When a claim moves between related companies or between separately insured entities within the same business, related entities exclusions can prevent an otherwise legitimate claim from responding. For businesses built around related entities in any form, the consequences can be significant.
The context
Vertical integration has become a common growth strategy for mid-to-large Australian enterprises. A construction group that once subcontracted design work now owns the design practice. A developer that once engaged an external project manager now runs project management in-house through a wholly owned entity. These moves can improve margins and give businesses greater control over quality, while reducing reliance on external suppliers.
But the exposure is not limited to groups that have integrated vertically. The same issue can arise in businesses that have structured themselves around separate entities for operational or regulatory reasons. A professional services firm running a distinct entity, and a distinct policy, in each state it operates in is a common example. The entities deliver the same services under the same brand, and it is routine for one state entity to subcontract work to another when capacity or expertise requires it. Nothing about that arrangement looks unusual from a business perspective but from an insurance perspective, it can determine whether a policy responds at all.
Often, the gap only surfaces when a claim is made, revealing an insurance program that no longer reflects how the business is structured or operates.
Related entities exclusions are common across professional indemnity, management liability and other financial lines wordings. Their underlying rationale is understandable: insurers generally do not want to cover disputes between parties whose interests are closely connected.
“Related” can extend beyond subsidiaries and sister companies to entities or persons that own, control, manage or operate the Insured, entities controlled by an Insured party, family members and joint venture partners.
The result can be a gap in cover created simply by the way the business is structured.
Where the exposure sits
A related entities exclusion can remove cover for claims between companies within the same group, or involving a related party such as a director, shareholder or associated company. The reason for the exclusion is understandable. Insurers do not want to cover claims that are manufactured simply to create an insured loss.
The difficulty is that the same exclusion can also catch genuine claims arising from the way a business operates. A parent company might engage a subsidiary or sister company to provide professional services. If that work is performed negligently, the parent may need to recover its loss from the related entity, either because of its own governance requirements or because a head contract requires it to take action against the party responsible. If the exclusion applies, the claim may not be covered even though the underlying error and resulting loss are entirely genuine.
This is often only discovered when a claim is made. The more entities a group has, and the more work that passes between them, the more opportunities there are for the exclusion to become relevant. That can apply to groups structured by state, service line or subsidiary, rather than just large vertically integrated businesses.
There can also be consequences beyond the immediate claim. Head contracts, joint venture agreements and shareholder arrangements may require a business to recover losses from the entity responsible for them. If the related entities exclusion prevents that recovery from being insured, the business can be left funding a loss it expected its insurance program to address.
Why combining everything is not the answer
The solution might be to put every entity under a single policy. But that is not always practical or even desirable.
Many businesses have separate entities for good reasons. They may want to ring-fence liability between different parts of the group or different entities may require different limits. A combined program does not necessarily accommodate either.
It is also not a straightforward solution where related entities have different risk profiles or require different classes of insurance. A property fund, for example, may require investment management insurance, while a development or construction entity may require professional indemnity cover. Those risks are often placed with different insurers, particularly where markets do not write both financial institutions and professional indemnity exposures for the same type of risk.
Combining entities simply to avoid a related entities exclusion is therefore not always practical and may cut across the way the program needs to be structured in the first place.
Specialist insight: Three questions to ask before your next renewal
- Does our related entities exclusion preserve cover for claims arising from genuine third-party arrangements involving a related entity, or does the exclusion apply more broadly?
- Have we mapped our intercompany service arrangements against the current policy wording, rather than relying on the wording from our last renewal?
- If a head contract requires us to take recovery action against a related entity in our supply chain, will our policy respond?
As corporate structures evolve, insurance programs need to evolve with them. A business that has added three subsidiaries since its last major program review should be checking whether its insurance still reflects the way the group operates.
As the corporate structure evolved, insurance programs have too often been renewed against last year’s risk profile rather than the group as it exists today
The solution is usually found in the wording itself. Some insurers will consider a carve-back to the related entities exclusion where the claim arises from a genuine commercial arrangement between related entities. The availability and scope of that carve-back will depend on the circumstances and the wording negotiated at placement.
That makes the placement process important. The broker needs to understand how the entities within the group interact, where services are being provided between them and where contractual obligations sit. Those details can then be tested with insurers before the policy is placed, rather than being discovered when a claim is made.
For businesses with complex group structures, this needs to be considered as part of the placement rather than treated as a standard wording point. The right question is not simply whether the policy has a related entities exclusion but how that exclusion will operate against the way the group actually does business.
When the structure changes, the insurance needs to change with it
Vertical integration is not going away. As businesses change how they operate, their insurance programs need to keep pace.
A related entities exclusion should not simply be accepted as standard wording at each renewal. It should be considered against the way the group is structured, the services its entities provide to one another and the contractual obligations those entities have to each other and to third parties.
“The problem is rarely that businesses have related entities. It is that the insurance has not been reviewed to reflect what those entities actually do for each other.” Luke Vumbaca, Partner, SRG Australia
When did you last review your related entities exclusion against the way your group actually operates?
