The insurance company determines that the cost of continued litigation may well exceed the cost of the settlement offer presented by the plaintiff. It recommends that the insured accept the offer. What if the insured prefers not to accept? Is that an option? Who pays the continuing legal costs? And where is this explained in the insurance policy?
What is a Hammer Clause?
A ‘Hammer Clause’ is an insurance policy provision which stipulates what happens when an insured does not consent to settle a claim, as recommended by their insurer.
Let’s back up here and explain what we mean:
- An insured is sued for an error they made that is covered by their insurance.
- After careful analysis of the allegations and a settlement offer from the plaintiff, the insurance company recommends the insured accepts the offer and settles.
- The insured disagrees with the recommendation. Now what happens??
This is where the hammer clause comes into place.
A hammer clause stipulates what happens when the insured does not consent to settle based on the insurer’s recommendation. Depending on the wording, if the insured doesn’t agree to a settlement they might be responsible for any defense and settlement costs going forward.
The Hammer Clause appears in policies such as Directors and Officers Liability (D&O), Employment Practices Liability (EPLI), Professional Liability, and Errors and Omissions (E&O), and is often found under the heading “Consent to Settle”.
Hammer clauses can vary greatly. Let’s go through an example to see how they work:
How does it work?
ABC Ltd hired Johnny to work at their company. A year into his tenure, Johnny committed a crime at work, and ABC terminated his employment. One month later, ABC Ltd received notice of a lawsuit filed against them by Johnny alleging wrongful termination. Johnny feels he’s been the victim of retaliation.
ABC Ltd notifies their insurance company of this claim, and under their EPLI policy the insurer starts funding the defense. As additional facts present themselves, the insurance company determines that the cost of continued litigation may well exceed the cost of the settlement offer presented by the plaintiff. ABC Ltd rejects the settlement. They argue the reason for terminating Johnny was based on the crime he committed.. ABC Ltd fears that by settling, they are admitting to wrongdoing and their reputation would suffer.
The ‘Hammer Clause’ provision in ABC Ltd’s EPLI policy stipulates how ABC will contribute to funding the defense if they choose to continue to defend rather than accepting the settlement the insurer recommended they take. That may mean they would have to shoulder all additional expenses going forward – both defense and settlement.
If their policy has what’s called a ‘soft hammer clause’, ABC Ltd could either accept the settlement as recommended by their insurer, or move forward with defending the lawsuit knowing they might have to absorb a portion of the costs.
In this situation, the Hammer Clause will set out in advance the percentage of defence costs each party is responsible for after the insurer recommends settling. For example, if the Hammer Clause stipulates 70/30, then the insurer would be responsible for paying 70% of defence costs while the insured would pay 30%. Again – this is only the case if the insured chooses to continue defending, despite the insurer recommending that they settle.