What Is Gap Risk and Why Is It Important?

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Table of Contents

• What is Gap Risk?
• How Can I Be Exposed to Gap Risk?
• How Can I Minimise Gap Risk?
• Key Takeaways

If you have third party subcontractors carry out work for your business, it is crucial that your business is protected from their mistakes. If not, you may be subject to gap risk and may have to pay for damage that you have not caused. This article will explain what gap risk is and outline the steps you should take to protect your business from it.

What is Gap Risk?

Gap risk is a term that describes where you face risk or liability under an ‘upstream contract’, which has not been (or cannot be) passed through in your ‘downstream contract’. An upstream contract is where you are providing goods or services to another party, like a: 

• principal;
• client; or 
• customer.

A downstream contract, in contrast, is where you are the party receiving goods or services from another party, like from a: 

• subcontractor; or 
• supplier.

How Can I Be Exposed to Gap Risk?

Under a head contract, you may have obligations to the principal to:

• compensate them if you cause any injury or damage to property;
• rectify defects or issues;
• to have insurance, including works insurance, public liability insurance and professional indemnity insurance.

This is where minimising gap risk is important. Ideally, you would have a subcontract in place between you and the subcontractor. This subcontract should state that the subcontractor must compensate you against any damage they cause to the property. This way, they will be legally responsible for the damage, and you will not be out of pocket.

If, however, the subcontractor was not legally responsible for compensating you for property damage, you might not be able to claim the amount you need to pay the principals. Rather, you will need to pay it yourself. This is a gap risk.

You may also face a gap risk where the subcontractor either: 

• does not have a public liability insurance policy; or
• where the level of its insurance coverage is less than what you need to take out under the head contract.

How Can I Minimise Gap Risk?

In an ideal world, all gap risk would be eliminated. However, commercial realities often mean that gap risk cannot be entirely eliminated. Instead, the focus should be on minimising it as much as possible.

A key way of minimising gap risk is through the use of your contracts. This typically involves:

1. having the head contract reviewed from a legal and insurance perspective; and
2. ensuring your subcontracts are properly drafted to pass the obligations, risks and liabilities under the head contract to your subcontractors.

Reviewing Your Head Contract

When reviewing the head contract, you and your lawyer should look to minimise your risk exposure to risks you usually are responsible for. 

Ideally, you will want to ensure:

• there is a reasonable cap or limitation on your legal responsibilities;
• you exclude your legal responsibility for consequential loss;
• your legal responsibility is reduced to represent the extent to which you cause any injuries or damage;
• you are not giving unreasonable compensation; and
• you have the right insurance coverage in place. 

In essence, where you face a potential risk under the head contract, you want to ensure that you are comfortable accepting responsibility for it. Ideally, you will want to ensure you are able to rely on your insurance policies to protect you if anything arises.

Drafting Your Subcontract

The best way to minimise gap risk is by having your lawyer draft the subcontract so that it properly passes your legal responsibilities from the head contract to your subcontractor. This is sometimes referred to as a “pass-through”. 

If there is an obligation under the head contract, you should also include this obligation in the subcontract. This will ensure that your subcontractor has legal responsibility for that obligation as well. 

Below is an example of passing through a provision from a head contract into a subcontract.

Head contract clause:

Subcontract clause:

Here, we have passed the obligation to indemnify on to the subcontractor. This way, if you are liable to indemnify the principal against any damage that the subcontractor causes, you will likely be able to pass this indemnity on to the subcontractor.

Key Takeaways

It is important to mitigate and minimise gap risk by having a thorough legal and insurance review of both your head contract and subcontract. If you are exposed to a claim under your head contract caused by your subcontractor’s actions, you will want to be able to pass this claim to your subcontractor. It is important to ensure that if you cannot pass a claim to your subcontractor, you have appropriate insurance policies in place. If you have any questions or would like assistance reviewing contracts, contact LegalVision’s contract lawyers on 1300 544 755 or fill out the form on this page.