What do a mallet, sledgehammer and jackhammer have in common? Ifyou are an insurance buyer, one of these tools is in each of youremployment practices liability, directors and officers liability,and errors and omissions policies.

Most comprehensive general liability policies contain limitlanguage, which states the insurer has a "right" to settleclaims--thus leaving an opportunity for discussion. The settlementlanguage in D&O, E&O and EPL policies are quitedifferent.

Although the terminology used in this article istongue-in-cheek, the real life significance is critical. The hammerclause deserves more attention than many insureds give it.

It is wise to understand the potential impact this clause willhave on a claim before it's too late. It is important enough torevisit in light of recent changes in underwriters' approaches andits effect on claims settlements.

There is technically no "hammer clause" in the policy. Instead,it is insurance jargon that refers to a caveat in the policy thatlimits the insured's options during claim settlementdiscussions.

The clause detailing these limits actually is the part of thepolicy that defines the insurer and insured obligations when bothdo not agree on whether to settle a claim.

In most E&O, EPL and D&O policies, the insurer reservesthe right to make that decision at least to some degree. Usuallythe clause can be found under the "Defense Settlement" section,although it can also appear in the "Definitions andReporting/Notification" sections.

In broad terms, the hammer clause dictates whether the insurerwill pay anything over the first proposed settlement, and if so,how the settlement amount in excess of the proposed settlement (andrelated defense costs) will be divided up between the insurer andthe insured. The insurer's clout in the matter has given rise tothe "hammer" terminology.

There are a number of options being offered and ways in whichcarriers approach this important clause, making it a crucial partof the insured's insurance buying decision. (See accompanyingtextbox, "Avoid The Hammer.") Although rarely referred to asco-insurance, in reality that is exactly what it should beconsidered.

For example, assume an attorney or physician, or consultant orsupervisor (in an E&O claim case) is facing a $200,000settlement and has a $1 million limit policy. If this policy hasthe harshest hammer language available--we refer to it as a"jackhammer" clause for descriptive purposes--the attorney or otherprofessional insured now has to decide if he will settle and reducehis limit (thus the amount available for future claims in thispolicy period) by $200,000 (excess of the SIR) or pay the costs tolitigate until final adjudication.

In addition to lowering the aggregate limit for any remaining orfuture claims, it will now be part of the insured's loss experienceand could set a precedent for future plaintiffs--a situation thatis often experienced in the EPL world.

By settling the claim, the insured also runs the risk of theincumbent carrier nonrenewing and insured facing a challengingprocess of replacing coverage with negative loss experience.

Another example of jackhammer impact involves an EPL policypurchased with $1 million limit subject to a $100,000 self-insuredretention. An employee brings a sexual harassment suit and iswilling to settle for $150,000.

The insurer wants to accept, resulting in a cost to the insuredof $100,000 and an insurance company cost of $50,000.

The insured, however, does not want to settle due to a strongdefense, fear of setting a precedent, attracting other plaintiffsand risking its reputation. The insured decides to litigate at acost of $250,000 and ultimately is victorious.

The total cost to insured is $200,000--the SIR of $100,000, plusthe excess over the SIR ($150,000) reduced by the carriercontribution ($50,000). The carrier's contribution is the amountthe carrier would have paid if the insured had decided to acceptthe original settlement.

If the only change in this scenario was the policy was issuedwith a "mallet," the out-of-pocket cost for insured would be theSIR of $100,000 plus $30,000 (30 percent of the $100,000 over theoriginal $150,000 settlement proposal) for a total of $130,000.

See the significance?

Add a "rubber handle" and the insured could have saved another$50,000 (50 percent of retention) and/or if "rubber handle"included a "victorious bonus" the $30,000 would have beenwaived.

Let's outline why this should be an important consideration.

A number of factors need to be considered.

An insured's loss history is required for at least five yearsand plays a significant part in the underwriting process.

E&O and D&O underwriters in general shy away fromclaims-experienced accounts. Claims experience also affects thequality of coverage underwriters are willing to provide, especiallyE&O and D&O underwriters, and the cost of suchinsurance.

Another often overlooked but important factor is the additionalfinancial costs the insured has to take into consideration whendeciding to pursue the judicial process. Without the right 'hammerclause' the insured's ability to make a wise business decision topursue litigation could easily be adversely impacted.

It is important to provide the option to pursue litigationthrough the judicial process if an insured cares to make thatbusiness decision. Pursuing litigation is a critical component ofmanaging a business and needs to be available to insureds.

With that said, the insurance carrier will suggest that they areentitled to make an economic business decision. I suggest a stronghammer as this is a no-win situation for the insured and probablywill live with them for some time.

Read on because there are ways to compromise between carrier andinsured.

Sometimes settling early and often encourages other plaintiffs.Although the rule of thumb is that these claims only get worse withtime, depending on the coverage, most notably EPL, settling early,in some situations, sends a message of "we pay."

In some cases, the outcome of the settlement could besignificant in both monetary and nonmonetary terms--for example, inpatent infringement litigation for Research In Motion, theOntario-based wireless device company that developed theBlackBerry. In such situations, insureds may want to litigate, andwithout the financial support of their insurance carriers, theymight not have the financial wherewithal.

The partnership between insured and insurer should not be testedduring this critical time.

Another question begs to be asked which is oftenoverlooked--what happens if the insured pressures for litigationand ultimately the final settlement is far less than the originallyproposed settlement or the insured is found innocent? Who is thebeneficiary of the insured's diligence and conviction?

In summary, there are many approaches to addressing the hammerclause--each with their own advantages and disadvantages.

While it is not the only factor when purchasing insurance, thehammer clause should be studied carefully during the purchasingdecision-making process and understood.

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