Insureds in certain professions or positions depend on the value of their reputations to keep their practices or companies growing and profitable. A loss of reputation arising out of one or several perceived violations of individual or public trust can act to destroy the continued viability of a company.

Because the injury caused by the violation of specific trusts is not contemplated by the commercial general liability (CGL) policy, special liability policies exist to defend and pay on behalf of the insured (or indemnify the insured) when these violations of trust are charged against the person or entity. Professional liability policies, errors and omissions liability policies and executive liability policies are examples of these "non-general" liability forms.

These special liability policies allow the insured to choose whether or not to agree to a settlement offered by or accepted by the "injured" party. Known as the "consent to settle" provision, without it, the insured would be at the mercy of the insurance carrier's desire to settle. But exercising the consent to settle triggers what is commonly referred to as the "hammer clause."

A Hammer by any Other Name

The provisions of the "hammer clause" seek to convince the insured to accept the settlement offer by spelling out the consequences if the offer is refused. Other names for the "hammer clause" are the "cooperation clause" and the "coinsurance clause" (not like the coinsurance used in property coverage). Regardless of the term used, the effect is generally the same - the insured is penalized for not accepting the settlement if the total judgment amount plus defense exceeds the amount for which the claim could have been settled.

Different levels of penalty exist among the many hammer clauses ranging from an absolute exclusion of all amounts over settlement to those where the insurance carrier and the insured split the amount over the settlement amount by a pre-determined percentage. The varying degrees are discussed below.

The Bigger the Hammer, the Greater the Damage

Two distinct hammer clauses exist: the "full" hammer (for lack of a better term); and the modified hammer. The "full" hammer is more common and its penalty is much greater. The modified hammer is often referred to as a coinsurance clause.

The Full Hammer. Essentially, the full hammer states that if the insured refuses to consent to settlement, the most the insurance carrier will pay is the amount for which the claim could have been settled plus the defense cost incurred to that point of the settlement acceptance.

The Modified Hammer. Insurers choosing to use the modified hammer do not punish the insured as extensively as the carriers applying "full hammer" wording. This is often referred to as the coinsurance clause because the insurance company agrees to split the amount with the insured that exceeds the accepted settlement plus defense costs to that point; essentially making the insured a "coinsurer" on all amounts over the settlement amount.

The two most commonly used modified hammer clause coinsurance percentages are 50 percent and 70 percent. Each percentage is the amount the insurance carrier will pay; so if 70 percent is used, the insurer will pay 70 percent of all amounts over the settlement amount plus defense cost to that point. Of course, the amount paid by the carrier is subject to and limited by the limit of liability carried.

A Little Velvet on the Hammer. Some policy wording works to entice the insured to agree to the settlement by offering incentives; the most common being the reduction of any self-insured retention or deductible if the insured accepts the settlement.

Variations of the above-presented "hammer clause" provisions exist; some are hybrids combining the "full hammer" and modified hammer for different expenses (i.e., the full hammer applies to defense cost while the modified wording applies to the amount of damages paid). These variations and hybrids are not discussed as the above are the most common provisions; plus, understanding the full and modified hammer allows an understanding of any combination of the two.

The "Hammer's" Effect on Coverage Limits

Once the insurance carrier has gained the injured party's acceptance of a settlement amount, the insured's coverage limits are reduced; regardless of the limits purchased. In effect, the insured no longer has access to the full amount of coverage they purchased at policy inception. Of course, the total penalty is based on whether a "full" hammer or modified hammer clause is in use.

To demonstrate the effect on limits of each major type of hammer clause, consider the following loss scenario: A female employee sues a large corporation for $2 million alleging sexual harassment. The suit is immediately turned over to the employment practices liability insurance (EPLI) carrier to provide defense and coverage for any judgment (up to policy limits).

During the pre-trial negotiations, the plaintiff agrees to a $500,000 settlement which is immediately communicated to the insured corporation. Because of the consent to settle wording, the insurance carrier cannot simply pay to settlement, the insured must give permission.

After conducting its own internal investigation, the corporation is convinced that none of its employees or management did anything inappropriate. The corporation comes to the conclusion that the employee is simply trying to "shake them down." Because of their own findings and fear that a settlement would trigger more people to try to pursue such suits, the corporation refuses the settlement opting to take the case on to court.

At trial and on appeal the corporation loses. The plaintiff is awarded $1,200,000, and defense costs total another $300,000. Total cost of the claim is $1,500,000.

For purposes of the example, the insured has a $2 million per occurrence limit. Two assumptions are made as well: 1) defense costs are within the limits of coverage; and 2) when the settlement offer is accepted, defense costs total $100,000 (making the total amount $600,000). Self-insured retentions are ignored in this example. How will each of the "hammer clauses" respond to this non-consent based on the above information?

"Full Hammer" Response: Before commencing trial, the insured knows the most the insurance carrier is going to pay is $600,000. Why? Because the full hammer clause states that the maximum paid is the amount for which the claim could have been settled plus defense costs incurred up to the day the settlement offer was accepted by the injured party. The insured must pay $900,000 out of its own cash.

A cousin to the "full hammer" is the "pounding hammer" (again, for lack of a better term). This takes the hammer clause one step further stating that if the insured refuses to settle and insists on continuing to fight, they do so on their own. The insurance carrier pays to the insured the amount of accepted settlement plus incurred defense costs to the point of acceptance and steps out of the picture. The insured becomes responsible for its own defense (and the associated costs) and any judgment over the amount already paid to the insured. Such a pounding hammer generally convinces the insured to settle. Here is an example of such language:

• "Our duty to defend also ends if you fail or refuse to consent to a settlement we recommend and the claimant will accept. You must then defend the claim at your own expense. As a consequence of such failure or refusal, our liability for loss shall not exceed the amount for which we could have settled such claim had you consented, plus claim expenses incurred prior to the time we made such recommendation."

Modified Hammer Response: Depending on the coinsurance percentage applied, the modified hammer is far less punishing than the full hammer. If the coinsurance percentage is 50 percent, the insurer pays all of the $600,000 for which they could have settled plus 50 percent of all amounts over that; in this case, $450,000. In total, the insurance carrier pays $1,050,000 and the insured pays $450,000 (again, ignoring SIR's).

Had the coinsurance percentage been 70 percent, the insurer would pay the $600,000 plus $630,000 (70 percent of the remaining $900,000) for a total of $1,230,000. The insured would be responsible for only $270,000.

Hybrid Hammers

Modified and Full Hammer hybrids can also be found. The most common divide expenses into two classes: 1) amount to cover the judgment for the wrongful act (loss amount); and 2) defense cost. These hybrid forms often apply the modified hammer's coinsurance percentage to the loss amount, but a full-hammer type wording is used for the defense cost (limiting coverage for defense cost to the amount incurred when the settlement was accepted).

Under this policy wording scenario, the 50 percent coinsurance policy would pay $950,000 ($500,000 settlement + $100,000 defense + $350,000 of remaining loss amount). The $200,000 additional defense cost incurred after the accepted settlement offer plus the remaining $350,000 loss amount would be the responsibility of the insured. Likewise, a 70 percent coinsurance form pays $1,090,000, leaving the insured responsible for the remaining $410,000.

Defense costs are not only subject to the consent to settle provision, but also general policy provisions. Some (if not most) policies presented in this two-part miniseries include defense costs within the limits of coverage; but a few pay defense in addition to the limit of purchased liability. How the policy responds to defense cost in general will directly affect the way defense costs are handled in the hammer clause.

Hear the Hammer Ring

A full hammer may be less expensive than a modified hammer, but the damage it can cause following a loss makes the modified hammer, or some hybrid, a far better option. Knowing the purpose of these clauses and how they apply strengthen the agent/client relationship.

Providing insureds the best policy for the premium is the goal, or at least should be, of every agent. Knowing how the competing policies apply the consent to settle and hammer clause is an important consideration when comparing forms.