Expected recovery at 100, 150, 200 and 300 per cent of the charges, what a higher cap is worth paying for, and why the exclusion decides it.
Size a liability cap by pricing the losses it stops you recovering: for each failure scenario, take its annual probability times the part of the loss above the cap. On an illustrative contract with 5,800,000 of annual charges and an expected loss of 350,000 a year, a cap at 100 per cent of annual charges leaves the buyer 62,000 a year of unrecoverable expected loss, and a 200 per cent cap leaves 4,000. But if lost profits are excluded, the buyer keeps 132,000 a year whatever the cap: the exclusion, not the cap, is the clause that matters.
Worked in full in Contract Management by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Liability caps are usually negotiated as multiples of the charges, 100, 150 or 200 per cent, because that is what the templates offer. The multiple means nothing until it is set against the size and likelihood of the losses the contract can actually cause. The calculation below does that, and puts a price on the supplier's request to be paid for a higher cap.
| Failure scenario | Probability a year | Loss to the buyer | Expected loss | Of which lost profit |
|---|---|---|---|---|
| Minor failure | 20% | 400,000 | 80,000 | 0% |
| Serious failure | 5% | 3,000,000 | 150,000 | 40% |
| Severe failure | 1% | 12,000,000 | 120,000 | 60% |
| Expected annual loss | 350,000 |
Annual charges are 5,800,000, so the contract is worth 17,400,000 over three years and the expected loss is 6.0 per cent of the charges. The probabilities come from the service's history, the supplier's record and the buyer's own incident data; they will be rough, and rough is enough to rank the options.
Expected recovery = Σ probability × MIN(recoverable loss, cap)
Expected loss kept = expected loss − expected recovery
In Excel, with probabilities in B2:B4, losses in C2:C4 and the cap in F1: =SUMPRODUCT(B2:B4,(C2:C4<$F$1)*C2:C4+(C2:C4>=$F$1)*$F$1), or a helper column of =MIN(C2,$F$1) times the probability, which is easier to audit.
At 100 per cent of annual charges the cap is 5,800,000. Minor and serious failures sit under it and are recovered in full: 80,000 plus 150,000. The severe failure is 12,000,000, so only 5,800,000 is recovered and the 1 per cent chance of it contributes 58,000 of recovery instead of 120,000.
| Cap, % of annual charges | Cap | Expected recovery a year | Expected loss kept a year | Recovered | Kept over the term, undiscounted |
|---|---|---|---|---|---|
| 100% | 5,800,000 | 288,000 | 62,000 | 82.3% | 186,000 |
| 150% | 8,700,000 | 317,000 | 33,000 | 90.6% | 99,000 |
| 200% | 11,600,000 | 346,000 | 4,000 | 98.9% | 12,000 |
| 300% | 17,400,000 | 350,000 | 0 | 100.0% | 0 |
The cap only bites on the severe scenario, so the useful question is how large that loss is. Covering it in full needs 2.07 times the annual charges; above that, a higher cap buys nothing.
Suppose the supplier will move from 100 to 200 per cent for a 0.75 per cent increase in the charges, 43,500 a year. The higher cap is worth 346,000 minus 288,000, or 58,000 a year of expected recovery. The trade is worth 14,500 a year to the buyer, and the break-even uplift is 1.00 per cent. Beyond that, the buyer is paying more for the cap than it is expected to return, and may do better to insure or carry the tail itself.
Most contracts also exclude indirect and consequential loss, and many exclude lost profit expressly. In this case 40 per cent of the serious loss and 60 per cent of the severe loss is lost profit. Take it out and the severe loss the buyer can claim falls to 4,800,000, which is already under a 100 per cent cap. What counts as indirect or consequential loss, and whether lost profit falls inside that phrase, depends on the wording and the governing law, so the safe drafting names the heads of loss expressly.
| Cap, % of annual charges | Expected recovery a year | Expected loss kept a year | Recovered |
|---|---|---|---|
| 100% | 218,000 | 132,000 | 62.3% |
| 150% | 218,000 | 132,000 | 62.3% |
| 200% | 218,000 | 132,000 | 62.3% |
| 300% | 218,000 | 132,000 | 62.3% |
Every row is the same. With the exclusion in place, raising the cap from 100 to 200 per cent is worth nothing, so paying 43,500 a year for it is a straight loss. The 132,000 a year the buyer keeps is entirely the exclusion. A negotiator with limited credit should spend it on carving lost profit, or a defined list of losses such as the cost of replacement services and data restoration, back into the recoverable heads, not on the multiple.
A cap is only worth what the supplier can pay. An 11,600,000 cap against a supplier with thin equity and no matching insurance is a promise, not a recovery. Ask for the insurance certificate and check that the cover limit, the excess and the exclusions line up with the cap.
Price the cap as expected loss kept: 62,000 a year at 100 per cent, 4,000 at 200 per cent, and 132,000 at any level once lost profit is excluded. Negotiate the heads of loss first and the multiple second. Contract Management prices each clause of one supply agreement in money and per unit before signature, and the free workbook for this case includes the liability test among its working documents. The same expected-value method applied to another protection is in is a longer warranty worth more than a better remedy.
Commercial contracts commonly cap liability at 100 to 200 per cent of the annual charges or of the fees paid in the prior twelve months, with uncapped or higher caps for matters such as data protection or confidentiality. The right level depends on the losses the contract can cause: in the example, covering a 12,000,000 severe failure in full needs 2.07 times annual charges of 5,800,000.
Only if the extra expected recovery exceeds the price. Moving from 100 to 200 per cent of the charges adds 58,000 a year of expected recovery in the example, so a 0.75 per cent price increase, 43,500 a year, is worth paying. With lost profit excluded, the same move adds nothing, because no recoverable loss exceeds the lower cap.
Often it does. In the example lost profit is 40 to 60 per cent of the larger losses. Excluding it reduces expected recovery from 288,000 to 218,000 a year at a 100 per cent cap, and makes every higher cap worthless. Negotiating which heads of loss are recoverable usually moves more money than negotiating the multiple.
This article is one calculation from Contract Management. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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