Contingent liability (also referred to as indirect liability or vicarious liability) is a debt or loss that may occur in the future for a business. There are several categories of contingent liabilities and rules that govern how they must be reported. Examples include lawsuits, investigations, and audits. Each presents a unique risk of loss. Essentially, contingent liability refers to “expected loss” and how to handle that loss financially.
Understanding how each type of contingent liability works is crucial to selecting an appropriate contingent liability insurance policy. This blog post will provide an overview.
What are some examples of contingent liability?
In real estate, contingent liability comes up quite often. A few examples where it applies include:
- Suppose a contractor makes a mistake and damages property during renovation. In that case, the real estate firm or owner could be liable (hence the term “vicarious liability,” meaning you are responsible for others’ actions vicariously).
- Another type of contingency liability may come from employees making mistakes. Employee errors are why contingent liability insurance is often part of Errors and Omissions policies.
- Finally, lawsuit damages are a standard contingent liability faced by realtors, real estate firms, and investors. On average, businesses in the US spend over $1 million per year on litigation damages and legal fees each year. And real estate businesses are by no means exempt.
(Note: Contingent liability is also a term used in real estate contracts referring to a requirement that must be met for the terms of the contract to be carried out. Contingent liability in this context is not covered in this post.)
Types of contingent liabilities and reporting requirements
The International Financial Reporting Standards Foundation (IFRS) has specific guidelines for reporting contingent liabilities in bookkeeping. GAAP (generally accepted accounting principles) also require companies to register contingent liabilities per three standards: full disclosure, prudence, and materiality. In addition, each category of contingent liability has different record-keeping requirements. The three types of contingent liabilities include probable, possible, and remote.
Probable contingent liabilities have a 50% or greater chance of occurring. For example, let’s say that a real estate firm is sued for negligence. After consulting with legal counsel and reviewing the details of the case, the firm leadership might determine that there is a strong chance that they will lose the lawsuit. In this case, the contingent liability is considered to be probable. The firm then sets aside the estimated damages from the lawsuit and reports it in its balance sheet as a liability and as an expense in profit and loss reports.
Possible contingent liabilities have a 50% or lower chance of occurring. Sticking with the above example, if legal counsel cannot determine if the plaintiff has a strong case or if it seems like their chance of winning is below 50%, then the contingent liability is referred to as possible. In this case, the liability only needs to be recorded as a footnote in the financial statements.
Remote liabilities are defined as having a slight chance of occurring. A frivolous lawsuit is an example of a remote liability. In this case, the firm does not need to record the liability or set aside cash on the balance sheet. With each contingent liability category, consult an attorney before moving forward.
How does contingent liability insurance work?
Contingent liability insurance might appear in several different policy types under various names. But it’s vital to ensure that your company has the appropriate coverage for the real estate industry’s unique challenges.
Under a general liability policy, contingent liability will be referred to as indirect liability and may cover bodily injury, property damage, and personal injury. E&O insurance (or professional liability insurance) may also have a contingent liability clause. This type of insurance specifically covers mistakes or negligence by contractors, agents, and employees.
Contingent liability insurance covers expected losses, such as lawsuit damage and other losses from contingent liabilities. McGowan Program Administrators (MPA) Real Estate Umbrella Program provides appropriate coverage for real estate businesses. The umbrella covers a range of commercial, industrial, and residential properties and includes contingent liability. MPA’s experienced brokers can guide you to a tailored policy that fits your company’s individual needs.