Indemnity Clause Explained

Indemnity clauses are very useful contractual provisions that are common in many kinds of agreements, especially commercial agreements. From insurance transactions to contracts for the supply of goods and services, indemnity clauses are a necessary yet somewhat complex provision to include in your contracts. The indemnity clause requires one of the parties to reimburse the other party for damages claimed by a third party. The clause is intended to protect one of the contracting parties from legal responsibility for damages or losses suffered as a result of some contract-related activity.

In this article, we will explain the indemnification clause definition, why these clauses are important, when you should use them, and when you absolutely should not.

In order to properly grasp what an indemnity clause is, you must understand what is meant by the word “indemnity.” An indemnity is a security or protection against a loss, damage, or some other financial burden, such as costs and expenses. An idemnity clause in an agreement provides that one person promises to be responsible for loss or damages occurring under circumstances described in the contract.

The agreement specifies that the party will compensate the other for the loss suffered as a consequence of a specified event(s). The occurrence of this event is known as a ‘trigger event.’ This could be:

The triggering event is agreed upon by both parties and included in the contract. You may sometimes see an indemnity clause referred to as a hold harmless clause or an indemnity and hold harmless clause.

The indemnity clause in contracts shifts or transfers potential costs or losses from one party to another. The risks that the other party faces, if realized, will be covered by the party who has agreed to be liable under the indemnity clause.

Here’s an easily understandable five-step breakdown of the way indemnification works: 

After understanding the indemnity clause meaning, it becomes apparent that indemnification clauses are a good way to protect yourself or your business from financial or other losses. This is especially necessary when the party with whom you are entering into the arrangement is likely to take actions that may cause you or third-party damages or losses.

The provisions allow you to decide how much risk you are willing to take in each transaction. You can also protect yourself or your business from potential damages or a lawsuit from a third party that can arise as a result of the actions of the other party involved in the transaction. 

There are two sets of circumstances in which you should use an indemnification clause:

Indemnification can be used in many contexts for a variety of reasons. High-risk contracts are more likely to have indemnity guarantees proposed by the party with higher bargaining power. Simple indemnity clauses are useful if potential damages are high or when a party is likely to suffer a loss from a transaction. 

There are many other types of indemnities that can be included in your contracts. Limited liability indemnity clauses cover all losses except those attributable to the party’s own negligence. Third-party indemnities promise to indemnify a party against claims by a third party.

What an indemnity will cover and who will take legal responsibility is ultimately up to the parties to agree on. The type of clause they use will also depend on the circumstances of their agreement. 

There are many styles and variations of indemnity clauses. Some indemnity clause examples are listed here: 

Of course, this is not an exhaustive list. Indemnity clauses can be drafted into an agreement in any style agreed by the parties, ideally with advice from a legal professional. Most agreements have a clear trigger event and a protocol following it describing how the indemnity is to be paid.

Typically, it is the issue of compensation that needs to be negotiated. How and when the indemnifying party will pay the party to be indemnified is a matter of bargaining between the parties involved. While the indemnified party will want all of their losses and legal and professional costs may incur in defense of a claim against them, the indemnifying party will want to limit what it pays only to what they may consider “reasonable” costs. The parties will negotiate, reach an agreement, and state it clearly in their contract to avoid ambiguities. 

There are exceptions to indemnification obligations, and these are likely to relate to the negligence attributed to the party being indemnified. When a party’s own actions contribute to triggering the indemnification clause, their entitlement to indemnity can be invalidated. Some common exceptions to indemnity clauses include: 

If any of these circumstances are proven to be true, the indemnifying party is not obligated to compensate the party claiming the right to be indemnified. For example, an insurance company is unlikely to make payments for a claim where the loss incurred was due to a purposefully fraudulent act by their policyholder. 

When indemnity clauses relate to the two parties in the contract (called inter-party indemnity), they are more likely to be misused. Here are some of the ways that they are commonly misused:

There are other ways in which an indemnification clause can be misused. The triggering event could be directly linked to a breach of warranty. A breach of warranty does not afford a party the right to terminate the contract, but adding an indemnity clause may permit termination, making the provision unfair.

Generally, misuse of indemnity clauses is less likely to occur with clauses relating to a third party. Note that an indemnification clause excluding or limiting liability in a business-to-business contract may be prohibited by law in some jurisdictions. You should always contact an attorney to ensure that your clause does not violate any provisions of applicable law.

It is easy to confuse an indemnity clause with a guarantee. The purpose of the two are similar, however, the obligations imposed differ.

When an indemnity clause is triggered, it provides a primary obligation on the indemnifying party to pay compensation for the loss or damage incurred. On the other hand, when a guarantee clause in a contract is triggered, the guarantor is required to either pay you compensation or fulfill the contract. If you buy a phone with a warranty or guarantee from a third-party manufacturer and it simply stops working, you are likely to be offered a new phone before you are offered cash compensation for the damage. 

If you want to protect yourself from potential risks when you are entering into an agreement with another party, then including an indemnity clause is the best way to go about this. Each party can negotiate terms they are comfortable with, including limitations as necessary. The clause is likely to make the indemnifying party more cautious, knowing they will be held liable if the triggering event occurs. They will need to assess their risk before signing the agreement.

Be careful not to abuse indemnity clauses, and check with licensed attorneys to make sure that your contract is within the scope of the law. You can use indemnity clauses properly if you understand them.