parties. Oral contracts, which are enforceable in many situations, and contracts that arise by conduct often lack a clear definition of the performance required by the promises. As a result, they are subject to misunderstandings and disagreement. When the parties can't agree, some binding authority, like a court or arbitration board must decide. As a result, a party to oral or implied contract may end up with a deal they did not intend, in addition to the expense and aggravation of presenting their case to a court.

There appears to be a popular belief that a contract is a signed writing, and only a signed writing. This is false, a contract is a legal obligation formed by an agreement; a signed writing is a common form. There is some truth to the common notion, in that there is a legal rule, intended to prevent fraud, that requires certain contracts to be in writing to be enforceable, but that rule has exceptions and is not universal. The writing is not the contract; it is a description of the agreement. If the writing fails to adequately describe the obligations formed by the exchange of promises, or attempts to impose illegal or inappropriate obligations; it may be changed or not enforced as decided by a court of law that can cause unexpected liability. This understanding underscores the importance of using due care when obligations are committed to paper and that obligations may arise without a writing and from outside a writing. A businessperson seeking to limit potential exposure to liability should understand the fundamental nature of contracts. Otherwise, a person may unintentionally incur an enforceable legal obligation in the course of doing business.

Written contracts are best for a business trying to control potential liability. With some degree of care, the written contract goes a long way to avoid unexpected liability. Writing, or drafting, clear and precise contracts, is a part of any comprehensive effort to minimize unexpected liability. Accordingly, the writing should describe the expectations and obligations of each party under the contract clearly and fully and address as many contingencies as possible. The terms of the contract may include provisions related to the risk of loss or impose the duty to carry insurance to cover particular risks. It may include a clause that determines damages or a dispute resolution method in the event of breach. The contract may spell out the order of performance of the parties and the time and method for payment. There are a number of clauses that can be included in contracts to apportion risk and to help ensure that the parties get only the liability, and therefore benefit, of what they bargained for. Where the contract fails to address a particular matter or the parties disagree about what the agreement was, the courts will decide and the expense and aggravation of unexpected liability will again surface.

Liability can take many forms. The word liability has many variations, but those directly relevant to negligence include: vicarious liability—liability for a supervisor based on the conduct of a subordinate; enterprise liability—liability for every member of an industry determined according to their market share; joint and several liability—where each co-defendant is responsible for the entire obligation even though they may have not caused all the injury. Liability can attach to an employer based on conduct by an employee, perhaps two hundred miles away. Liability has been imposed on companies simply because they were part of a particular industry that caused harm even though that company may not have caused injury. If a party is liable for 35 percent of a million dollar verdict, that party may pay the entire sum and would be forced to go after the other responsible parties for the difference. Businesses must continue to operate in the face of perpetual risk, therefore businesses would be wise to take steps to minimize the chance that somehow and in someway, often never contemplated, they will be liable for someone's injury.

The standard of care relies on words that invite argument, "reasonably" and "foreseeably," and make it difficult to determine with precision whether a particular behavior will incur liability. However, that does not mean that businesses are powerless to protect themselves from unwanted liability. The legal profession is an important component of liability risk management for businesses and individuals. People tend to call lawyers after trouble arises; as a method to control liability, this reactionary use of the legal profession is not ideal. Prior to an injury, a lawyer could have advised the business to take reasonable precautions that may have prevented the injury or at least limited the business's liability for that injury. A contract could have been written slightly differently, or a warning sign could have been put in a particular place, or any number of seemingly slight factual variations to a casual observer could have made a large legal difference. When a business has a continuing relationship with legal counsel—many businesses have in house or general counsel—a company can often avoid or limit liability that arises from common business by engaging legal advice on the best practices for doing business in their industry. For example, counsel for a manufacturer may advise to alter a warning on a particular product because a similar warning had been held inadequate by a court.

The government provides an important source of liability risk protection with particular business organization laws. Imagine that a person starts a business and operates it as a sole proprietor or two or more people get together and carry on as a general partnership. If someone dies because a patio they built collapsed and a court decides that they were at fault, a judgment against the business is awarded and the business is responsible. If the business is bankrupt, the owners themselves are personally liable for judgment. This means that the owner's house, car, savings account, and other assets are all up for the taking in order to cover for the damages. Sole proprietorships and general partnerships have unlimited liability; legally, the business and the person are the same thing. State governments, however, provide an alternative business form that has limited liability; legally, the business is separate from the owners. The two most popular entities are the corporation and the limited liability company (LLC). A relatively simple and inexpensive filing will form either entity and when coupled with certain administrative practices, the entity will limit the liability of the owners to the amount they had invested. Generally, a judgment against an LLC or corporation is collectable against only the assets of that LLC or corporation. In the above example, the judgment may take everything that the business has, but the owner's personal assets would typically be safe. Hereafter, limited liability entity (LLE) refers to corporations, LLCs and other limited liability forms that may be available under state law.

The LLE controls the chances of liability by compartmentalizing the effect of liability to parties associated with the entity. For the individual who starts a business, the LLE contains the legal liability to the business which leaves personal assets aside. This same concept applies to businesses as well because businesses may start and own other businesses. A company may set up and own several different LLEs which each own certain operations or particular assets. In that way, potential legal obligations that could threaten the entire organization are contained to only those assets committed to a particular LLE. For example, consider a cab company that has a fleet of fifty cabs. The company may set up an LLE for each cab. If an accident were to occur, the company could be spared from paying the insurance policy for every cab. This would allow the entire company to be insulated from liability. This principle also applies to real estate. Companies with various real estate holdings and operations may own a separate LLC for each building. These, of course are only examples of a general concept and not necessarily effective in every given case. These ownership structures are very complicated and involve significant consideration of relevant law by experienced professionals before they can be used.

Despite best efforts of businesspersons and their legal counsel, events occur and accidents happen and so it is often wise to purchase insurance. Generally, insurance is an agreement by which one party assumes a risk faced by another party in return for a premium. An insurance policy is a document detailing such an agreement. Insurance policies cover a wide variety of risks; some of the common types purchased by or for individuals are life insurance and health insurance. Fire insurance covers losses by fire to specific property and casualty insurance covers legal liability; accident, property damage, etc. Together, they provide comprehensive coverage for real property and specified personal property like boats, cars and planes. These types of insurance are so called "first party insurance" because the triggering event for coverage is loss to the insured property (Dobbyn, 2003).

The most prevalent type of insurance and the type most relevant to this discussion is third-party liability insurance. The triggering event is not loss to the insured's property but liability of the insured for damage to another or another's property. Commercial General Liability (CGL) policies are a common form of liability insurance purchased by businesses. CGL policies typically cover a broad spectrum of risks, from customer injuries to libel and slander suits. The basic agreement is that the insurance company will pay the amount, up to the agreed maximum, that the insured became legally obligated to pay as damages. Under such a policy, the insurer is said to have the duty to indemnify the insured. The word indemnity refers generally to an insurance relationship and simply means that one party must make good on the losses of another party. In addition to the duty to indemnify, an insurance policy will typically put on the insurance company the duty to defend any lawsuit that arises from a covered event. The duty to defend may also apply to potentially fraudulent or frivolous actions brought by a third party because the allegations in true would be covered under the policy. Liability insurance also comes in several forms to cover the great many events that can potentially cause injury, including professional malpractice insurance used by doctors, lawyers and other professionals to cover the possibility of claims that arise from their practice.

In the first decades of the 2000s, experts have begun stressing the necessity for businesses to obtain some form of cyber coverage because of the universal dependence upon computers and the Internet. As of 2015, most businesses maintained websites (including social media pages) and stored records as well as employee information on computer networks. Therefore, they are exposed to both third-party and first-party liability. If a business does not properly safeguard the confidential or private information stored on its network or an offense is committed electronically, the company may have to pay to defend against individual allegations. Additionally, if a business's network is hacked, the company may suffer first-party losses to restore the system, notify persons affected, manage the crisis, and heighten security measures (O'Rourke, 2014).

Conclusion

Society must balance the interests of business and the injuries that flow from it. The law attempts to strike that balance by allowing the injured to recover and also by giving businesses an incentive to prevent injury. To minimize the risks of legal liability, a business or individual must first understand the nature and source of legal liability within their particular field of endeavor. With that knowledge, steps can be taken to eliminate known risks, reduce the affects of possible risks and prepare for the chance of unforeseeable or uncontrollable risks.

Terms & Concepts

Breach: A violation of a legal obligation

Contract: An agreement between two or more parties that creates legally enforceable obligations.

Corporation: A business form provided by state law that creates a separate legal identity for a business that limits liability for corporation owners to the amount they have invested in the corporation.

Foreseeable: The quality of being reasonably anticipatable; relates to liability in tort, in that a foreseeable injury is a more likely case liability than a non- foreseeable injury.

Commercial General Liability (CGL): Type of insurance policy purchased by businesses to cover a broad spectrum of risk arising from liability to a third party.

"Hand Formula": General formula described by Judge Learned Hand used to determine whether particular conduct was negligent. Breach of a duty of care is indicated where the possibility of injuries times the severity of injury is more than the cost of preventing the injury.

In house or general counsel: Attorneys that advise businesses on a continual basis with respect to general legal matters associated with their business. If those attorneys are employees of the firm they are called "In House." Such general practice attorneys often coordinate efforts with specialist attorneys should the need arise.

Insurance: An agreement by which one party assumes a risk faced by another party in return for a premium; an insurance policy is a document detailing such an agreement.

General partnerships: A business structure that requires no filing with the government and arises when two or more people carry on business for profit. Partners have unlimited liability for partnership obligations. See also, Sole proprietor.

Limited liability company (LLC): A business form provided by state law that creates a separate legal identity for a business that limits liability for corporation owners to the amount they have invested in the corporation.

Negligence: A type of tort whereby an injured plaintiff can recover from another if the plaintiff can prove that the other party breached a duty of care owed to that plaintiff and the breach caused the injury.

Sole proprietorships: A business structure that requires no filing with the government and arises when someone carries on business for profit. Sole proprietorships have unlimited liability for business obligations.

Strict Liability: Liability that does not depend on negligence or intent to harm; is based on absolute duty to make something safe.

Tort: A civil wrong for which a remedy may be obtained, including negligence.

Bibliography

Garner, B. (Ed.) (1999). Black's law dictionary (7th ed.) St. Paul, MN: West Publishing.

Gormley, T.A., & Matsa, D.A. (2011). Growing out of trouble? Corporate responses to liability risk. Review of Financial Studies, 24, 2781–2821. Retrieved October 31, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=62989702&site=ehost-live

Hadlock, C.J., & Sonti, R. (2012). Financial strength and product market competition: evidence from asbestos litigation. Journal of Financial & Quantitative Analysis, 47, 179–211. Retrieved October 31, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=74405990&site=ehost-live

Dobbyn, J.F. (2003). Insurance law in a nutshell. St. Paul, MN: West Publishing.

Owen D.G., Phillips, G.G. (2005). Products liability in a nutshell. St. Paul, MN: West Publishing.

O'Rourke, J. (2014). Internet liability. Smart Business Philadelphia, 8(5), 18. Retrieved December 3, 2015 from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=93652538&site=bsi-live

Van der Smissen, B, (1990). Legal liability and risk management for public and private entities. Cincinati, OH: Anderson Publishing.

U.S. Congress, Congressional Budget Office. (2003). The economics of U.S. tort liability: A primer. Washington, DC: U.S. Government Printing Office.

The `wild west' judgments. (1996). International Insurance Monitor, 49, 17. Retrieved October 31, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=9610084561&site=ehost-live

Suggested Reading

Inwood, J. (2003). Liability risk management. Caterer & Hotelkeeper, 192(4296), 48. Retrieved March 22, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=11975430&site=ehost-live

Fiscus, P. (2002). Hope for the best prepare for the worst. Pharmaceutical Executive, 22, 22. Retrieved March 22, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=7924609&site= ehost-live

Corlosquet-Habart, M., Gehin, W., Janssen, J., & Manca, R. (2015). Asset and liability management for banks and insurance companies. Hoboken, NJ: Wiley.

Cuddihy, T. (2000). Environmental liability risk management for the 21st century. Geneva Papers on Risk & Insurance—Issues & Practice, 25, 128. Retrieved March 22, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=3157453&site=ehost-live

Swartz, T. (2006). LLC, S-Corp or sole proprietor? Professional Remodeler, 10, 8–12. Retrieved March 22, 2007, from the EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=21645473&site=ehost-live